Finance expert Peter Cox explains the important role cash plays in the overall financial picture of a business.
Pest controllers are quasi retailers so let us get rid of the myth that for some extraordinary reason pest controllers are not. Why? You have product you are selling, not from a shopfront but over the phone. In fact, from a liquidity point of view, the generation of cash in this industry is a lot harder than other businesses operators in your town and district. I will explain why later in this article.
Cash is king in business and the cash crisis that lead to the collapse of Dick Smith’s shows what can go wrong when businesses allow inventory levels to explode and working capital (that is current assets, less current liabilities) gets out of control.
A good measure to check your liquidity position in a pest control operation is the cash cycle.
There are three parts to the cash cycle calculation:
Cash cycle = Days stock on hand + days debtors outstanding + days creditors outstanding.
The financials
Let’s consider the following case study of a pest management business.
|
Sales |
2014 |
2015 |
|
Sales |
500,000 |
550,000 |
|
Purchases of inventory |
30,000 |
40,000 |
|
Average Inventory |
10,000 |
15,000 |
|
Cost of sales |
100,000 |
110,000 |
|
Average debtors |
65,000 |
80,000 |
|
Average creditors |
5,000 |
6,000 |
The calculations
Stockturn = Annual cost of sales / Average stock on hand.
The table below outlines the stock for a pest control business (which is the product in the store for use in upcoming pest control jobs).
|
Stockturn |
2014 |
2015 |
|
Cost of sales |
100,000 |
110,000 |
|
Average stock |
10,000 |
15,000 |
|
Result |
10x per year |
7.3x per year |
Component of the cash cycle #1
Days of stock on hand = Days in the year / Stockturn.
|
Days stock on hand |
2014 |
2015 |
|
365 days in the year |
365 |
365 |
|
Stockturn |
10x per year |
7.3x per year |
|
Result |
37 days |
50 days |
Component of the cash cycle #2
Days debtor outstanding = Average debtors (amount owed to business) divided by (Annual account sales x 365 (days)).
Account sales are all sales where you do not receive payment on delivery of services. In this case study we will assume 90% of total sales are on account.
|
Days debtor outstanding |
2014 |
2015 |
|
Average debtors |
65,000 |
80,000 |
|
Annual account sales |
450,000 |
495,000 |
|
Result |
52 days |
59 days |
Component of the cash cycle #3
Days creditor outstanding = Average creditors (amount owed to suppliers) divided by (Purchases x 365 (days))
|
Days debtor outstanding |
2014 |
2015 |
|
Average creditors |
5,000 |
6,000 |
|
Annual purchases |
30,000 |
40,000 |
|
Result |
61 days |
55 days |
So the cash cycle for this pest management operation is:
|
2014 |
2015 |
|
|
Days inventory on hand |
37 days |
50 days |
|
Plus |
||
|
Days debtor outstanding |
52 days |
59 days |
|
= Operational cycle |
89 days |
109 days |
|
Less |
||
|
Days creditor outstanding |
61 days |
55 days |
|
= Cash cycle |
28 days |
54 days |
So in 12 months, the case study pest management operation cash cycle has deteriorated by nearly double the amount of days, despite the fact the revenues are increasing.
For me, the cash cycle is the best indication of the underlying health of a pest management business; it shows how well the management is managing the cash flow on a day-by-day basis.
For a pest management operation I aim for a cash cycle of less than 40 days.
Obviously on my rule of thumb this case study operation has problems. An accountant can always tell you where the problems are (and I am one) based on past results, but a good business advisor and or owner/manager will have the strategies to improve the situation into the future.
Pest management operators get into trouble because they run out of cash. There have been many corporate and privately owned companies, even in this industry who have reported profits yet have a cash flow problem and that is because they have a working capital issue.
If you do not manage the problem (which will be the subject of my article in the next issue) the business will have a liquidity issue and in particular we can all be thankful of the low interest rates at present.
Businesses that are making sales and profit probably think that everything is all right. Indeed the reporting press and the press releases put out by the PR firms for public companies concentrate on these two elements when reporting results. However, if these sales and profits are not being converted to cash then any business may well need to borrow to pay suppliers and pay overheads and that’s when they get into trouble.
Working capital is not linked directly to profitability, just ask Dick Smith’s.
Remember ‘cash is king’.
Peter Cox, Director, Peter M Cox & Associates
