Do you struggle to have enough cash in your business to do what you need to do, when you need to do it? Very few businesspeople have been taught how to manage and build cash flow. They struggle because they haven’t yet solved the mystery of their business numbers.
Because they don’t understand their numbers, they can’t speak the language of business and communicate effectively.
Because they can’t interpret their numbers, they can’t listen to the story their numbers are telling.
Consequently, they can’t use the information to make sound business decisions and are forced to guess how to manage and build their cash flow.
The language your numbers speak paints a picture of your performance, productivity and profitability. That picture forms a pattern and tells a story. Your story will show you how to move forward to manage and build your cash flow.
The key to solving the mystery of your business numbers so you can build your cash flow is:
See the big picture of how your numbers connect and interact.
Separate facts from opinions, estimates and assumptions, and
Let your numbers lead you as you navigate your way to your targeted objectives.
Art vs. Science
How your numbers connect and interact is more of an art than a science. In science, we have been conditioned to look for precise, exact and accurate answers to the problems and challenges we encounter. In Finance and Accounting, you are forced to rely on opinions, estimates and assumptions to try and quantify with numbers results that are not easy to quantify.
Accountants are forced to use limited data and information to accurately describe, as best they can at that point in time, how well a business is really doing. Karen Berman and Joe Knight, in their book, Financial Intelligence, perhaps expressed it as well as it can be put. “Accounting and Finance are not reality. They are a reflection of reality, and the accuracy of that reflection depends on the ability of accountants and finance professionals to make reasonable assumptions, and to calculate reasonable estimates.”
Lesson 1 made reference to the fact that Sherlock Holmes never used deductive reasoning to solve a mystery. Instead, he used inductive reasoning. Deductive reasoning starts with a hypothesis, examines facts and reaches a logical conclusion. This is what we have been conditioned in science to do – look for precise, exact and accurate answers. But, for deductive reasoning to work, the hypothesis must be correct.
In business, that is difficult, if not impossible, to do. Because there are so many different industries, so many types of business structures and varying business operations, coupled with changing regulatory compliance and taxation, the federal government established a framework of guidelines for financial accounting. ‘GAAP’ is an abbreviation for Generally Accepted Accounting Principles.
GAAP outlines acceptable standards, procedures, rules and regulations accountants follow in recording, summarizing and reporting financial information contained in financial statements. GAAP is not a single accounting rule but rather a complex aggregate of how to account for transactions incurred in business operations. Think of GAAP as an acceptable range in which to operate, as opposed to a single, precise and exact standard.
Inductive reasoning takes a different approach to solving problems. It begins with observations and looks for patterns. Patterns form stories, and the stories lead you to solving mysteries.
Lesson 2 looks through the magnifying glass for patterns in your business numbers. By separating the facts in your financial statements from the opinions, estimates and assumptions that are there, you can begin to see the big picture of what is really happening financially in your business, why it is happening, and how you can use the information to manage and build your cash flow.
The Financial Jigsaw
The big picture of how your numbers connect and interact is like a jigsaw puzzle. Putting the puzzle together may at first seem overwhelming. But, as the pieces are connected together, the picture begins to come into focus. If you have never been taught how to manage and build your cash flow, then you might feel like someone trying to put together a jigsaw puzzle without having the box top picture to look at and guide you in connecting the pieces. If you don’t know what the picture looks like, it is difficult to put it all together.
Your financial statements are like the straight edge pieces of a jigsaw puzzle. They frame the border of the puzzle and give it structure. They help you get started in putting the puzzle together. Your numbers are like the individual pieces of the puzzle. It takes some work and diligence to put them into place so they make sense and the picture takes shape. The three financial statements to concentrate on are:
The Balance Sheet – Sometimes referred to as the Statement of Financial Position, or The Statement of Financial Condition.
The Income Statement – also known as the Profit and Loss Report
The Cash Flow Statement – which can be presented in one of two formats: The Indirect Cash Flow Statement, or The Direct Cash Flow Statement.
A closer look at your financial statements will help you see what the box top picture of managing and building cash flow looks like, so you can begin putting your puzzle together. Your balance sheet will contain the following categories: [Note: For a more detailed look into how your financial statements are arranged, we have a free report available.]
Balance Sheet
Please pay particular attention to the categories that are highlighted. They will become more important very quickly. Your balance sheet tells you what you own, what you owe and what is yours to keep.
Assets
Cash
Cash Equivalents [Marketable Securities]
Accounts Receivable
Inventory
Notes Receivable
Current Assets
Gross Fixed Assets
Accumulated Depreciation
Net Fixed Assets
Goodwill
Other Investments [Trademarks, Copyrights, Patents, etc.]
Total Assets
Liabilities and Equity
Accounts Payable
Short Term Debt: Lines of Credit
Taxes Payable
Other Liabilities
Current Liabilities
Long Term Debt
Total Liabilities
Common Stock
Net Income
Retained Earnings
Total Equity
Total Liabilities and Equity
Income Statement
Your Income Statement tells you if you are pricing your products and/or services profitably.
Sales [Revenue]
Cost of Goods Sold [COGS]
Gross Profit
Marketing and Selling Expenses
General and Administrative Expenses
Operating Income
Depreciation
Amortization
Interest Paid
Net Profit Before Tax
Income Taxes
Net Profit After Tax
Cash Flow Statement
[Direct Cash Flow Statement – this is the one you really need. It will be discussed in greater detail as the lessons progress.] Your Cash Flow Statement tells you where your cash came from and where it went.
