Growth eats cash. There are lots of stories about profitable businesses that went under due to lack of cash.
As one of my business coaches says, "You can't spend profits, you can only spend cash." What he means by this is that when using accrual-based accounting, you typically recognize revenue before you receive the payment. At Blue Fish, we recognize revenue when we invoice our clients, but they pay us 30-90 days later. So while your books may show a profit, you may not have the cash to pay your bills on any given day. And if you can't pay your bills, you go under. The reverse is also true, by the way - we lost a lot of money last year but were able to weather the storm because we had a lot of cash in the bank.
While any company can have this issue, Growth exacerbates the problem. Here's why:
Assume you run a web-based business where users pay you by the month. You're growing fast, and your current servers can't handle the traffic. You need to buy a new server today, and you decide to buy a big one that can handle 10,000 new users. The server will pay for itself once you reach 5,000 new users. If you don't buy the new server, you won't grow your business because performance on your current server is holding you back. So you need to buy this server in order to grow.
The problem is that you don't have 10,000 new users yet, you only have a couple of hundred, and they aren't enough to pay for the server. But without the new server, you'll never grow to 10,000. It's the classic chicken-and-egg problem. So in order to grow, you have to spend cash. That cash can come from one of 3 places:
- Cash generated from operating profits
The art of "cash management" is using these three sources to the best result.
My business has been profitable since inception, and I used to buy everything with the cash my operations generated. At some point, I learned that this is BAD cash management, because I was using a very liquid asset (cash) to buy an illiquid asset (a server that I'll use over 5 years). This never got me in trouble, because I wasn't growing very quickly. But about 5 years ago, we started really growing (we were the 10th fastest growing company in Austin).
- a lot more servers to buy (that wouldn't be fully utilized right away)
- bigger office space to lease (that wouldn't be filled right away)
- more developers to hire (who wouldn't release products right away)
- and more sales people to hire (who wouldn't fill their pipeline right away).
If I pay cash for each of these things, I'll run out of cash because my business can't generate it fast enough.
So the short course on cash management is to use the appropriate kind of liability to acquire your assets. I learned that it's OK to get a loan to buy something, even when you have enough cash to buy it outright. Even though you are paying interest, it leaves your cash in the bank where you might need it later. So now, I buy equipment through a leasing company that spreads out my payments over 5 years. And I have a line of credit at the bank that I can draw on if I need to cover a short term cash-flow hiccup.
And I keep at least 3 months expenses (not just payroll) in the bank at all times, which means I need to anticipate my expenses over the coming months, and I need to be mindful when I make decisions about when and how much to pay myself.
Here's a similar question about cash reserve guidelines: http://answers.onstartups.com/questions/2388/cash-reserves-guidelines/2406