Understanding Cash Flow: A System Dynamics Analysis

UNDERSTANDING CASH FLOW: SYSTEM DYNAMICS ANALYSIS* Working capital management is vitally important to the success of the small business. If sales vary during the year because of seasonality, growth, or uncertainty, then working capital is difficult to control. The firm's current assets and liabilities (in particular, receivables, inventory, and short-term payables) change in response to sales fluctuations. As a result, flow may sometimes be inadequate to sustain operations, even though profitability is satisfactory over the whole year. * The author wishes to acknowledge the support and advice of Ray Shreckengost of RSS Associates, Dr. Herb Myers and Dr. John Clark of Nova University. This paper summarizes the first stages of a research project which uses System Dynamics to improve financial control in small businesses. Further detail and model documentation are available on request. Improving flow management is a major priority for many small businesses. The advent of the microcomputer makes improved planning possible, but there is a related need for modeling approaches which illustrate the realities of small business. One such method, financial simulation using System Dynamics, is described in this article. It has been used by the author to aid flow management in firms which suffer from uneven sales. This technique provides a more comprehensive understanding of the causes of working capital changes and suggests what, if anything, can be done to improve the situation. The second part of this article includes an explanation of the way in which flow management problems can affect the small firm. Part three briefly describes the System Dynamics approach and the way in which such models are constructed. In part four, the working capital position of a case study business is analyzed, and the causes of fluctuations in current assets and liabilities are explained. CASH FLOW MANAGEMENT number of analysts have pointed out that the financial of the game' are distinctly different for the small business.1 The vast majority of small firms are undercapitalized. As a result, they depend on various sorts of short-term financing such as accounts payable, accruals, and lines of credit. Problems arise because these must be liquidated periodically. This, in turn, means that must be generated from elsewhere in the business in order to meet these obligations. At a time when sales, inventory, and receivables are in a state of flux, it is difficult for the manager to be sure of an adequate flow. In this sense, working capital management is about the timing as well as the size of current assets and liabilities.2 1 See, for example, J. A. Welsh and J. F. White. A Small Business Is Not a Little Big Business,' Harvard Business Review (July August 1981). 2 J. L. Lyneis developed this approach in Designing Policies to deal with Limited Financial Resources,' Financial Management (Spring 1975). Problems of liquidity adjustment are especially difficult for the seasonal business. One must bear in mind that rules of thumb such as cash flow equals after-tax profit plus depreciation' are inadequate guides for financial managers when sales are not uniform due to important differences in the timing of flow and profitability.3 This distinction is especially important for the small firm, because generating sufficient to satisfy creditors is essential for short-run survival. Profitability, by contrast, is a much more abstract concept which applies over the long term. 3 A. R. DeThomas explains the interconnections between flow and profit using an accounting model in Ins and Outs of the Flow of Funds,' American Journal of Small Business (July-September 1982). Evidence suggests that many firms are ill-equipped to make the difficult decisions involved in flow management. …