Collections from Customers
Cash paid to suppliers [Inventory Paid]
Expenses Paid [MSG&A Paid]
Interest and Other Paid
Income Taxes Paid
Cash Flow from Operating Activities [Operating Cash Flow – OCF]
Fixed Asset Investment
Other Investments
Cash Flow from Investing Activities [Investing Cash Flow – ICF]
Borrow [Payback]
Additional Capital Paid In [Paid Out]
Dividends
Cash Flow from Financing Activities [Financing Cash Flow – FCF]
Increase (Decrease) in Cash [Change in Cash Position]
Beginning Cash
Ending Cash
Changes in one statement are reflected in another. By putting all the pieces together, you can trace cause-and-effect relationships. [The book, Managing By the Numbers, mentioned in Lesson 1, takes a closer look at these relationships.]
The very first thing to look for in analyzing and evaluating financial statements is to make sure the highlighted numbers match up. This is how the statements interconnect. If the statements don’t match they are not interconnected, and their numbers can’t be relied upon. If they do match, you can be reasonably certain that the statements are fundamentally correct, and you can dig deeper into your numbers.
Understanding financial statements allows you to speak the language of business. Financial statements are arranged to give you a picture of the financial position and condition of your business. Your financial statements serve as the Table of Contents for the story your numbers are telling you. They set the stage for what you need to look for in your numbers.
Finding the Facts
Separating facts from opinions, estimates and assumptions in your financial statements is vital to solving the mystery of your business numbers. If you are to listen to what your numbers are telling you, you must be able to differentiate the facts you can count on to help you make sound business decisions.
Lesson 1 made reference to an observation that Verne Harnish offered in his book, SCALING UP!. “The only indisputable facts in any set of financials are the numbers that relate to cash. Only your cash and debt balances are facts. Banks recognize this and use these numbers to determine your performance.”
He went on to say, “your profit is an opinion, and data can be manipulated to provide a specific outcome. Your balance sheet is for the most part also an opinion; you can amend valuations to produce the desired result.”
In the financial statement categories listed above, cash and debt were highlighted. Take a moment to review the listed categories and remember this all-important truth:
Every category except cash and debt balances is formed, or based, on an accountant’s opinion, estimate or assumption.
That is why if you had three accountants prepare your financial statements, you could conceivably end up with 3 completely different sets of financials. All could be legal and fall within the guidelines of GAAP.
Moving forward, if you are to manage and build your cash flow, you must concentrate on cash and debt. It’s not that the other numbers are not important. They are. But, to manage and build cash flow, you need numbers you can depend on to show you the way. What are the numbers that drive cash and debt balances and can help you build your cash flow?
The Numbers to Track
You have to track the right numbers if they are to be your roadmap and guide you in navigating your way to your targeted objectives. For now, a listing of the right numbers to track is sufficient to get moving in the right direction. The following lessons will lead you step-by-step in building your cash flow.
Direct Cash Flow Statement – remember that it works just like your checkbook, so it is easy to follow and track where your cash comes from and where it goes. Your direct cash flow statement answers these questions:
How much did you collect from customers?
How much did you pay suppliers?
What were your operating expenses?
How much interest did you pay?
How much income tax did you pay?
How much cash did you make from business operations?
What new capital assets did you purchase?
What other investments did you make?
Did you sell any capital assets?
Did your other investments bring a return?
How much did you make from your investments?
How much did you borrow?
How much did you pay back?
How much additional capital was added to your business?
How much was taken out of the business for distributions and/or dividends?
How much did you make from your financing activities?
How much did your cash increase/(decrease)?
How much cash did you start the accounting period with?
How much ending cash did you have?
Note: Please remember that all of these questions deal with your cash and debt. Your direct cash flow statement cuts through all opinions, estimates and assumptions; and lets you see clearly how your cash flow is being affected by your performance. Think of your direct cash flow statement as a magnifying glass that gives you a closer look into what is happening financially in your business. Your cash flow statement is the one statement you really can’t do without.
11 Milestone Numbers
Core Capital [Building working capital]
Cash Flow [Banker’s calculation]
Operating Cash Flow [The lifeblood of your business]
Marginal Cash Flow [Avoid ‘growing broke’]
Change in Cash Position
Current Ratio
Net Debt [Liquidity to meet debt obligations]
Days Outstanding [To determine cash needed]
Working Capital
Interest Paid
Capital Purchases
4 Tests of Operating Cash Flow [OCF]
Is OCF positive?
Is OCF greater than Net Profit Before Tax?
Is OCF greater than Capital Purchase Investments?
Are OCF and Net Profit Before Tax trending in the same direction?
To navigate your way toward your targeted objectives you have to make constant course adjustments. Just like airplanes and sailboats vector toward their destination, a business must change course when necessary.
Moving Forward
Without a clear picture of where you want to go, you can’t make the necessary adjustments to stay on course. Only your cash and debt balances, and the numbers that relate to them, can let you clearly focus on the changes that need to be made to manage and build your cash flow.
Lesson 1 outlined what you need to do to position yourself to solve your business number mystery, and to lay the foundation for managing and building your cash flow:
Learn to speak the language of business
Understand the story your numbers are telling you
Create a roadmap that will take you from where you are to where you want to go
Get accurate, complete and timely financial reports, and
Focus on the numbers that are important and drive your cash flow.
Lesson 2 allowed you to look through the magnifying glass to gain a clear insight into:
How Accounting and Finance are more art than science, and understanding and interpreting them is like putting together a jigsaw puzzle. [Financial Statements reveal patterns of performance, productivity and profitability.]
The only two indisputable facts in any set of financials: cash and debt balances.
The right numbers to track to manage and build your cash flow [the numbers that drive your cash flow]
Since these are the numbers banks use to evaluate your performance and determine your creditworthiness, the next lesson will let you see your business through their eyes.
