Know Your Financials
Your company’s financial statements, when reviewed with a critical, wide-open eye, provide important insight into how your operational practices influence your cash flow. Here are some items to consider the next time you take a look at your financials.
Balance Sheet
The balance sheet shows more than just a snapshot of your assets, liabilities, and equity. It more importantly shows the amount of capital you’ve got invested in the business and offers insight as to which of those investments are creating the biggest drain on cash flow: Key areas to consider include:
- Accounts Receivable How much your customers owe you - and more importantly how long they owe you directly impacts your cash flow. Pay attention to your Accounts Receivable turnover and average collection periods – both which measure the speed at which your business collects the amounts your customers owe.
- Accounts Receivable Turnover is calculated by taking Sales divided by Accounts Receivable. For example:
Sales = $100,000
Receivables = $20,000
A/R Turnover = $100,000/$20,000 = 5
This means you’re turning your receivables over 5 times per year. As a general rule, the higher the number the better. The more times you turn over your receivables, the more cash you have for other operations and growth.
- Average Collection Period is determined by taking 360 divided by your Accounts Receivable Turnover. For example:
Average Annual Days = 360
A/R Turnover = 5
Average Collection Period = 72 days
This means it takes an average of 72 days for your customers to pay you for credit sales. Clearly, the bigger this number – the longer you’re waiting for cash to become free for other business activities.
- Inventory If your business sells goods, whether they’re specialty clothing or industrial machine parts, you need to have those goods on hand and available for sale. So, it’s reasonable that you’d have a fair investment in inventory. However, how quickly you can convert that inventory into sales has a huge effect on available cash. Take a look at how your inventory balances grow over time. Compare the growth rate to that of your sales. If inventory is growing faster than sales, that nearly always means your cash flow is suffering. Take some time to calculate your Inventory Turnover, too.
- Inventory Turnover measures the rate at which you use your inventory on an annual basis. It’s most often calculated as follows:
Sales = 100,000
Inventory = 5,000
Inventory Turnover = 20 times per year
You can easily re-calculate this result to report of days it takes to turnover inventory by doing the following:
Average Annual Days = 360
Inventory Turnover = 20
Inventory Turn Days = 18
While you might be inclined to think that faster is better in terms of analyzing these to numbers relative to your cash flow, too fast an Inventory Turnover may mean you’re not buying as effectively as you should. Be sure to check averages for your industry as a gauge for what your ratio should be.
- Debt includes both your short and long term obligations. Whether it’s a line of credit to fund inventory purchases or a long term loan on plant equipment – or even your accounts payable balances, the amount of debt you carry can say a lot about how well your company manages cash. Having too much debt in relation to the resources available to cover interest and repayment costs can spell bankruptcy. Having too little debt may hamper your ability to grow, but may also mean you’re depleting cash to finance activities for which you really should be borrowing. Analyze your debt regularly, evaluate over time, and compare to industry averages to see if you’re on the right track.
Statement of Cash Flows:
Broken into three categories – Financing, Investing, and Operations, Statement of Cash Flows provides a detailed picture of how you obtained cash and where you spent it over a specific period of time. It also shows whether cash flow grew or declined over that same period. As you analyze your statement, consider the following:
- Financing
- How much are you borrowing?
- Do you invest personal funds into the business each month?
- How big are your loan payments?
- Do you pay dividends to investors?
- Investing
- How much do you spend on equipment or other physical assets?
- How much do you spend on inventory purchases?
- Operations
- What are total sales?
- How big are operating costs?
- How much interest do you pay on borrowings?
- What are your tax expenses?
The Statement of Cash Flows starts with your beginning cash balances for the statement period, then answers each of the above questions in the form of a number – negative or positive – and finally, calculates ending cash balances or net cash flow. While intuitively it seems good to have positive or growing cash flows – that’s not always an indicator that you’re optimizing cash flow. Here are two simple examples to illustrate why:
Example #1: Negative – but in a good way.
A company has a very profitable year in terms of total sales and decides to use a portion of those profits to pay off two outstanding loans. This results in negative net cash flow for the period, but reduces overall debt loads which will free up operating income for other business activities.
Example #2: Positive – but not really.
A company that’s losing sales and net profit margins opts to borrow more money via a structured loan from its investor group. This action gives the business enough lift to show a positive net cash flow for the period, but creates higher debt levels and future payment obligations for not only the debt itself, but interest expense as well.
