Why is it vital for businesses to understand their liquidities?
Liquidities are a remarkably simple concept yet can become an extremely complex problem management tool for business owners. Let me give you a basic definition of what I exactly mean by “liquidities”: it is the amount of cash that a business has. To better understand this concept, I will narrate a story. As you will see, I will touch the following concepts (in order): note receivables, the difference between revenues and sales, cash-burn rate, toxic debt, convertible loan, note payable, and finally, financial strategy.
Once upon a time, in the small town of Hyoshi in the province of Yokohama, an old fisherman named Hiro had a tiny shop where he sold fresh vegetables and fish. The shop was perfectly situated at the intersection of two large roads, one used by the fishermen to go from the sea to the city, and the other by farmers that had to transport their products to the city. Hiro had left the sea decades ago to dedicate himself to his newly opened business and making it profitable. After years of managing his shop, Hiro had seen it all, from the crisis to the gold era, and the time seemed right to retire so he could spend more moments at the tea shop with his friends. Being very family-orientated, he wanted to offer the shop to his grandson Yuko who always had a keen interest in how his grandfather ran the shop. After months of training working together, Yuko had to face his first test: running the shop alone for an entire month without Hiro’s help. The challenge was exciting to Yuko; he really wanted to show his grandfather that he was capable and would do anything to impress him. A month later, Hiro returned to the shop, and they looked at the business’s financials. Yuko was euphoric: his sales doubled the ones his grandfather had the previous year (year on year comparison). Hiro was happy as well: seeing his grandson succeed was his greatest wish! But the more they dig into the numbers, the more Hiro’s smile disappeared. At one point, he stood up and went to check the cashier machine: it was empty.
Hiro: What happened with the money you made?
Yuko: I implemented a new selling strategy grandpa! You see, I realized people were sometimes ready to purchase more products, but they did not have enough money to pay for it on the spot. So I sold them all these products in exchange for notes where they have until the end of the month to pay me! It worked so well that I banned everybody from paying with cash to keep incentivizing people to purchase at our shop! Tomorrow is the 31st, and all the money will be back, don’t worry about it, it’s called marketing grandpa! Also, think about it: I doubled the revenues for last month.
Hiro: it’s not really marketing Yuko, it’s accounting. Your customers bought your products with an extended deadline for payment, and we usually call this a note receivable. And don’t misunderstand something Yuko, you have not made double the revenue of the previous month, you doubled the sales. Sales and revenues are not the same. Sales is the total amount of all the products sold in a given month. Revenues is the amount you receive. In a perfect world, they always coincide, but in the real world, sometimes they can be different. Let’s wait tomorrow and see what happens.
In Hiro’s experience, this was an awful sign. If the cash did not arrive tomorrow, Yuko will not have enough money to pay his fish suppliers for the month and will not be able to order any new fish to put the business on hold.
The next day arrived, and one-third of the people came-in to pay Yuko in cash. This was terrible; Yuko had barely enough money to cover the shop’s monthly rent and pay his vegetable suppliers. What Hiro had feared happened: there is not enough cash to pay the fish suppliers, which could be devastating. Yuko was crushed and could not believe his eyes, two-third of the people had not paid him back his money:
Yuko: how is this possible grandpa? Why would they do this to me? They all promised me that they would pay!
Hiro: You see Yuko, this is the first lesson you should learn about running a business: understanding your liquidities is extremely important. First, what is your monthly cash burn rate?
Yuko: My monthly cash burn rate? What is this?
Hiro: This is the amount of cash that you need to spend in a month to have your business up and running.
Yuko: Well, let’s see… Every month I must pay rent for the shop, electricity, water for the fish, our suppliers of fish and vegetables and this is it, I think. Oh, and I must pay myself a salary, of course!
Hiro: This is right, Yuko. Now, how will you cover all these costs if you let everyone come in and buy at credit on the premise that they will pay you later?
Yuko: Well, it was not supposed to end like this… It’s not me, it’s them! People can’t be trusted!!
Hiro: No, Yuko, your customers are not the issue here. Delays in payment can happen; it is not a problem. The problem comes from you: you should know your costs and make sure to have enough cash to pay them at the end of each month! Good business owners know how to manage their liquidities.
Yuko: Ok, I understand… But all those note receivables are still worth money, right? So it’s just a matter of time before we receive our payment and move on, right?
Hiro: Theoretically, yes. But what happens if people do not pay? Sometimes, some receivable notes are not paid because their holders cannot pay them; it is a reality of owning a business. When this happens, you must register them in your books as an expense on your side; it is what we call: “bad debt”.
Yuko: Bad debt? What is it?
Hiro: Bad debt is an expense that the shop faces and that it will not recover. You gave away some merchandise against a promise of payment. Unfortunately, this promise of payment — note receivable — was never fulfilled, which means that you just lost twice money: the merchandise and the money owed for this merchandise! But we will talk another day more in-depth about bad debt, now is not the moment.
Yuko: I’m sorry, grandpa, I didn’t know about all this. So, what should we do now?
Hiro: Well, we have a few options. The first one could be going to see the bank and ask them for a loan; this would be taking on debt. But it will come with interest to be repaid which would be a cost to us. The second option could go to see your very wealthy uncle Jon and ask him to either invest in our business and become an owner of the shop with us or ask him to lend us some money as a loan. What do you think?
Yuko: I love uncle Jon, let’s ask him to lend us some money! Plus, it is the only solution that is free!
