Managing Cash Flow Mismatches – A SMEs Perspective
Cash flow mismatches occur when there is a disparity between the timing of cash inflows from sales activities and cash outflows from settlement of liabilities within an organization. In simpler terms, it is when the rate of cash inflow does not equate or lower to the rate of cash outflow. The greater the shortfall disparity between the cash inflows and the cash outflows, the higher the risk that the business may not be able to fulfil its recurring expenses, meeting unexpected expenses or embarking into capital expansion on a timely manner. Cash flow mismatches can be either short term in nature as a result of temporary economic distortion that would eventually normalize by market forces in the immediate term or something that is more permanent in nature, largely due to structural weaknesses in the business itself, perhaps as a result of incompetent management or nature of business.
Generally, cash flow mismatches affect all businesses, regardless of their size. Although it is a common problem facing business, it must not be left untreated, especially when the issue arose out of structural weaknesses of the business. This article emphasizes on cash flow mismatches of SMEs mainly due to their limited accessibility to ad-hoc short-term loans or additional capital to counter the mismatches as opposed to larger businesses that generally have credit abundance. For SMEs, successfully managing cash flow mismatches is crucial for its survival, therefore, understanding this financial concept is important. Failure to manage this issue can lead to difficulties in meeting monthly statutory obligations and other obligations such as salaries, EPF & SOCSO contributions, taxes, premise rental, stock purchases and other monthly operating expenses responsible in making the business afloat.
To gain better understanding on the concept of cash flow mismatches, we provide an example based on actual event in Malaysia as below. Company A had been operating for more than 10 years before its operation was sold to a Public Listed Company in year 2023. The company experienced cash flow mismatches during early part of its operation as described in the example below.
Example – Actual Event.
Company A, a sole proprietorship was incorporated in the year 2010 with an initial capital of RM100,000. The objective of the company was to undertake the role of an importer cum distributor of medical thermometers and blood pressure monitors imported from overseas for the consumer market in Malaysia. To reach the end consumer market, Company A adopted a B2B (Business to Business) business model by cooperating with retailers in Malaysia.
Company A had a series of discussions with prospective retailers to allow for the initial entry of the devices in Malaysia. The retailers had requested an average margin of 30% on the recommended retail price with a 30-day credit period on a consignment basis. Further, the retailers had also requested that Company A contribute advertising allocation, provide sales promoters, and absorb listing fees. After extending the 30% margin to the retailers, commonly known as “retailers’ margin,” Company A retained an “importer margin” of 35% on the cost price as profit. The retailers hesitate to offer outright purchase terms because the medical devices that Company A was distributing were relatively new in Malaysia, with no historical sales track record and almost no brand awareness presence at that time. In desperation to launch the medical products in Malaysia, Company A had no other option but to agree to the one-sided terms and conditions as demanded by the retailers. To fulfil the supply obligations, Company A had bought stocks based on the “minimum order quantity” (MOQ) imposed by the overseas supplier at a CIF value of RM80,000 and delivered 90% of said value to the retailers; the remaining 10% was retained by Company A as an allowance for any urgent request from the market. This left Company A with the remaining capital of RM20,000 to act as a buffer to cover daily operating expenses that may be incurred.
After the delivery of the initial order to the retailers, Company A was informed by the retailers that the average take-up rate of the stocks at the retail stores was only 10% per month, making it relatively lower than what was predicted by Company A. Company A was expecting an average take-up rate of at least 30% per month to allow for sufficient cash inflows to cover the rising monthly operating expenses of marketing and advertising, promoter salaries, and other fixed costs. Based on a 10% retail take-up rate per month, Company A can only fully recover the initial stock delivery to the retailers progressively over a period of 10 months. Further, the monthly payment from retailers on sales proceeds was only credited to Company A after 60 days, a departure from the 30-day credit period that was agreed upon. The low take-up rate coupled with delays in payment had caused a shortage of cash to fulfill its monthly obligations, hence the cash flow mismatches. The cash flow mismatches can be summarized below.
