Profitability and Cash Flow: How Forecasting can Impact a Manufacturer’s Bottom Line

January 5, 2023

At a glance

  • Main takeaway: When you start to consider what is impacting your bottom line, especially in our rapidly changing environment, it’s important to focus on what is impacting both your business’s profitability and cash flow.
  • Impact on your business: As manufacturers, if you are not actively monitoring and measuring your inventory while anticipating demand, you could be putting your business at risk.
  • Next steps: Do you need help forecasting? Contact Aprio’s Transaction Advisory Services practice to learn how a 13-week cash flow model can keep your business on track.

Schedule a consultation with Aprio today.

The full story:

When we talk about what affects the bottom line, the focus tends to be on how we make money. While making money is a good goal, leveraging a 13-week cash flow model gives your company the ability to forecast, at a high-level, your short-term financial decisions and keep a pulse on your performance a quarter at a time. Furthermore, analyzing cash flow and the assets necessary to support that cash flow allows you to make investments and increase your cash or profitability on hand.

What does this mean? Let’s look at this quick example:

A growing business has money on paper, but when it comes time to distribute the cash, they do not have the funds. Where did all the cash go? The growing business has profitability on their income statement, however, the working capital needed to support the business — inventory, accounts receivables (AR) and accounts payable (AP) — is also growing. This results in all their profitability is getting sucked into their balance sheet and they have no cash on hand.

This example is a common thread for many businesses. When you start to think about what is impacting the bottom line, you need to consider what is impacting your profitability and your cash flow, or what is known as the cash conversion cycle. The cash conversion cycle helps businesses understand how long it takes to convert their inventory into cash flow. There are three basic components to the cash conversion cycle:

  • Days Sales Outstanding (DSO) measures how quickly, on average, your customers are paying their invoices. As we think about receivables, you must have an expectation of what your DSO should be based on the terms that you extend to your customers. However, we have been seeing some fluctuations to DSO due to the current economic environment.
  • Days Inventory Outstanding (DIO) measures how much inventory your company has on hand and what you need to meet demand. There are two elements to inventory that can help you get your total inventory value on your balance sheet — the number of units or products you have on hand and the cost per unit. Lately, we have seen both elements rise, which can create different challenges.
  • Days Payable Outstanding (DPO) measures how long you can stretch paying your vendors. During an inflationary environment, you need to make sure you are leveraging your vendors’ terms to the fullest.

Are you collecting payment within your terms?

As a result of our current economic environment — inflation and a potential recession — we are starting to see customers stretch payment causing AR aging to increase.

The first step in getting your DSO back inline is by ensuring you are collecting within your terms. This may mean you will need to review what processes you have in place or what new processes should be implemented to get you back within terms. The second step is to:

  • Review your AR aging on a weekly basis,
  • Have a collections plan in place and
  • Understand the cadence of your communications to customers.

Your DSO is impacted by the terms you extend to your customers. When you review your AR aging, realistically, it should be somewhere in the 45-day range because not everyone is going to pay within 30 days.

How much inventory do you need to support your business?

When talking about DIO, it is dependent on your supply chain lead time, particularly in the terms of your key SKUs and what products are moving. For the past two-to-three years, supply chain lead time and volatility increased causing many businesses to build up inventory to insulate them from the risk of being without product. Now, we have started to see a challenge as inventory levels have increased (deliberately) and customer demand has decreased causing many businesses to be stuck with an abundance of inventory. This is where you must regularly monitor and track your key SKUs. Every business should make an informed decision as it relates to how they can reduce DIO by measuring and asking:

  • Are my products moving as expected? If yes, keep doing what you are doing with demand forecasting.
  • If no, that’s when you start to have a problem and need to dig deeper and look at what type of inventory you have on hand. Is it perishable or nonperishable? Does it have elastic or inelastic demand? Does it have an elevated risk of shrinkage if it sits on the shelf too long?

If your DIO is increasing because your cost per unit is going up and you do not spot it soon enough, you will have a declining profitability sitting on your balance sheet. You want to be deliberate in your actions by forecasting demand, managing total inventory units to meet the demand and knowing your cost per unit which will then determine your sales price.

Are you using your vendor terms to the fullest?

There are some business owners who pride themselves on being debt-averse, meaning they pay their bills as they come in. While this works great for businesses who have a healthy cash cycle, however, times may be tighter for others. For example, in today’s inflationary environment, we are all shifting together so it’s important to revisit and make sure you:

  • Take full advantage of all your vendor terms. So, if you get 30 days, use the full 30 days.
  • Compare your terms with industry averages.

Forecast your future demand a quarter at a time

The greatest risk to a business is when you do not monitor and anticipate future needs. As macroeconomics create greater uncertainty, developing a 13-week cash flow model, an industry standard for a quarter, will help you forecast, so you can make data-driven and actionable decisions. The 13-week model has a two-step approach where you need to ask yourself:

  1. What do I sell and what money do I expect to make on my income statement?
  2. How does that income turn back into cash via my balance sheet?

Think of it as a cause-and-effect exercise — if I am monitoring, then I will know that if I make “X” actions, then my DIO should go up, or if I make “Y” actions, then my DIO should go down. A 13-week cash flow model will help you think about what you can sell, what you need to have on hand to sell it and how long it is going to take those customers to pay you after you sold it.

The bottom line

We live in rapidly changing times, and without a crystal ball, it’s crucial to monitor your inventory if you hope to accurately anticipate future demand. While making a sale is great, your production needs to be driven by sales forecasting and your ordering needs to be driven by your vendor lead time, otherwise you will be putting your business at risk. Aprio’s Transaction Advisory Services practice can develop a 13-week cash flow model unique to your manufacturing business to help you monitor and measure to keep your business on track.

Schedule a consultation with Aprio today.