Hiro: Wrong Yuko, it would not be free! Jon might be your uncle, but he is a very tough negotiator. We would have to put some equity of the shop on the line as a guarantee if we cannot repay him. This is called a convertible loan.
Yuko: Oh, no… I thought this would only be my shop after you gave it to me… Isn’t there any other option? I can cut my salary for this month and beg the fishermen to accept a delayed payment, and I will even give them more money if they wait!!!
Hiro: This is a good idea that you have here Yuko. As an entrepreneur, times can sometimes be rough, and you must make some sacrifices to make ends meet, even sometimes your salary. Let’s talk to our fish suppliers as well. You see, when you run a business, it is imperative to have strong relationships with your suppliers. Like that, if you ever have a problem of cash and cannot pay them right away, they can issue you a note, exactly like you did with your customers, but this would be a note payable since you will not receive any money, but pay it.
Yuko: But do you think they will accept?
Hiro: I used to work with our fish suppliers, there will be no problem with this; however, they will not be happy. But before we move on Yuko, tell me what is the lesson you’ve learned here.
Yuko: Well, it’s simple grandpa, I’ve learned that running a business is not only about making your customers happy or selling a lot… It is about making both your customers and your suppliers happy. And to do this, you need to have a secure grip on your liquidities to understand the cash that you have in your hands at the end of each month.
Hiro: Mmmmmh… didn’t you forget someone in your reasoning?
Yuko: I don’t understand? Who could that be?
Hiro: What about yourself? You see Yuko, you are the only employee of this shop, and you will not receive your salary on time this month: this will put you in trouble to live in the first days of the month. Does that make you happy? I don’t think so. If you have employees, you will have to make them happy as well.
Yuko: True grandpa, I forgot about this… Well, that’s it then: customers, suppliers, and employees!
Hiro: What about me now? This is also my business, and I have to inject more cash as an investment in the shop because you mismanaged your liquidities. As an investor, I am not happy at all!
Yuko: I’m so sorry, grandpa, I had not realized. Managing a business is tough; there is a lot to learn, and liquidities are much more complicated than I thought. At the end of the day, everyone must be happy: customers, suppliers, employees, and investors and all this through liquidities. So this means that I cannot accept note receivables anymore. No more credits for anybody. Yuko is done with this. Only cash.
Hiro: No Yuko, you misunderstood liquidities. It is ok to have some note receivables from the right customers. But this means that you will need enough cash to cover up for them or some note payables that will offset your receivables, do you understand?
Yuko: I understand, so it is better to have lower sales but enough liquidities than higher sales and no liquidities at all, is that right?
Hiro: Not necessarily Yuko. You see, handling a business’s finances is a very subjective topic, there is never a right or wrong answer. Some business owners privilege growth over stability and want as many sales as possible to grow their clientele and expand rapidly. If they don’t have enough liquidities, they will ask for external funds somewhere, the bank or investors. On the other hand, the vision for this shop is to stay in the family for decades to come, which means that we must be the sole owners. To do so, we need to have a firm grip on liquidities and pay our bills at the end of the month. As soon as you have received enough cash during a month to cover your burn rate, you could take some risk to boost your sales and accept note receivables. Also, negotiating with your suppliers for some more time to pay and undertaking note payables would be great: in case of liquidity problems, we would have more time to pay our suppliers.
Yuko: So all small shop owners prefer stability over rapid growth if I understand well?
Hiro: Again, you are trying to make a general rule out of something extremely subjective. Each shop has a different financial strategy, and there is no right or wrong path to liquidities. The most important lesson here is that a good shop owner understands the implications of his financial strategy and controls his liquidities. That way, he will always be a step ahead before he needs to talk to his suppliers, customers, investors, or the bank.
Did you get the point of this story? Liquidities are an essential part of owning a business. There is no right or wrong solution for managing them as long as you don’t run out of cash at the end of the month to pay your engagements (be it your rent, your suppliers, your bills, etc.). But liquidities go far beyond “paying your bills”. Indirectly, — and from a stretched philosophical perspective, I must admit — it reflects your company’s financial strategy. It can tell whether you are a risk-taker (Yuko) or are more risk-averse (Hiro). It also indicates your business goal: do you want to achieve financial stability and have a prosperous business with a financial safety net, or do you want to grow as fast as possible with the risk of exploding while striving? Family-owned businesses and more traditional businesses would tend to go for financial stability. Startups, on the other hand, go for the second one: exponential growth.
The beauty of a technological startup is the exponential growth it can achieve in a short manner of time. The risk is that the company mismanages its liquidities and explodes while growing because it will not be able to match both ends between the cash injected in the company and the cash outflows. Too often, startups that had high sales during a month believe their growth will continue at the same pace and will hire too many people to sustain this growth. This increases their monthly cash burn rate and puts additional pressure on their liquidities. It is risky because if the extension is not sustained, the company will find itself short on cash and need to raise additional capital to inject more liquidities to keep moving. However, cash is not easy to find, and if a business doesn’t find it on time, it is the end, game over.
In this story, we touched many different concepts: from basic working capital items (note receivables, note payables) to financial statement notions (the difference between sales and revenues, bad debt) to more financial planning and funding (cash-burn rate, convertible loan, and financial strategy). Yet one doesn’t need to be an expert in mastering all these notions perfectly to understand the idea of liquidities: make sure you have enough cash in your hands to make have your business up and running. Plus, as we’ve seen with Yuko and Hiro, there is no secret to managing liquidities, is there? It is all about planning.