How Small Medical Manufacturers Can Maximize Cash Flow
Cash, the elixir of life for corporations, must be effectively managed to survive, compete successfully, and grow revenues. As Jack Welch, legendary CEO of General Electric, once said, "Cash is king." Cash flows in and out of businesses on a daily basis, with the level in the company coffers constantly changing. Yet, according to a 2009 survey by the Business Literacy Institute and published by the Harvard Business Review, "A majority [of executives] were unable to distinguish profit from cash. Many didn't know the difference between an income statement and a balance sheet. About 70% couldn't pick the correct definition of 'free cash flow.'"
As a consequence, business owners and managers overlook the importance of managing this flow, often neglecting the timing of cash transactions to focus on the levels of revenues and expenses. To their chagrin, their companies find that success can lead to disaster; despite rising sales and paper profits, they lack the cash to pay vendors and employees.
The single greatest objective of every business, no matter its size, industry, or history, is to achieve and maintain a positive cash flow, a condition where cash coming in equals or exceeds cash going out. According to Chad Carson, president of the Avicenna Division of Ametek Engineered Medical Components, the primary key to [business] success is cash flow, an opinion shared by most successful business professionals.
Understanding Cash Flow Relationships
Visualizing your company's available cash as the volume of water in a bucket might be helpful in understanding cash flows and their relationship to your company's financial health. The level in the bucket rises as cash comes in from sales and/or operating loans, and falls as cash is used to pay salaries and other expenses, purchase inventory, repay loans, or provide bonuses to yourself and others.
The minimum amount of cash maintained (the level of water in the bucket) in your bank accounts or near cash equivalents such as savings accounts or short-term financial instruments depends upon your forecast of the future business environment. For example, if you expect a business downturn or the need to purchase new equipment in the future, you would try to increase your cash (i.e., raise the level of water in the bucket) to be prepared for the projected use of cash. On the other hand, if you project stable sales and continued profits, you might elect to lower the level by reducing your product prices and margins to gain additional market share, paying yourself a bonus, or repaying long-term loans early. Decisions that affect cash inflows and outflows are the elements of cash flow management.
Three Principles of Cash Flow Management
Analyzing cash flow and the financial processes that affect it are keys to determining whether your company is healthy and able to weather coming storms, or is heading for a cash crisis and failure. Effective cash flow management requires reliable, timely accounting information on a consistent basis, and constant adjustment as the business environment changes.
To improve your cash situation, implement the following principles:
1. Eliminate the Gap Between Expense and Revenue
In most companies, expenses precede revenues. A medical device manufacturer may incur costs for months, even years, before receiving its first dollar of revenue. This may be due to research, obtaining regulatory approvals, establishing manufacturing capability, and implementing effective marketing and sales strategies. Once sales begin, the company continues to wrestle with the lag between manufacturing and shipping their product until receiving payment. A cash manager for a medical device manufacturer can reduce the gap between the points that expense is incurred and payment received by:
- Seeking European Approval of a Product Prior to or Simultaneously with a U.S. Application—Due to the differences between the approval systems, there is generally a one- to three-year delay in launching new medical devices into general clinical practice in the United States as compared to in the European Union. This is partly because the regulatory process in Europe is less bureaucratic, more efficient, and more predictable than in the United States. Another reason is that FDA requires evidence of both safety and efficacy of a device, whereas a European CE Mark only requires proof of safety and that the device performs in a manner consistent with the manufacturer's intended use.
- Implementing Effective Accounts Receivable Policies to Stimulate Fast Payment—Many companies use a combination "carrot-and-stick" approach to speed accounts receivable collections. The "carrot" is a discount from the billed amount, usually 1% to 2% if the invoice is paid within 10 days of issuance, while the "stick" is an interest penalty added to the invoice amount after due date (usually 30 days). Other methods to speed collections include bank transfers, pre-approved credit card transfers, and required deposits or COD arrangements for new customers.
- Ensuring that Billing Procedures and Process Are Efficient in your Company—Corporations with separate administrative, sales, and operations departments often suffer bureaucratic inefficiency, reflected in delays between completing a sale (delivering a product) and issuing an invoice to a customer for payment. Since many organizations have set times and processes for handling accounts payable, delays in billing or mistakes on an invoice can add weeks to the payment process. Failing to understand a customer's requirement for payment approval is another impediment to fast pay, particularly in healthcare, where payment cycles typically exceed 45 days or more. Analyze your internal procedures to accelerate invoicing and ensure that your billing personnel understand the payment requirements of your customers.
