Cashflow Phase Shift

Cash vs. accrual accounting. Do you know why this is important?

If you've hired a bookkeeper & accountant, chances are you encountered this concept at some point.

I remember years ago, early on in my entrepreneurship career, coming across this concept and thinking it was just 'an accounting thing' that was technically necessary to make your P&L standard per GAAP.

Something for my books guys to figure out.

Oh, how wrong I was.

Now, after going through the ups & downs of the cash pain that comes from poor cashflow management those years back, I feel deep in my bones the importance of proper accrual accounting. So let's just say I'm very grateful for the line of credit we had with my old bank.

But, I digress.

Let's talk definitions.

In a pure accounting sense, cash accounting is tracking money in & out of the business, when it moves. Accrual accounting is tracking money in & out of the business on the dates it's supposed to move, and recording un-moved money on the balance sheet until it moves.

Simple enough, and here's a simple example.

Your B2B business makes $1m each month with $800k in expenses and COGS. $200k in profit. Invoices are due within 30 days after issue (net-30).

As a matter of cash, this scenario might be typical:

• In January, you send out invoices for $1m of services and collect $1m of cash
• In February, you send out invoices for $1m of services but some clients are late to pay their January invoices. You collect $800k of cash.
• In March, you send out invoices for $1m of services, and all your clients catch up on payments. You collect $1.2m of cash.

In a cash accounting sense, the business "made" $1m, $800k, and then $1.2m each month, respectively.

However, in an accrual accounting sense, you made an even $1m each month.

Only, in February your Accounts Receivable went up $200k, and in March it went down $200k, which you then realized as cash.

This might seem intangible, but underlies a crucial risk to your business: cashflow phase shift.

When you're running a business day to day you notice the cash. $1m of accounting income sitting in unpaid invoices can't be spent on payroll. Cash can.

So what can happen is that over time, your cash needs are off-synced from the nice, neat accounting flow of money as invoices get sent out and payroll gets paid.

This is cashflow phase shift.

Picture this more complex, real life scenario:

• In January, you invoice clients $1m. $1m cash is collected and you pay $800k in expenses. $200k profit.
• However, on Jan 21 your largest client decides not to renew their contract. Your monthly revenue drops to $800k for February.
• Then, six clients decide not to pay their invoices on time. Your actual cash collected in February totals only $400k.
• With expenses of $800k that month, you're now $400k in the hole and your profit from January is wiped out, with payroll quickly approaching.
• To make matters worse, you already spent most of the $200k profit from January and the cash is gone.
• Luckily your CEO is skilled at sales so she spends a few hours calling up prospects in the sales pipeline and closes two deals. These clients agree to pre-pay 2 months up front and you collect $500k in cash on Feb 8, a week before payroll goes out. The cash hits your account on Feb 11, just in time for payroll to be processed.
• Expenses are covered, you book a cash profit that month, and move onto March.

This is the kind of thing that happens all the time in real business reality, outside of spreadsheets.

However... something very important just happened in an accrual sense.

Cash may have been covered but this what really happened:

• $200k of recurring revenue was lost.
• You have a collections problem with $400k of invoices past due. New invoices are now going out, and you still haven't collected on the first ones.
• You have an obligation to service the two new clients who pre-paid for the next 2 months, but there won't be any new cash coming in from them until their pre-pay period is over. So next month your income is only $800k, and you still have to pay for COGS & expenses for 2 months to service the new clients. So your "cash profit" from February is inflated and the next 2 months will feel way less profitable than usual.
• The pre-payment that happened on Feb 8 wasn't on your original billing cycle. You prioritized this to bring in quick cash before payroll. But, now your cashflow has shifted forward in time. Originally you invoiced clients on the 1st, payroll went out on the 15th, and all was well. You had two extra weeks to collect cash before payroll after net-30 terms. Now those invoices go out right before payroll and on your normal net-30 terms probably won't be paid before payroll goes out next time.

This cash solution to a cash problem has now effectively 'phase shifted' your cashflow forward in time and changed your timing of when cash comes in and out of the business.

If your CEO is looking at cash on a month to month basis, she will now expect $1.05m in income. But this only kicks in after the pre-pay period, and after payroll goes out in month 3 after those deals were closed because of your net-30 terms. That cash hit will be felt for at least three more months.

And this example is for a healthy business with decent profits.

If this business were running at thinner margins, got hit with an unexpected COGS increase from contractors, or carried any amount of debt, this situation quickly goes from bad to nightmare.

So.

What can we do about this?

1. Keep an eye on your cash vs. accrual books and specifically on your deferred revenue, which may be categorized as 'customer prepayments' or something similar.
2. Know where your Accounts Receivable is at all times and be aggressively on top of collecting on invoices way before you think you need to be.
3. Have a plan of what Payables you can push back in a cash crunch if you need to. Do this in advance before you need it so you're not slapping together rough spreadsheets at the last minute.
4. Always normalize your invoices to set payment days each month with mid-month invoices pro-rated so cash syncs to the service period for that given month.
5. Aggressively cut your operating expenses and other costs in the case of a large revenue drop. Cut faster & cut more than you think you need.
6. Don't rely on new revenue / future sales / deals in the pipeline to cover lost revenue. The time delay between old revenue dropping and new revenue coming in is a primary source of the phase shift.
7. Secure a line of credit and other working capital debt instruments way in advance of when you think you need them, and get larger lines than you think you need.
8. Keep enough cash on hand in the business to cover regular expenses for at least a month and preferably more if possible.

Luckily, with some good cashflow planning and proper management discipline to make the right decisions, these problems can be mitigated well before they appear.

I wish you well in all your cashflow activities, and may you forever have accurate & elegant accounting.