If you ask most high schoolers what it means to be rich, the answer will likely translate to “make a large salary”. Growing up I still remember the heyday of Mike Tyson, when as a pro boxer he was bringing in a $20 million purse per fight.
Fast-forward to 2003, and Mike Tyson is declaring for bankruptcy. The prize fighter that accrued over $300M in his boxing career is now broke. What happened? Iron Mike basically ran into a cash flow problem.
Mansions, exotic pets, divorces, and owning over 100 cars can cost a lot of money. Over the years, Mike Tyson put his $300M to many, many uses. When the record-breaking fight purses stopped, lifestyle changes clearly did not accompany that. As a result, the outflow of cash from Tyson’s estate outpaced the inflow of cash and finally left him destitute.
The example of Mike Tyson can also be clarifying when it comes to thinking about a business’ cash flow. As we can imagine, the story doesn’t end when the business records an eye-popping amount of revenue – in many ways that is only the beginning of the story.
When the company records revenue, a large part of it is earmarked for the payment of bills, existing projects and loan repayment. Depending on how many prior obligations you as entrepreneur have assumed, an awesome month of revenue may end up falling short of what you need to stay in business. There is also the issue of timing: it can take days or weeks for your recorded to revenue to appear as actual cash in your bank account.
There are two things to manage when it comes to cash flow: cash outflows (money that leaves the business in the form of expenses), and cash inflows (cash sales, investments, and accounts receivables).
Your expenses and short-term liabilities can be controlled through discipline and diligent record keeping. This is one way to keep your company from going broke: be mindful of your cash outflows and take proactive steps to ensure they do not surpass cash inflows.
Somewhat less controllable is the collection of accounts receivable. Not all customers pay their bills, and many who do don’t pay in a timely manner. This is more than an inconvenience: a business may find itself facing bankruptcy if a certain number of checks do not show up when expected.
Rogers recommends two ways that cash-strapped companies can pull themselves out of a cash flow problem: keep accounts receivables low (collect them in a timely manner, in other words), and lower inventory levels. The collection of receivables means the business has more cash on-hand, and lower inventory means fewer expenses during the rough patch.
Like many things in life, what you don’t know can hurt you. If you do not have a clear idea of the costs it takes to deliver your service or product, the line between solvency and insolvency cannot really be known. This is where the ride ends for many businesses (29% of startups, to be exact).
The good news is that by becoming aware of this major pitfall, you can begin planning to avoid it.