I recently got to work with a small manufacturer who had a multi-week work-in-progress period. This small business was using quickbooks but growing quickly and so often managing more by the level of cash in the bank account than by budget. While I was working with them, the business got the hang of looking at their COGS and their variable costs vs fixed costs and more of an accrual style of reporting. They also shifted to more of a product distribution model which meant longer receivable delays and more planning. I realized that with that supposed “improvement” of business maturity there was a possible loss: that of deliberately funding the increase of inventory to support sales growth.
When operating on more of a cash basis, this business had to use current sales to cover the cost of future growth, because they had to buy inventory this month, and do labor this month, for product that would not be ready until next month (or later). They had started out with a direct-to-consumer model and so sales were entirely cash in the beginning. Since anticipated future sales were higher, they had to figure out how to create that product with the cash they had on hand, because inventory providers were unwilling to provide credit for such a small startup. As they grew as a business and we focused on looking at accrual accounting, it becomes apparent why separately tracking cashflow is so important – because in an accrual presentation, the cash needed to fund the higher investment for higher future sales becomes invisible, each month looks like it can cover itself.
I once had an angel fund investment go south and what we heard back was that somehow in the transition from cash to accrual accounting they had come up a significant amount of money short (maybe 1/3 of the round they had just raised). A funder stepped in a provided it, but at sufficiently punitive terms that our investment became pretty insignificant. The CEO and CFO were replaced, of course, but I had always wondered how that could possibly happen. Now it makes sense to me, that if they had done their financial modeling on an accrual basis and not attended to cashflow, they could have raised a bunch of money for growth and missed how much inventory they’d have to build to support that growth and how far ahead of sales they’d need the cash. It’s also possible that they underestimated how long their cash-conversion-cycle would be: that route from dollar invested in inputs, created into goods, shipped to distributors, sold to customer, and then easily 90 days from shipped-to-distributor until finally returned-to-company.
Another angel I know invested in a homey wood-toy company who got caught by that: the homey wood toys were manufactured in China and required a 6 week boat ride to get to US distribution. Growing sales required also growing an even bigger cycle of toys in the manufacturing/distribution pipeline.
Net: although accrual style accounting is standard for a mature company, you lose important information if you don’t still also do a cash accounting.