“You can get by with decent People, Strategy and Execution, but not a day without Cash. Cash becomes even more critical as the business scales up, since ‘growth sucks cash’. The key is innovating ways to generate sufficient profit and cash flow internally, so you don’t have to turn to banks (or sharks) to fuel your growth.”
Verne Harnish offers this insightful glimpse into the criticality of cash to your business in his best-selling book, SCALING UP, How a Few Companies Make It…and Why the Rest Don’t, ISBN: 978-0-9860195-2-4, Copyright 2014, page 195, Chapter entitled ‘THE CASH INTRODUCTION’.
In our last blog, we began our journey to understanding the importance of cash management to business survival, stability and growth. It might serve us well to take just a moment and review the major points we covered in that blog. We discussed the following:
Cash is real money. It is not an abstract idea, but rather a concrete asset.
How Lou Mobley and IBM crafted an Executive School to train decision-makers to understand the interconnections of financial statements and the role the cash flow statement plays in effective management.
Conventional financial statements are fragmented and the connections between them aren’t apparent. Unless you can see the cause and effect connections you can’t see the big picture and know for sure how your business is really doing.
The balance sheet and the income statement are built upon opinions, estimates and assumptions. Only the cash flow statement contains indisputable facts you can rely on.
Accountants employ two formats to create the cash flow statement: Indirect and Direct.
The one financial statement business owners and decision-makers cannot do without is the direct cash flow statement.
The direct cash flow statement functions like your checking account and checkbook--it is easy to understand and track what is really happening in your business.
In this blog, we want to take a deeper dive into the assertion that only the cash flow statement contains indisputable facts you can rely on.
To prove the point let’s look closely at what Verne Harnish covers in SCALING UP.
In the third chapter in his section on CASH, he takes you through a case study of a seemingly healthy company that is in actuality ‘growing broke’. A little background story to this case study is enlightening. This chapter was co-authored with the team at Cash Flow Story--Alan Miltz, Joss Milner and Nathan Keating. Cash Flow Story is the result of collaboration with international bankers on the creation of a tool that would let them vet potential businesses for loans. The international bankers wanted a reliable way of determining the creditworthiness of a business and whether or not it was a good risk for the lender.
The Cash Flow Story team, headquartered in Australia, developed Cash Flow Story, a software program designed to improve cash flow and actively develop a cash flow culture within a business, as well as revealing the strengths and weaknesses of the business. Their goal was to create a tool that would allow businesses to double operating cash flow and sleep better at night. They were successful in their endeavor and today Cash Flow Story is embraced worldwide by lenders and business owners alike. In our coming blogs, we will examine Cash Flow Story inside and out to give business owners and decision-makers a comprehensive understanding of cash flow--how to manage it and maximize it.
The case study centers around a manufacturing company that over the span of 15 years grew from a start-up to a well-established organization, with nearly $42 million in annual revenue. Over the last 10 years, the company grew profits, and the owner had no concerns that the business was doing well. His bankers on the other hand knew he was ‘growing broke’ and could not sustain its present growth. They also knew matters would only get worse as the business continued to scale up. The owner didn’t realize that a healthy profit and loss statement can mask cash flow problems, and he didn’t understand the supreme importance of cash.
Verne Harnish inserts a comment in this case study that every business owner should consider taking to heart. On page 220 he stresses, “It’s imperative that you understand your business from the perspective of bankers and investors, so you’re not frustrated by their apparent lack of appreciation for the company you’re scaling up.” Perhaps the greatest shortcoming we have experienced in working with the businesses and owners we have had the privilege to get to know is that they tend to look at their business from only one perspective--profit. To see the big picture of how your business is really doing you need to look at the business from three perspectives, not just one. There are really three bottom lines in business and each bottom line corresponds to one of the three major financial statements:
Return on Assets (ROA) corresponds to the balance sheet.
Net Profit Before Tax (NPBT) corresponds to the income statement.
Operating Cash Flow (OCF) corresponds to the cash flow statement.
Operating cash flow is the lifeblood of your business.
It is the bottom line knowledgeable bankers and savvy investors use to evaluate businesses and management effectiveness. In this case study, the owner was looking at profit to know how he was doing. The bank was looking at operating cash flow to judge the stability of the business. Verne Harnish found that 80% to 90% of the businesses he visits are profit-focused and have inadequate cash flow. In this case study, the owner was looking at revenue and profit. Both were growing significantly and he was happy. The bankers on the other hand subscribed to the old saying that ‘revenue is vanity, profit is sanity and cash flow is king’. You can’t pay bills, take money out of the business or pay your taxes with profit--it takes sufficient cash and cash flow. Until a business becomes serious about measuring and growing cash it will struggle.
