In corporate management, rising sales are often treated as a success indicator. An increase in sales volume may indeed show that market share is rising, that customers are interested in the product and that the firm’s operations are expanding. In financial management, however, it is misleading to treat sales growth as a positive development on its own. An increase in sales and an increase in cash in the till are not the same thing.
A firm that sells more may at the same time have to buy more raw materials, hold more inventory, produce more and grant more trade credit to its customers. Cash leaves the firm first; collection from customers comes later. The longer that interval, the greater the firm’s financing need. Turnover may therefore grow while cash shrinks; if the firm cannot finance its growth, it may fall into a serious inability to pay.
1. Turnover and cash are not the same thing
Turnover is the total monetary value of sales in a given period. Recording a sale does not mean that the sale proceeds have been collected at the same moment. In firms that sell on credit, revenue may arise today while cash arrives in 30, 60, 90 or more days.
If, for example, the firm sells goods of 10 million lira today and grants the customer 90 days’ credit, the sale appears at once in the income statement. The 10 million lira is not yet in the firm’s bank account. In producing those goods the firm may already have bought raw materials, paid wages, used energy and incurred other production costs. In other words the firm may have made a sale, and even a profit, while the cash arising from the sale has not yet arrived.
This distinction becomes much more important in periods of rapid growth. As sales rise quickly, trade receivables and inventories can grow quickly too. The balance sheet may expand while cash in the till declines.
2. Why does growth consume cash?
A rapidly growing firm usually needs more cash in three areas: inventory, receivables and capacity. More raw materials and finished goods are stocked in order to sell more. If credit sales are rising, receivables from customers grow. If production capacity is insufficient, new machinery, warehousing, vehicles or staff may also be required.
If the payment terms granted by suppliers do not lengthen to the same extent, a material financing gap appears. The interval between the day the firm collects from the customer and the day it pays the supplier must be financed from the firm’s own resources or from bank credit.
If growing sales are not financed by customers, the financing burden is borne by internal sources of self-finance, by shareholders, by suppliers or by banks.
3. How can cash fall while turnover rises?
Suppose a manufacturing firm has annual sales of 500 million lira and aims to raise them to 750 million lira next year. That is a strong growth rate of 50 percent.
Assume that, in the firm’s financial model, the net working-capital requirement is about 20 percent of sales. In other words, for every 100 lira of sales the firm must on average tie up 20 lira in inventory and receivables.
When sales are 500 million lira, the working-capital requirement is about 100 million lira. When sales rise to 750 million lira, that requirement becomes 150 million lira. To achieve the growth the firm must find about 50 million lira of additional working capital.
Suppose the firm earns a 10 percent operating margin on the extra 250 million lira of sales. Additional operating profit is then about 25 million lira. At first glance the picture looks distinctly favourable. The additional working-capital need created by growth is, however, 50 million lira. The firm may therefore generate 25 million lira of extra profit while needing 50 million lira of extra finance in order to sustain the growth.
If there is not enough cash in the till and the firm cannot obtain bank credit, it may struggle to pay suppliers, employees or tax liabilities on time despite a strong rise in sales. That is the core mechanism meant by “going broke while turnover rises.”
4. Why is the cash-conversion cycle critical?
One of the most practical ways of understanding this relationship is to look at the cash-conversion cycle. The cash-conversion cycle shows, approximately, the financing interval between the payment the firm makes to the supplier and the cash it collects from the customer.
If, for example, the firm sells its inventory in 70 days on average, collects from customers in 80 days and pays suppliers in 40 days, the cash-conversion cycle is about 110 days:
70 days of inventory + 80 days of receivables − 40 days of payables = 110 days.
This means that the firm must finance about 110 days of its operating cycle from its own resources or from external finance. As sales grow, the monetary counterpart of that 110-day financing burden also grows.
5. What should a rapidly growing firm monitor?
When management assesses sales growth, it should look at whether several indicators are moving together. If sales rise by 30 percent while trade receivables rise by 60 percent, collection quality may be deteriorating. If inventories grow much faster than sales, production and inventory policy may be consuming cash. If supplier terms shorten while customer terms lengthen, the financing gap may widen.
Days sales outstanding, days inventory outstanding, days payable outstanding, the cash-conversion cycle, cash generated from operations and the capacity to meet short-term debt should therefore be monitored together. When the sales budget is prepared, a cash budget should be prepared in parallel. Otherwise the firm may look successful on paper and tight in the bank account.
When a growth plan is drawn up, not only the sales target but also the additional working capital and credit lines that those sales will require should be calculated in advance. Finance is not a matter to be sought afterwards; it should be an integral part of the growth decision.
A firm’s growth is healthy only to the extent that it can be financed. Rising sales matter; what matters more is how much of those sales, and how quickly, converts into cash. Wages, taxes, loan instalments and supplier debts are paid in cash.
If the link between sales growth and working capital is not established, growth may indebt the firm rather than strengthen it and may raise liquidity risk. If cash flow weakens while turnover grows, that is not a success for management; it is an early-warning signal.
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