For an owner, you’ll never feel quite as hopeless or helpless as when your business is caught in a cash trap. What’s truly frightening is that many owners don’t know what a cash trap is – and more importantly – what to do if they’re stuck.So what is a cash trap? You can search through the Internet, and find a myriad of interpretations and definitions. Most are likely to either put you to sleep or make your head spin, especially the ones in terms of investing, such as this one on Investopedia.
You need a definition more relevant to your business. I found a nice one on the Start Up Blog by Steve Sammartino: “Definition – the gap in ‘time’ and resulting cash flow impact between suppliers and receiving actual payments from sales to customer.”
I checked in with my financial team, and here’s what we developed:
“Every business must invest its profits, if only to maintain a competitive edge and meet inflation. But if the required investment exceeds reported profits plus an increase in permanent debt capacity, it is a cash trap.”
Still sound a little too academic? Alright, let’s boil it down.
What we’re really getting at with a “cash trap” is that there is not enough cash flow to cover the cost of your new equipment, generate a profit, and maintain your position in the competitive marketplace without incurring too much debt.
How does this look in the real world? And if you’re in one, how the heck do you get out?
Real-World Cash Traps: Scenario #1
Forgive me if the following two scenarios feel a little too close to the truth. I run into them every day, and they’re particularly relevant to owners in the printing industry.
In the first scenario, Printer A is hard at work when a man strolls into his office. “My name is Bronson,” he says, “and I need a huge order. And FAST.”
Bronson is a concert promoter, and he’s booked a show in town. He needs to print up 25,000 t-shirts for the show, and he’s just fired his previous printer. He needs the work done, and he needs it now.
Now for Printer A, this is a rather appealing prospect. Business has been good, but not great over the last quarter. Like most people in the business, he’s keeping his head above water, but he’s not doing it while drinking a martini aboard a luxury yacht.
On top of a mediocre year on the books, his daughter is about to get married, and you know what that means: He needs to use a big influx of cash.
Thus, Bronson seems like a great lead. But putting together an order that fast, and in that tight of a time frame, may be nearly impossible. Printer A’s current t-shirt printing capacity is at 100 pieces per hour, which means he there is no way he can turn around the job in time.
However, he knows there is a high-speed press which, if purchased, could help him crank out the job. He wasn’t planning on taking on an extra-heavy debt load, but he decides this will motivate him to get up and seek out new businesses. He gets on the phone and calls his equipment rep.
Guess what? Printer A is headed straight for a cash trap.
Mistakes Made in Scenario #1 by Printer A
- He jumped at the new offer for business too quickly. Printer A feels like he’s in more of a cash pinch than he really is. Perhaps he should have looked at some other options, like taking out a home equity loan to finance his daughter’s wedding.
- He doesn’t really know much about Bronson. Who is this guy? What if he doesn’t pay on time? If he doesn’t, Printer A’s company will be in a serious cash crunch if an invoice goes delinquent more than 30 days. And is there potential for a long-range deal? Printer A needs more answers, and ones that indicate a win-win situation.
- He hasn’t adequately analyzed his cash-flow. Printer A may think he’s got the number worked out in his head, but is this really a good idea? Just how much will this eat into the current level of profits? What happens if this machine sits idle after this big order?
- He hasn’t explored alternative options to buying the equipment. Are there incremental ways to add the equipment to the process without buying it outright? With leasing, he can rent the equipment for a short period, and not have to worry about what happens if Bronson leaves and never comes back.
Real-World Cash Traps: Scenario #2
Say hello to Printer B. As a commercial printer, he’s been eyeing the higher margins of wide-format digital printing. The situation is similar to Printer A, except for one major difference: Printer B has decided to sell his business and move entirely into wide-format digital printing.
Printer B feels like he’s in a good situation to make the leap. His current book of business is big and relatively successful. He has a lot of local clients who come back to him time and time again. He’s had a lot of offers in the past to sell his business, and he figures now is a great time to sell.
He also decides that the time is right to pursue a new challenge. He’s built a business once, so why can’t he do it again? If you’re not all-in, and fully committed to your company, then what chance does it have to succeed?
Printer B sells his business and opens up the wide-format company. He’s also wandered into a cash trap.
Mistakes Made in Scenario #2
- He didn’t have contracts in place before he made the leap. It’s one thing to have faith in your ability and belief in your marketing plan. But without guaranteed cash flow, there’s little chance that your business will succeed. Printer B did not have ironclad contracts before he made the leap, and as a result, his cash flow will suffer.
- He didn’t consider using his current business as a springboard. Printer B had a steady cash flow with his current business. His “all-in” theory might be true in terms of dedicating his time, but in fiscal reality, it just makes for a lot of unnecessary stress. His current business would have allowed him to continue to maintain its cash flow and slowly make the transition. Eventually, he could either sell or keep his current business when the new operation is up and running.
- He compared apples to oranges in terms of his own ability. At the base level, there are many similarities between wide-screen digital formatting and commercial printing. But there are also plenty of differences. To assume he can just walk-in and not have to suffer through a learning curve will likely be his undoing, as he simply doesn’t have time to learn the business.
How to Get Out of a Cash Trap and Ask These Critical Questions to Avoid the Cash Trap
Printers A and B are in a serious bind. To get out of the cash trap, they only have two options. They must either:
- Stop investing entirely, and maximize their business for cash
- Invest so heavily that they can gain enough market share and revenue to resume a healthy cash flow
If you haven’t guessed, neither option is attractive. Naturally, the most attractive choice is to avoid the cash trap altogether, and that begins with analyzing your current cash flow. Your analysis must answer these two critical questions:
- At what point in time does my cash flow allow me to acquire a piece of equipment?
- What is the best way of acquiring it?
Answer those two questions accurately, and you avoid the cash trap.
It’s not rocket science. It’s just a matter of respecting what your numbers tell you and being honest with yourself.