Whenever there is shortage of cash everyone can be heard screaming “we have a cash flow issue!”. However that may not always be the case. Quite often a cash flow can be a profitability issue. You may ask how? Let’s start by looking at each one individually.
Cash flow issues
Cash flow issues are caused when the capital (including retained profits) of the firm are tied up in the working capital. The key working capital items in the professional services game are the recoverable Work in Progress (WIP) balances that have not yet been billed and the billed amounts that clients have not yet paid. They can also occur when firm capital is invested in assets without being appropriately financed to ensure a smooth cash flow impact. In these instances the profitability of the firm is recorded accurately and is sufficient to cover the drawings of the partners. Therefore the shortage of cash flow stems from the working capital and investment in assets.
On the flip side the shortage of cash can be a profitability issue. This is where the profits of the firm are not sufficient to cover the drawings of the partners. Sometimes this can be easily determined by looking at the firm’s Profit and Loss which shows that the firm profit is less than the drawings of the partners. However in other cases the profit levels of the firm reported in the Profit and Loss are incorrectly reported at levels in excess of the partners drawings. So what could potentially cause the masking of this profitability issue? The two major ones are WIP and debtor balances that are not recoverable. Both of these balances if over inflated will incorrectly drive up profits and then mislead the partners to believe that there are sufficient levels of profit to support a certain level of drawings.
Here are some common examples of the underlying causes to cash flow and profitability issues for firms.
- Fixed price quote too early
In the eagerness to secure a new project and/or new client a fixed price is agreed with the client before you have the opportunity to fully scope out the intricacies of the project and assess realistic contingencies for issues that may occur. This can lead to non-recoverable time being spent which impacts on profitability.
- Fixed price scope creep
The project/client work is fully scoped and all issues are considered to be adequately built into the fixed price agreement. However as the work for the client rolls outs you don’t stick your guns about what is and is not included in the scope of the fixed agreement. The client is allowed to get away with broadening the scope and non-recoverable time is spent impacting profitability.
- Taking on the wrong client
You know that feeling, the uneasiness you get when talking to a potential new client. You’re not able to exactly put your finger on it but there is a sense that all is not quite right. However it is an exciting opportunity and should increase the profile f the firm. Then, down the track as the work progresses issues arise, client issues. The client is unreasonable in their expectations and communication. Your team get upset, the client gets upset, time is wasted and bills are not paid.
- Compromising standard payment terms
The firm has policies in place for all clients on payments. However it is a great project, unbelievable opportunity and the client is asking upfront for some deferred payment terms. It may be payment on the contingency of an occurrence such as completion of a transaction, or on finance being achieved, or a new investor coming in. All of these invariably get delayed and push what were already extended payment terms to be even longer, putting the squeeze on cash flow.
- Avoiding the hard conversation
How often has the finance/administration team gone to a partner/client manager to discuss a client who is late paying their fees. Then instead of picking up the phone to talk the client the partner/client manager, in the hopes of keeping the client happy, gives them a little longer to pay. This delays the difficult conversation with the client until things inevitably turn pear shape causing the firm to wait or lose out altogether.
For assistance in identifying and addressing cash flow issues within your professional services practice speak to your usual Hanrick Curran advisor or alternatively contact Tim Taylor on Nathanael Lee on 07 3218 3900.
Please note that this publication is intended to provide a general summary and should not be relied upon as a substitute for personal advice.