So what caused the bankers in the case study to question the stability of the business? The answer is cash flow. Bankers have a specific formula for defining cash flow. To them, cash flow is the change in cash and debt balances over a given period of time. Here is what they saw in the case study. The owner-operated his business using an overdraft account. He had no cash of his own in the bank. Over the last year, the short-term debt of the business increased $2.3 million dollars. The long-term debt grew by $1 million. The company’s cash flow over the last year was a minus $3.3 million dollars.
A side note here worth remembering is a quote by Greg Crabtree made in his book, SIMPLE NUMBERS, STRAIGHT TALK, BIG PROFITS, 4 Keys to Unlock Your Business Potential. On page 58 he states, “You can’t build wealth until you get out of debt. And make no mistake, getting out of debt really does help you build wealth.” In coming blogs we will explore Greg Crabtree’s approach to cash management and wealth building.
In the case study the owner was trying to fund his growth through debt. Unfortunately, in the real business world he is not alone in that approach. Inevitably there comes a point in time when that methodology is unsustainable. Bankers know it and they are on guard watching for it. As owners, we need to be as diligent as they are.
If you’re not tracking cash flow the way bankers do, now’s a good time to start.
Here is the formula for determining your cash flow:
Step 1 - Calculate the change in your cash position. Subtract your ending cash totals on your balance sheet from your beginning cash position at the start of the accounting period--for example one year.
Step 2 - Calculate the change in your debt position. Subtract your ending total debt from your beginning total debt on your balance sheet.
Step 3 - Add the two totals together to determine your cash flow for that accounting period.
In the case study, there was no cash, so the change from the start to the ending position was zero. Total short-term debt increased from $5 million to $7.3 million. Long-term debt grew by $1 million dollars. So the total debt went up by $3.3 million dollars. Adding the two together you come up with 0 + (-$3.3 million dollars) = minus $3.3 million in cash flow for the year. So, even though the income statement showed a profit, cash flow told a very different story. A story that the bankers knew pointed out trouble ahead.
In the case study, reference was made to one more tool that bankers use to determine the creditworthiness and health of a business and to serve as a red flag warning to alert them to possible danger ahead. It is a financial ratio they call Marginal Cash Flow.
To measure performance, productivity and profitability, financial ratios are used for comparative purposes.
Percentages lend themselves readily to comparison, whereas dollar figures do not. Bankers use Marginal Cash Flow as another useful measurement of cash flow. This ratio calculates how much cash is required by the business (most often referred to as working capital needed), and compares it to the amount of cash the business has available to service overhead (known as gross profit).
In the case study, the business had revenue of $42 million dollars, gross profit of $13 million and the working capital needed for operations was $17.4 million dollars. The Marginal Cash Flow looked like this:
Gross profit margin = $13 million/$42 million = 31%
Working capital needed = $17.4/$42 = 41%
Bankers often convert these percentage ratios into cents per dollar of sales. In this case study, the business produced 31 cents for every dollar of revenue which could be used to fund overhead of the company. But the company needs 41 cents for every dollar of revenue to operate the business. In this example the bankers realized that every time there was a dollar in sales, the business required 10 cents more to function than it brought in.
Unfortunately, this is not a sometimes occurrence in the business marketplace today. The majority of businesses have a similar relationship between their gross profit margin and their working capital needed for sufficient cash flow. Whenever this relationship occurs the business is going backwards in cash. In effect, they are ‘growing broke’.
To correct this imbalance a business has two options:
Increase their gross profit margin, or
Reduce the working capital needed
In future blogs, we will take a closer look at working capital, how it is calculated and how bankers use it to determine whether or not they make loans. They often refer to this process as risk management ratios and the two most commonly used are:
Current ratio, and
Quick ratio
This case study offers an insight into the differences in perspectives in business evaluation.
The owner of the business felt everything was going in the right direction. The income statement showed he was making a profit. The bankers knew the business was in trouble and going backwards in cash with every sale. This case study illustrates the importance of cash and cash flow in business. It also verifies the fact that the only two indisputable facts in any set of financials are cash and debt. Everything else is based on opinions, estimates and assumptions.
When business decisions are founded on opinions, estimates and assumptions, the door is opened to needless struggles. Such decisions are only as good as the guesses you make. Guessing eventually leads to wasted time, effort and money. Sound business decisions are rooted and grounded in financial reality. The one thing business owners cannot ever afford is to fool themselves. A business must be anchored in financial reality to survive and thrive. Being anchored in financial reality means:
Getting accurate, complete and timely financial reports
Interpreting and understanding the story your numbers are telling you, and
Using the information to your advantage in your decision-making process.
And without the cash flow statement, specifically the direct cash flow statement, a business will find itself at the mercy of changing conditions, marketplace fluctuations and competitors’ initiatives.
It really all boils down to cash and debt. Controlling a business requires managing cash and debt effectively.
In our next blog we will dig deeper into financial ratios, especially those that drive cash and influence debt.
