Agencies Shouldn’t Run Out of Cash

We had a project last year with a small-ish (19 FTE) shop with fairly aggressive growth goals. The partners had been running this agency for a while, but they kept hitting a wall around 25-30 FTEs. They’d get up there and then fall back down to around 20 FTEs. This is a common size barrier for many shops. It’s a transition point where breaking past requires more sophisticated processes and a change from “everyone wears multiple hats” to a focus on bringing in specialists for specific roles.

The reason behind their latest reset was a surprise lack of cash. They staffed up quickly at the end of 2020 to handle the increased demand they saw. However, a combination of a few large slow-paying accounts, significantly higher salary expenses, and losing a critical account drained their cash reserves.

Part of our work with them was building a model that helped project how much cash they’ll need based on growth rates and hiring expectations. This, plus some structural changes and greater financial discipline, gave them the foundation they needed to grow more sustainably. They aren’t past the 30 FTE barrier yet, but they’re close and on much better footing than they were a year ago.

​

Growth requires $$$

When agencies grow, there’s typically a delay between paying out expenses for doing the work they sold and collecting cash from the associated invoices. This delay is the difference between when you pay the salaries of the people working on the project and when you collect the associated invoice.

​

Measuring the amount of growth capital

Calculating this is trivial with a well-constructed financial model, but what if you don’t have one? Luckily, we can get a rough estimate of how much cash you’ll need to grow with only a few data points. The main determinants are the change in Accounts Receivable and the change in salary expense required to handle the new work.

First, forecast your new annual sales. Divide that by 365 and then multiply it by your average invoice collection time in days (your Days Sales Outstanding). This is your forecasted Accounts Receivable (AR).

Take your forecasted AR and subtract your average AR. This is the change in AR. To put it another way, this is the additional financing you’ll be providing to the new clients.

Then, figure out the cost of that growth. If you sell more accounts this year vs. last, how many more devs, designers, and/or marketers will you need to support the additional projects?

Forecast those employee expenses, then divide by 365 to get the salary expense per day.

Now, calculate your average invoice delay. This is the average number of days between when a production employee does work and when you send the invoice for that work. E.g., If you invoice on the 10th of every month for the work done last month, your average invoice delay will be the days in a month (30) plus the additional days before you send the invoice (10), divided by two. So a firm that invoices on the 10th of each month will have an average invoice delay of 20 days [(30 + 10) / 2].

Take your Days Sales Outstanding, subtract the days per pay period, and then add the average invoice delay. This will give you your Salary Float Days, or the average number of days you need to float your salaries before you collect on the invoices for that work.

Multiply the salary float days by the daily salary expense, and you get your additional salary cost.

Finally, add your change in AR to your additional salary cost, and you arrive at an estimate for the average additional capital needed to finance your growth.

​

Where’s the cash come from?

Most of the time, shops use their cash on hand to finance growth. Since most shops hold around 3mo of OpEx in cash on hand, their growth rates typically aren’t fast enough to cause issues. Unfortunately, as our client experienced, a few delays and a lost account were enough to drain these reserves. This is where banking relationships for lines of credit or medium-term working capital loans can be helpful.

​

Reducing risk and stress

The pro move here is to do some scenario analysis. Once you have that initial model built, add in some scenarios where you alter your core assumptions up or down and examine their impact on cash flow and cash reserves. Keep a buffer here that’s in line with your personal risk profile and you’ll reduce a lot of unnecessary stress.

​

Growth You Can Rely On

Forecasting cash flow is a critical part of reliably growing a digital agency. This is why it’s a core part of our Comprehensive Growth Evaluation. We work with your team to analyze your firm, identify areas of strength, candidly evaluate weaknesses, document where you are today, uncover where you want to go, and chart a course to get there.

​

​

​