Businesses have a flow state (cash flow, that is) just like people do. In 1990, Mihaly Csikszentmihalyi wrote his seminal book on the flow state of mind in which time seems to fly and our minds operate at optimal performance.
Similarly, a business can achieve a flow state in which goods or services and cash flow quickly through the organization. When they do, good things happen. Let’s take a look at why this is.
The classic example used to illustrate flow principles is the apple cart. Even in this very simple business, one can see how the flow of goods and cash has positive effects.
For example, an entrepreneur with nothing but an old cart must first obtain a loan even to start her business. Since she has nothing, she must borrow to get money to purchase her first cartload of apples to sell. The three percent rate she pays sounds reasonable until you know that she must pay the three percent back that day. On an annual basis, she is paying more than 1,000 percent interest!
How is that possible? How can she even survive paying those kind of rates? The answer is flow! Let’s see how she does it.
A Cash Flow Example
She buys her fruit with $10 at the beginning of the day, having just borrowed the money at 3 percent daily percentage rate. At the end of the day, she sells out of fruit and has $12 in hand. She returns the money she borrowed (principle) $10.00 and interest of $.30, and she pays herself $1 in order to eat and pay any other expenses. She is left with $.70 profit that she can use to purchase fruit tomorrow or make repairs to her cart, etc.
If she continues to at this pace, always selling out of $10 of fruit each day, she will gradually become self-sufficient. At the end of the 15th day like this, she has saved enough to purchase her own inventory, and she no longer has to borrow to purchase her inventory.
This increases her profit by $.30 a day or a whopping 43 percent! If she continues saving her profits −or retaining her earnings, as we say− in another 10 days she will have enough saved to purchase two cart loads of fruit.
Scaling Your Cash Flow
At this point, she has options. She can continue to make a small profit and operate one cart or she can expand. Perhaps opening a second cart or perhaps moving to a busier part of the city where she can sell out her single cart in the morning, and reload and sell out again in the afternoon.
Of the two options, the second is the more attractive option for our small capitalist. Using this approach, she does not have to spend money on a second cart and an employee to run it. In either case, though, she will double the flow through her fruit cart operation. She will have doubled her cash flow and her flow of inventory.
In the case of inventory we use the term “turns” to describe how often we sell out of inventory. So she has doubled her daily inventory turns from one to two. Since we measure turns on an annual basis, turning inventory twice daily means annual turns of 730, assuming she works seven days a week.
That is a tremendous pace! On $20 of invested capital, ignoring the cart for now, she produces $2 of profit, $1 for each cart load. Annualized this is a $730 return on a capital investment of $20, or a 3,650 percent annual return. Kind of makes you want to own an apple cart doesn’t it?
So despite having to pay a usurious interest rate on her loans, she is able to get along quite well by increasing her turns and driving cash flow. Of course, it gets more complicated as her business grows. But not matter how big the apple cart business gets, at its heart, and at the heart of every business, is this same principle of flow and turns. The more you are able to turn your inventory and the greater your cash flow, the more your business is worth to you.
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Editor’s Note: This article was originally published on Oct 12, 2012.