Pay attention to the means by which cash is coming and going for your business. And make sure you understand the source of large fluctuations and can adequately manage the future impact each of those changes may have.
Income Statement
While it’s a reasonably straightforward document that tallies up your business revenues and expenses to then calculate a profit or loss, the Income Statement can be misleading when it comes to revealing true financial health. As you review your Income Statement, here are a few things to remember relating to cash flow:
- Revenue is ‘booked’ when you make a sale, not when you collect the cash. Even though your sales numbers look great, you might have really high Accounts Receivable balances or really slow Accounts Receivable Turnover; both drains on your cash flow.
- Likewise, expenses are booked as you incur them, not when you actually pay the bill. Some of the most common items that haven’t been ‘paid for’ yet, but appear on the income statement for any given period include tax liabilities, payroll obligations, and outstanding amounts due to vendors.
- Depreciation and amortization are non-cash expenses; so while they reduce your profits ‘on paper’, they don’t impact cash flows.
Bottom Line
Your primary financial statements – Income, Balance Sheet, and Cash Flow, should be reviewed in concert, and regularly, to gain the best understanding of your company’s cash flow position, management and outlook. The better you understand them, the more equipped you’ll be to run your business more successfully.
Operate Effectively
Some of the most profitable businesses from a revenue and income standpoint have also gone broke. The reason? Ineffective and untimely use of cash. Here are a few ways to make sure you’re operating in a way that optimizes cash flow.
- Keep daily expenses in check. Whether you’re buying coffee and napkins for the break room or a new table for the war room, limit spending and make sure you’re getting the maximum value out of every transaction. Business travel and entertainment expenses are other line items to which you should apply strict control.
- Keep inventory as low and “just in time” as possible without being foolish. Purchase inventory based on realistic forecasts and buying trends for your industry. The same thing goes for supplies. Purchase only what you can realistically deplete in a reasonable period of time.
- Minimize fixed costs. In down times, uncontrolled fixed expenses can toll the death knell for many a business. Get the best value per square foot of leased office or plant space. Hire contractors instead of permanent employees if you can’t justify the longer-term cost.
- Consider leasing. While leases can sometimes cost more in the long-run, they can help stem big, day-one cash outlays for items like computer stations, copiers, and office furniture.
- Speed up your collections process. Do everything you can to get customers to pay on time – even a bit early. Offer discounts for early payment, charge late fees or interest on late balances. Accept electronic or card-based payments. If you process large volumes of payments or have multiple locations – get a lockbox service. Stop being a ‘nice guy’ when it comes to collecting from chronically late payers.
- Take a hard look at your salary. If you’re a business owner, don’t pay yourself a salary that’s out of line with the company’s performance. Look instead to industry averages for companies the same average size as yours, compare that to what you really need to get by, then compensate accordingly.
- Don’t be afraid to borrow. Remember, you need cash to keep the lights on and make sure everyone gets paid. Consider a line of credit to finance inventory purchases and seasonal fluctuations. Likewise, a longer term loan may make the most sense when it comes to paying for an office remodel or expansion. Borrowing can be a savvy, cost-effective way to reach your business goals while keeping cash flow on an even keel.
Manage Growth
One of the most surefire ways to tame wide fluctuations in cash flow is to master the idea of consistent, measured growth. Evaluate every growth opportunity - whether you’re renovating your manufacturing facility or hiring one more employee - and make sure you’re able to project a profitable and timely return on the investment. As you complete your evaluation for growth potential, consider the following:
- Is this growth ‘for real’ or just a ‘one-time-deal’? Make sure you know the difference. What you invest in the growth could mean the difference between company success and failure.
- Do you have enough people? Hire people that will make sense long term. Use reputable contractors to fill short term gaps and work-flow fluctuations.
- Do you have enough space? Be it manufacturing or warehouse space – you’ll need more of it as you grow. That said, don’t buy or lease more than you can handle in the foreseeable future. Look to shorter term leases or good bargains in the commercial real estate market before you make a commitment that might sink your business.
- Do you have too much control? If you’re working 90 hours a week and still seem to never have enough hours in the day to accomplish your goals, it might be time to delegate to others, regardless if they’re permanent or contracted employees. If the workload is too big, customers suffer. If customers suffer, they go away. And so does the cash that came with them.
