Just Because You Have It Doesn’t Mean You Should Spend It

Author: Larry Chester

At first glance, revenue recognition and cash flow planning don’t seem to have much to do with each other. One is an accounting question. The other is about managing money. Look a little closer, though. They’re actually two sides of the same problem. Both come down to the finances of your company. One deals with the proper financial reporting of revenue, and the other deals with availability of cash. And both depend on financial planning: planning for accurate financial reporting, and planning for the proper use of cash.

Revenue recognition is probably one of the more difficult parts of basic accounting for business owners. The idea is simple enough: match what you invoice to the work you’ve actually done. In practice, it’s anything but simple. You usually hear about it in construction, but it applies to any business where the work stretches over weeks or months for a total price, like a consulting engagement, an architectural project, or an annual marketing campaign. When nothing discrete gets delivered at the end of each week, how do you decide how much to ask your customer to pay, and when? And how do you determine how much revenue to post to sales for the month?

Now look at the cash side. In many of those same businesses, the money doesn’t come in neatly as the work gets done. It arrives in large chunks. Some of it pays for work already completed, but in some companies, it might arrive as a deposit for work that hasn’t even started yet, or the business might be receiving progress payments on a schedule. So the owner faces the mirror image of the invoicing question: when a big check comes in today, how much of it can you actually spend, and how much has to last until the next check arrives?

That’s the link. In one case, you’re billing for work that hasn’t been delivered because it’s part of a larger project. In the other, you’re receiving cash in advance of the completion of the entire project. Neither one tells you how to divide it up. You have to plan it, and then you need the discipline to stick to the plan, handing the money out as the work requires it, not as fast as the bank balance allows.

In other words, don’t get ahead of yourself.

The Invoicing Side

A heavy equipment repair company’s typical project cost over $2,000,000 and took a year to 15 months to complete. The plan (between vendor and customer) was for invoices to be issued as milestones in the project were reached. When the project was completed, a final invoice was to be generated. Except that the company was behind schedule on production and started invoicing for work that wasn’t yet complete. Soon they were a month behind in production, then two months. When the project wasn’t completed on time, the customer sent inspectors to see just how far behind the vendor was. The inspectors determined that they had paid more than $200,000 long before it was due, and the money stream stopped, pushing the vendor toward bankruptcy.

The fix starts with how you bill. Invoice on a schedule tied to the work, by milestone or stage of completion, not when you run out of cash. Then post revenue in the month it’s actually earned. A deposit for work you haven’t done yet isn’t your money. It’s for work you still owe your customer. Post it properly and your financial statements tell you how the business is really doing. Skip it, and your financials show unearned revenue. Eventually, someone notices.

The Cash Side

On the cash side, the problem looks different, but the results are exactly the same.

A marketing company we worked with billed its clients at the start of each quarter for stages of the annual campaign. The company’s financials seemed more like advertising re-runs. During the first month of every quarter, the bank account was full, and they freely spent on lunches, supplies, and materials. By the third month, they were scraping together materials to get work done, and scrambling to make payroll. Nothing was wrong with the business. They were simply spending two months of money in month one. They never seemed to learn the lesson. Their planning should have included dividing each quarterly payment into sections that matched that month’s “spend,” so that the cash was used progressively during the quarter, easing the stress on everyone.

Wedding businesses face the same thing. A wedding florist is often paid in full months before the wedding. It’s easy to see what happens next: the deposits coming in today for next June are paying for this weekend’s flowers. That works as long as new bookings keep coming, and sales keep rising. During that first slow season, the money for weddings already on the calendar is gone. That deposit never belonged to the florist. It was the couple’s money, held until the flowers were delivered.

A summer camp we work with starts collecting revenue for the next summer right as the current camping season ends, when camper families start paying in advance for the coming year. The prepayments collected between August and the following May have to carry the camp for the next full year. Even reducing staff to a bare minimum didn’t reduce the cash drain sufficiently. They were always chasing the next bump in receipts. The solution had two parts. First, they needed to find other sources of revenue during the lean months. Second, they needed to slowly but surely build up a cash reserve, or get an operating line of credit to carry them until the busy season arrived.

Managing the Cash

The time to decide how to manage that large payment is before it arrives at your bank. You know it’s coming, and you know what it needs to be used for. Which work, and which weeks or months, does it have to cover? Then treat the portion for future work as already spoken for, even though it’s sitting in your bank account, tempting you. This isn’t just a small-business problem. Companies large and small get into trouble when a healthy bank balance starts to feel like permission to spend.

The Takeaway

Every business that gets paid in big chunks has fat times and lean times. It’s easy to talk about the need for discipline, but much harder to implement: receive during the fat times, and put it away for the lean times. Plan the revenue you report. Plan the cash you use. And remember, just because you have it doesn’t mean you should spend it.