Profitable and Short of Cash: Understanding the Consulting Cash Gap

Profitable and Short of Cash: Understanding the Consulting Cash Gap

You will already know how good it feels to close a quarter where the work went well, the team stayed busy and the profit and loss statement shows a healthy result. Payroll still falls due on its usual date, whether or not clients have paid yet. The distance between profit earned and cash received is where a sound practice can find itself short of money.

Why can a profitable consultancy run short of cash?

Profit measures what the business has earned. Cashflow, the movement of money in and out of the business, measures what has actually landed in the bank. A principal can open the profit and loss statement in March, see a healthy net profit, and two weeks later be moving money between accounts to cover payroll because the cash has not yet arrived. Nothing on the statement was wrong. The business earned the profit and has not yet been paid for it.

Consultancies are exposed to this in a particular way. Salaries are a fixed, scheduled cost, paid on the same date each month or fortnight. Client payment is rarely immediate. Standard terms typically run one to three months from the date of invoice, and that clock only starts once an invoice has been raised, checked and sent correctly. An invoice with a missing purchase order number, the wrong rate or an unclear description of who did the work can stall and send the clock back to zero. The time between work performed and cash received can stretch to as much as four months.

For this reason cashflow can matter more to a consultancy's survival than profit. A practice can be provably profitable and still be short of the money it needs to meet its own obligations.

The question a leader has to answer

The matching question from the leader's side is whether the cash buffer was sized deliberately or left to whatever happens to be sitting in the account.

How can leaders keep a profitable practice solvent?

A useful starting point is to separate three things and be clear about each one.

The gap

The structural mismatch between paying people and collecting from clients deserves a name of its own: the consulting cash gap. It is a permanent feature of the professional services model, present in a two-person practice and in a two-hundred-person firm, because the mechanics stay the same. Salaries are fixed and scheduled. Client payment is delayed and variable.

Research from Trezy, a cash flow management specialist, puts a figure on the scale. A ten-person consultancy with $88,000 in monthly payroll can have $264,000 of working capital tied up while client payment catches up with work already delivered. That is three months of payroll. The same research notes that fixed costs, principally salaries, typically represent fifty to sixty-five percent of revenue and keep running whether billable work is flowing or has slowed.

• Bill weekly rather than monthly, where clients will accept it, so the invoice clock starts sooner.
• Front-load fixed-price and milestone engagements by taking a meaningful portion of the fee at kick-off, so less of the firm's own capital funds the work.
• Collect actively by following up from the day an invoice becomes overdue, rather than sending one reminder at sixty or ninety days.

Each of these shrinks the gap without eliminating it. Weekly billing depends on client agreement, and early follow-up asks you to have a direct conversation, though that conversation is easiest while the relationship is fresh and the debt is young.

The measure

Cash position needs tracking deliberately. The core measure is Days of Cash: cash and cash equivalents divided by average daily operating expenses. The result tells you how many days the business could keep paying salaries and every other regular cost if all incoming cash stopped today.

A typical target for a consultancy is 90 days. Too little cash leaves no room to absorb a shock and can push the business into emergency borrowing or a missed obligation. Too much leaves capital idle that could be reinvested, placed in an interest-bearing account, invested elsewhere or returned to shareholders. Ninety days balances the two.

• A client going quiet while salaries continue.
• A large invoice in dispute that delays a payment you were counting on.
• A slow month of new business that thins the pipeline.

Check Days of Cash on a regular cycle. It gives the earliest honest warning that the buffer is thinning, well before the situation becomes a crisis.

The buffer

The practical response to the gap is a cash buffer, sized deliberately. The minimum standard is one month of salaries held in reserve. Most consultancies need more, because one month barely covers a single normal invoicing delay, let alone a slow payer or an unplanned dip in billable work.

Building the buffer is an ongoing discipline. It has to survive the temptation to spend surplus cash the moment it appears, because the moment the buffer is needed is rarely announced in advance.

Seen together, the three parts work as a loop. The gap explains why cash runs short, Days of Cash shows how short, and the buffer gives you time to respond.

What do bank covenants ask of a consultancy carrying debt?

If your consultancy carries debt, whether a growth loan, an equipment facility or debt taken on through a leveraged acquisition, cashflow discipline becomes a formal obligation. Banks attach covenants to lending. A covenant is a commitment to maintain financial integrity beyond making scheduled repayments. Four kinds are common.

• Financial ratios

  The business holds specific ratios, such as debt to equity or a current ratio, within agreed bounds.

• Debt service coverage

  The business generates enough cashflow to cover its debt payments comfortably, with room to spare.

• Dividend limits

  Covenants may limit dividends and distributions, so cash stays in the business while it is under financial pressure.

• Reporting

  The bank typically receives regular financial statements, cashflow projections and other information on an ongoing basis.

Breaching a covenant marks the business as a higher-risk borrower, brings a heavier reporting burden to the leadership team and can lead to a formal restructuring of the debt on terms the business did not choose. Careless cash management with debt on the books puts at risk the relationship with the bank that holds the power over your financing.

Where to start

Three questions to put to yourself or your leadership team this week:

• How many days of cash does the business hold today, and when did you last calculate it?
• How long does it take from finishing a piece of work to the money arriving, and where does an invoice most often stall along the way?
• How many days past due does an invoice get before anyone contacts the client?

When the gap is understood, Days of Cash is checked on a regular cycle and the buffer is protected, a profitable practice is more likely to stay a solvent one.

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