- Slow retail take-up rate of stocks supplied to retailers,
- Delayed in payments from retailers and
- Monthly sales proceeds credited to Company A may not be sufficient to cover rising monthly operating costs.
Realizing the cash flow mismatches, Company A had withdrawn the bulk of the unsold stocks that were initially delivered to the retailers and kept only a handful of stocks at the retail stores to sufficiently maintain the 10% take-up rate. Subsequently, Company A revamped its business model by adopting the B2C (business-to-consumer) business model to complement the B2B (business-to-business) business model. The B2C model allowed Company A to sell directly to consumers or the public at large and take advantage of the following:
- Full control of sales activities by selling directly to end consumer,
- Greater profit margins by enjoying both the importer and retailer margins,
- The product can be sold on a cash basis rather than on credit and
- Sufficient and timely cash collection to restock for future growth and fulfill recurring/unexpected expenses.
These immediate changes were necessary to avoid liquidity and financial disruption. What is interesting about this example is that Company A had rectified its mismatches without incurring additional liabilities in a form temporary loans or injection of additional capital, instead applied adjustments of existing resources within the business to make a complete turnaround. Cash flow mismatches can be effectively managed by adopting the “Cash Flow Forecasting” technique, as it allows the business to detect the possibility of mismatches on a near-real-time basis. Please click here to download the “Cash Flow Forecasting” template. Tips on how to use the template are also included.
Another technique that can be adopted to determine cash flow mismatches is by calculating the trade debtors’ turnover period (in days) and comparing it against the trade creditors’ turnover period (in days). If the former is longer in days as compared to the latter in days, cash flow mismatches can be established. However, this technique has its limitations where it only provides cash flow mismatches state of the business based on historical data and excludes non-trade liabilities that arise from operating the business, such as salaries, utilities and other similar liabilities. In this case, “Cash Flow Forecasting” provides a more accurate indicator by providing a holistic view on the state of liquidity of the business, forward looking in nature and the mismatches, if any, can be quantified in monetary terms and provide greater details on what caused the mismatches. This would allow the business to make the necessary adjustments to its sales activities and its collections, and settlement of commitments to achieve a positive net cash flow position.
It is also important to note that businesses with cash flow mismatches, not only face higher liquidity risk, but they also face higher credibility risk, from within the organization and externally. For example, the cash flow mismatches may cause disruption in fulfilling mandatory obligations to internal employees, particularly when there is delay in salary payments and its provident fund contributions, delay in reimbursement of expenses to employees and stagnant salary increments that can cause severe discontentment among employees, therefore making it difficult to retain or attract talents. Equally, external suppliers may refrain from engaging with the affected companies due to the continuous delay in payments. As a result, affected companies typically operate with higher operating cost than its peers due to deteriorating credit rating and the absence of preferential pricing from suppliers. It is for these reasons; the affected businesses must resolve the issue surrounding cash flow mismatches on timely basis to ensure its relevance in business.
Disclaimer:
This article is the property of the firm. Written approval is required from the firm for personal and/or commercial use by third parties.
The actual event example given in this article, including the financial strategies adopted to rectify the cash flow mismatches, may not be suitable for other organizations. Any financial and non-financial losses incurred by the reader(s) in relying on the content of this article are not the responsibility of the firm. This article is merely expressing an actual event that took place to describe general overview of cash flow mismatches; it displays one of many financial strategies that can be used to rectify cash flow mismatches. In most cases, cash flow mismatches can be a complex issue that may require professional input from certified accountants.
Our firm, Megat Faizal Musa & Co., is a professional accounting firm that specializes in complex accounting and finance issues, corporate restructuring and recovery, due diligence, members’ voluntary liquidation, corporate turnaround of underperforming companies, mergers and acquisitions, family business advisory, and internal auditing.
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