Selma's Kitchen: Profit on Paper, No Cash in the Bank
Selma runs a small catering and bakery business from a rented kitchen in Katutura, Windhoek. Last month she sold N$52 000 worth of cakes, vetkoek and lunch plates, and her records show a net profit of N$7 200 after paying N$33 800 for ingredients, N$11 000 for rent, electricity, transport and casual help, and N$4 000 she took out for her family. About 60% of her sales are to nearby offices that pay at the end of the following month; in practice they take about 45 days. She has N$3 200 in the bank. On Friday she must pay her main supplier N$9 500 or lose her credit account, and next week she owes N$6 000 in wages and N$2 500 rent. A micro-lender has offered her N$15 000 repayable over six months at 25% interest per month on the outstanding balance, and a friend has offered to buy a 30% share for N$20 000. Selma says she cannot understand how she can be profitable and still unable to pay her bills.
1. Explain, using the figures, how Selma can show a profit of N$7 200 and still be unable to pay N$18 000 due this week. Show the timing of cash in and out and name the two main causes of the gap.
Read the worked answer
Profit is a period measure; cash is a timing measure.
Cash in for a typical month:
- Cash sales: 40% x N$52 000 = N$20 800
- Collections from credit customers: in a steady state, last month's credit sales, 60% x N$52 000 = N$31 200
- Total inflow about N$52 000
Cash out for the same month:
- Suppliers N$33 800 + overheads N$11 000 + drawings N$4 000 = N$48 800
So on paper about N$3 200 is left, and over the year the profit is real. The problem is the sequence, not the total. She pays the supplier roughly 30 days after buying, but her customers pay about 45 days after buying. Every month she finances about 15 days of credit sales out of her own pocket: 60% x N$52 000 x (45-30)/30 is roughly N$15 600 tied up in debtors at any time.
Two causes of the gap:
- Credit given to customers is longer than credit received from the supplier - her working capital cycle is negative in cash terms.
- Cash is withdrawn for drawings and fixed costs before debtors pay - the N$4 000 drawing and the N$18 000 due this week fall before the office money arrives.
Growth makes this worse, not better: each extra N$1 000 of credit sales locks up about N$600 for 45 days. A profitable business that is growing on credit can run out of cash every month. The answer is not more sales; it is shortening the cash cycle.
2. Evaluate the micro-lender's offer and the friend's offer. Which, if either, should she accept, and on what conditions?
Read the worked answer
Micro-lender: N$15 000 over six months at 25% per month on the outstanding balance. Interest is charged on what is still owed, so if she repays N$2 500 capital each month, interest is roughly 25% of (15 000 + 12 500 + 10 000 + 7 500 + 5 000 + 2 500) = 25% of N$52 500 = about N$13 125. Total repayment is about N$28 125, or roughly N$4 700 a month. Her profit after drawings is only about N$3 200 a month, so the instalment alone swallows the whole business surplus. This is borrowing to cover a timing gap with money that must be repaid on a fixed schedule - a classic way small businesses fail. She should take it only if she can (a) collect at least N$15 000 of debtors within two weeks, and (b) repay it within two months, not six.
Friend: N$20 000 for 30%. This values the business at about N$66 667. Thirty per cent of profit is 30% x N$7 200 = N$2 160 a month, or about N$25 920 a year, for as long as the business exists. Over three years that is far more than the lender's interest, but the payment is not fixed, there is no security at risk, and the friend may bring skills or customers. Selma also keeps 70%, so control is not lost.
Advice: neither is the first move. First squeeze the debtors (deposits, shorter terms), because that money is already hers. If she still needs cash to grow and the friend will sign a written agreement covering profit share, decision rights and exit, the equity is the safer option. The micro-lender should be a last resort and only for a very short period.
3. Recommend three changes Selma should make to her credit and cash management, and state the cash effect and one risk of each.
Read the worked answer
1. Require a deposit on orders and invoice on delivery. Cake and lunch orders should carry a 50% deposit, and office accounts should be invoiced the same day, not at month-end.
- Cash effect: if half of the N$31 200 monthly credit sales were collected on order, roughly N$15 600 moves forward into the current month.
- Risk: some offices may move to a competitor who allows full credit; she should apply the rule to new customers first and keep her biggest, reliable clients on negotiated terms.
2. Charge for time: 2% discount for payment within 7 days, or stop supplying after 60 days.
- Cash effect: a discount costs N$624 on N$31 200 of credit sales, but could pull collection from 45 days to under 20, releasing roughly N$10 000 of working capital.
- Risk: a discount cuts margin, so it should be calculated, not offered at random; slow payers may simply leave.
3. Negotiate 45-day terms with the supplier and cut drawings to N$2 500 for three months.
- Cash effect: 15 extra supplier days on about N$33 800 of monthly purchases is worth about N$16 900 of breathing space in the first month; cutting drawings saves N$1 500 a month.
- Risk: suppliers may refuse or demand a higher price, and the family budget is cut.
She should also keep a weekly cash-flow forecast (money in, money out, closing balance) and separate business and household bank accounts - the shortage is currently invisible until it becomes a crisis.