- Developing Efficient Accounts Payable Policies—Delaying payments as long as possible has the same effect on cash levels as collecting payments on invoices quicker. Smaller companies are often victim of this big company cash management strategy. Ranking vendors by their importance to your company, the availability of alternate suppliers, their prices (including their willingness to provide discounts), and their reaction to slow or late payment can allow your company to optimize cash, using it at the last possible instant to avoid harmful effect to your operation. Avoid automatic payments by bank or credit card to ensure against a "surprise" at an inopportune time.
- Establishing a Working Capital Loan Arrangement—Few companies have the luxury of being able to rely solely on the normal cycle of billing and collection to make required regular expenditures, even though they make every effort to reduce the gap between expense and revenue. A working capital line secured by accounts receivable and inventory can smooth out payment fluctuations, keeping cash balances at acceptable levels during most market conditions.
2. Maximize Cash Inflows (Receipts)
Increasing cash inflows requires active management of product pricing and sales, as well as eliminating failures to receive payment:
- Pricing Strategy—Revenue maximization and profit maximization, while similar, are not the same. Higher prices relative to competition can lead to higher revenues without the risk of lower profitability, if demand is relatively inelastic (sales volume remains stable as prices move up or down). To increase revenues and profitability, thereby maximizing cash inflow, companies should raise their product prices until demand begins to fall.
- Higher Sales Volumes—Identifying new uses or benefits for your existing products, targeting new users for products through geographical expansion, adding low-cost features to justify premium prices, improving sales and product training, and adding sales capacity can increase revenues and cash inflow.
- Maximum Account Recovery—Institute stringent account receivable collection policies and procedures, including the use of regular customer credit checks, outside collection agencies (at a point), and the sale of dormant, apparently uncollectable receivables. Customer communication is essential to identify and differentiate those customers who might require work-out scenarios and those who cannot (or will not) pay.
3. Minimize Cash Outflow (Expenses)
The key to profits and high cash levels is maintaining expenses as low as possible relative to sales volume. Good cash managers and business executives earn their pay on the expense side of the ledger. Cut expenses and cash outflows by:
- Implementing Semimonthly Payroll Periods—This simple change from biweekly pay periods eliminates the expense of two payroll periods per year and levels payroll costs month to month.
- Linking Employee Pay to Performance—Dr. Charlie Chi, acting CEO of Vitalwear and former CEO and co-founder of OtisMed (now part of Stryker), asserts that sales teams for medical device startups should be paid purely on commission, with no base salary or benefits. As an alternative, he suggests that "[paying] independent sales consultants purely on commission is the ideal way to go." Similar alternatives exist for production and administrative employees based upon individual or group performance.
- Eliminating Excess or Obsolete Inventory—Inventory ties up cash and increases administrative, storage, and interest expense. Operating on a "just-in-time" basis with suppliers minimizes these costs and the associated cash outlays.
- Using Outsourcing Partnerships—While core competencies should never be transferred to a third party, selective partnering can lower costs, improve efficiency, and reduce cash outflows. When asked about a strategic relationship with Spectrum Plastics Group to assist in the development of a complex injection-molded plastic spring, Eric Yee, global product manager for Lee Spring, said, "SPG takes on the difficult challenges and gives us the advantage we need to be competitive. They make it seem easy."
When asked about maximizing cash flow, Steve Martin, author of "Instant Profits: Making Your Business Pay and Achieving World-Class Profit Improvement," advised, "Scrutinize expenditures like your life depends on it (because your professional life does)."
The battle to maximize cash flow never ends. During a business lifecycle, managers constantly replenish their customers, vendors, and even the products and services they deliver. Regulations affecting new products change, as do tax laws. Technology advances can turn the landscape upside down, with new, exciting opportunities and continually emerging threats.
However, one element remains necessary year after year, in new markets and old, in every possible condition—the importance of cash. Master the capability of managing your company's cash flows and you will improve the organization's likelihood of long-term success.
What other tips can you suggest to maximize cash flow?