A new company may find itself profitable but “cash poor” for the following two r

Question

A new company may find itself profitable but “cash poor” for the following two reasons: 1) Immediate payables but delayed receipts. 2) Increasingly larger orders or perhaps one significantly large order. In the first case a company may be making profitable sales, but the receipts for those sales might not be coming in on time to meet or pay for expenses. Payroll expenses are immediate. Loan payments are on a schedule and must be made on time. A new company is still generally forming its relationship with suppliers and strives to make those payments quickly. On the other hand, a growing new firm might find that its new customers make their payments, but they are often delayed. In fact, the new company may make sales expecting payment in 30, 60, or even 90 days and include that in a sales contract. Thus, the cash coming in is delayed enough that even though the company appears profitable, it does not have the cash to pay its immediate debts. In the second case, a company may find itself with a very profitable, but unusually large order and may not have the cash, supplies, or facilities to meet the order on time. In this discussion, you are to: Further analyze (speculate or anticipate) what might lead to each of these situations. Discuss if these situations are limited to only new companies. Come up with ideas that could possibly overcome these two cash flow issues. As an engineer, come up with ideas to help management in these situations.

Explanation / Answer

The situations with regards to cash flow problems can occur due to other conditions and factors like high amount of overhead expenses, slow paying invoices, excess inventory, and overuse of debt and low levels of gross margins. High overhead expenses like rent expenses, cost of utilities, etc. hurts a business’s cash flow. Secondly slow paying invoices mean that many businesses have to offer lenient credit terms to its clients and customers so as to increase business from them. Thirdly many organizations carry or have to carry excess inventory. This ties up cash flow as inventories are not quick assets. Fourthly too much of debt will require servicing in the forms of interest and this can lead to cash flow problems.

No the situations that I have discussed above is not limited to new companies. Some of the factors and conditions are applicable to old and established companies as well. For instance in many industries (like capital goods sector for example or real estate sector for example) old and established companies also have high amount of debt. High leverage is the norm for companies in certain industries. As such in case of any cash inflow delay or imbalance the old and established companies will also face a cash flow problem.

The ideas to overcome the problem of immediate payables but delayed receipts are to start giving an incentive to customers to pay faster. For instance the company can offer a 2% extra discount to customers who pay within 10 days from the date of invoice. This will lead to the company being able to collect its receivables much quicker. The second problem or issue is that of increasingly large orders or one single large order. This causes the problem of cash being tied up as working capital and the problem can be solved by making use of a facility called purchase order financing.

As an engineer I would recommend the management to make use of financial engineering models to better manage their cash flow positions. Cash flow exposures of a company can be transformed by making use of derivative instruments and financially engineered contracts.

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