Businesses are often faced with the dilemma of whether to push revenues or emphasize strong cash flows and liquidity. It is a costly misconception that increased revenues always translate immediately into increased cash flows and liquidity. They are however of course not mutually exclusive, otherwise there would be no point in trying to grow a business. Translating increased revenues into increased cash flows requires the right customers, operating efficiency, as well as the appropriate credit and credit management policies. Business growth must be balanced with cash flow and liquidity considerations for the long term success of the business enterprise.
Acknowledging the importance of cash flows and liquidity to the survival of a business means managing its growth taking cognisance of working capital and cash cycles, ensuring that cash flows are not stifled by uncontrolled growth, the emphasis being on the word ‘uncontrolled.’ It is however exciting to see revenue figures rise … it signifies success in terms of customer and sales expansion, product or service acceptability, increasing brand acceptance and recognition, and a future for the company or enterprise.
New companies, particularly small and medium sized enterprises (SMEs), must be particularly careful in managing growth vis a vis liquidity because they do not have the cash cushion or track record (to access emergency funds) that may buy them the time/opportunity to change their business trajectory and recover. Business growth must be deliberately managed otherwise it will lead to business death, not because the idea/products were wrong, but simply from poor management policies and practices. In effect, cash flows and liquidity should not be sacrificed on the altar of rapid, frenzied growth.
But what is the difference between revenues and profits versus cash flows and liquidity? Revenues refer to sales, and increased sales means increased profits as long as costs or expenses are well managed … these are usually paper profits. Profits from increased revenues remain book/paper profits until sales have been collected in cash. This means that credit sales which sometimes represent the bulk of increased revenues, may not translate into an increase in real profits and improved cash flows or real liquidity. And therein lies the key to the difference. Strong cash flows and real liquidity mean there are available funds to settle obligations as they arise, whereas increased revenues and profits do not necessarily result in that outcome. Credit and credit management/collection policies must therefore be well articulated and adhered to, to ensure that increased revenues do result in increased cash flows and improved liquidity through increased profits. A business must have good customers who meet their obligations to the business when they fall due. We reiterate therefore that customer quality and appropriate credit considerations are important factors for real and lasting business growth reflected by increased revenues and profits. Only then can increased revenues and profits translate directly into stronger cash flows and liquidity (assuming other efficiencies in the system).
Businesses often use easy credit terms to promote sales. This is sometimes counterproductive in terms of cash flows and liquidity because they increase credit sales but don’t always become cash, or may take too long to turn to cash. Poor cash flows can also lead to increased finance costs from borrowing, reducing profits and eating further into cash flows, and worsening liquidity … a ripple effect. Without reasonable cash flows and liquidity, a business cannot succeed and thrive. It may be suffocated by its own growth.
A successful business must therefore maintain a balance between its desire to grow, the speed and timing of that growth, and its ability to finance its growth activities… strong cash flows and real liquidity are required to fuel growth.
Note: Different businesses/industries have what are considered to be the optimal liquidity measures for their efficient functioning, but that is not the subject of this article. The challenge with liquidity measures is that current assets include receivables due from customers and they may not all prove collectible. Realistically therefore, in calculating liquidity it may be best to use discounted receivables.