The Top 3 Areas Causing Cash Flow Issues: Old A/R, Too Much Inventory, and Poor Spending Decisions

The Boss asked me to help him understand his financials better. I asked what his main issue was, and he stated that he thought the profits were too low. We had developed a budget earlier in the year and he was comparing the actual financial reports to the budget. We knew the budget was not perfect as it was our first budget we wrote together and the first budget The Boss had ever written for his company.

After reviewing the profit and loss, The Boss pointed out the net income was running behind budget for the YTD. We began to discuss what could be causing this effect on the P&L. I had The Boss initiate a job costing SOP and The Boss said he had been doing this religiously with good results. So why was the profit not showing up on the financial statements? After calculating some percentages, we could estimate what the dollars should be for the cost of goods sold (COGS) and overhead. We reviewed the balance sheet and calculated purchases versus the COGS on the P&L. Here we found the beginning of the problem Purchases versus COGS according to GAAP.

I explained this as simply as I could using a grocery store example. I often try to use examples that anyone in the organization can relate to so The Boss can use the same example to train his staff. The store orders a case of 12 cans of soup in October and pays for the case in October. 10 cans of soup sell in October and 2 cans are left to be sold in November. The cost of goods sold for October should only reflect what was sold in October, not the full case that was purchased. The 2 unsold cans should be entered into inventory to be sold later. This is known as the “Matching Principle” in accounting.

What was happening in The Boss’ company was: the purchasing agent would buy products either to get a volume discount or, in the post-COVID year when the supply chain was unpredictable, the purchasing agent would buy products when he could get them to make sure materials were available when the company needed them. This might have been good for production but was not good for cash flow. The Boss had to use his LOC and may have to dip into his own pocket to fund the increase in inventory as it caused a cash flow crunch. Even worse, it caused the profit and loss statement to show a much higher COGS and a lower net income. In our example, the month of October would show a much lower net income; In November when the remaining product was sold, the net income would be much higher because the entire COGS for the case of soup was included in October, with no cost in November. This is what was happening on a much larger scale in The Boss’s company. By ignoring the Matching Principle, The Boss was causing himself much undo stress and anxiety and could eventually cause his banker to lose trust in the accuracy of his financial statements.

The correction was to lower the inventory and account for the new inventory correctly using a Work-In-Progress Report (WIIP Report) and turning that “Frozen Cash;” sitting in inventory into a more liquid cash flow to be used to fund operations. A more accurate P&L helps everyone’s stress levels. The Boss said, “This is why my account was always asking for a more accurate inventory!” The purchasing agent had such a hard time supplying the company with needed parts during the supply chain issues of late, when materials came available, he ordered in greater amounts. He was trying to do the right thing to secure the product but was unaware of the cash flow issues this was causing the company. This was an easy fix once the problem was exposed. It was a good thing The Boss was reviewing his financial statements monthly. We only had to look back 30 days to find the problem.