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Cash Flow: Your Company's Fuel Gauge

“Cash Flow: Your Company’s Fuel Gauge”

Use your cash-flow statement as a management tool.

Fixating solely on growth or even profit is a recipe for disaster. Successful second-stage entrepreneurs focus on cash flow. With cash in the bank, it doesn’t matter what your profit-and-loss statement looks like. But if you run out of cash, you’re like a NASCAR driver who runs out of gas — or spins out of control and hits the wall.

A balance sheet that shows rising sales and a healthy bottom line won’t mean a thing if you don’t have ample cash on hand to pay your employees, your landlord, the electric company or the IRS. And, all too often, that’s exactly what happens. A major accounting firm studied 60,000 companies that were forced to shut down. Nearly two out of three folded because of cash-flow problems. In fact, many young companies die while showing profits on their financial statements. They simply don’t have enough cash on hand.

Cash in, cash out

The operating cycle (the way cash flows through your company) is what makes cash so important — and so perilous. You start out with some cash in your checking account, with other cash tied up in inventories of raw ingredients, work in progress and finished goods. You sell to customers on credit, so accounts receivable rise to reflect the cash owed to you. When payments arrive, cash flows back into your company, completing the cycle.

But a fast-growing company can quickly and easily outpace its supply of cash. Rising sales mean laying out cash for additional inventory, increased production capacity, more employees and higher sales costs — expenses that your company has to pay almost as soon as they are incurred.

Meanwhile, your accounts receivable are also increasing, but you don’t expect customers to pay you for 30 days — or perhaps up to 90 days if they are slow. In essence, they are using your cash to finance their operations.

Stop-and-go indicators

Your balance sheet can only tell you whether your company is profitable. It’s your cash-flow statement that warns you about running out of cash. If the profit-and-loss statement is your company’s speedometer, then the cash-flow statement is its gas gauge. And though it’s nice to know how fast you are going, it’s far more important to know whether you have the necessary fuel to reach your destination.

Unfortunately, cash-flow statements are not particularly easy to create. They require you (perhaps with help from your financial officer or accountant) to sort, categorize and make adjustments to numbers on your financial statements. You also have to make some realistic assumptions about future expenses and revenues.

But the payoff for this work can be enormous. If projections show that you’re about to run out of cash, you can take immediate action to head off the impending crisis, such as:

  • Deferring some purchases to reduce outlays.
  • Stepping up collection of receivables to accelerate the inflow of cash.
  • Talking to a bank about a loan for working capital (if you have enough time and a healthy balance sheet).

On the other hand, you could find a more pleasant problem: more cash coming in than you need for operations. That should start you thinking about how to use that cash. You could:

  • Expand the company more rapidly than you had planned.
  • Set the cash aside and earn interest from a bank or securities.
  • Declare a dividend to the company’s owners.

Whether the cash-flow statement indicates a surplus or deficit, you’ll be able to take action sooner — and sleep a lot better.

3 elements to examine

A cash-flow statement looks at three sources of cash: company operations, investing activities and financing activities. For each category, your goal is to look at whether these items cause cash to flow into your company or out of it.

  1. Operations— These activities represent the sale of goods or services, as well as the cash paid out to produce those goods and services. Operations will probably involve the largest part of your analysis. Customer payments are generally the major source of incoming cash. Any other cash receipts are added to this figure. Outflows for operations include cash paid to suppliers (of inventory, insurance, advertising, utilities) and employees, as well as interest and income taxes paid.
  2. Investing— Activities include buying or selling buildings, land or major pieces of equipment, as well as any purchases or sales of securities, stocks and bonds for investment purposes. Cash flow from investing activities is increased by the sale of stocks or bonds held as investments; it is reduced by the purchase of property and equipment.
  3. Financing— Financing activities that bring cash into the company include borrowings under lines of credit, money raised by issuing and selling stock in the company, and additional capital contributed by the company’s owners. Outflows in the category include repayments of loans, dividends or other distributions to owners, and principal payments under capital lease obligations.

Crunching the numbers

In a very small company, the owner can look at each transaction and calculate its impact on cash.

But for most companies, the most efficient way to compute cash flow is to start with the net-income figure on the P&L statement and then make a series of adjustments. (Modern accounting software programs, such as QuickBooks, provide ready-to-run reports that can make all or most of these adjustments.)

Net income includes some important noncash items, such as depreciation and amortization. To calculate cash flow, add these to net income, along with any decrease in accounts receivable. Similarly, make adjustments to reflect changes in inventory value, accounts payable and accrued interest, as well as gains or losses on the sale of property. The result is net cash flow from your company’s operations.

Tip: Construct a "sources and uses of funds" statement to identify what adjustments are needed. This statement reports the status of key accounts, such as cash, accounts receivable and depreciation, at two periods (for example, the end of the most recent month and three months earlier.) Any change in those accounts is shown as either a source of cash or a use of it. The statement also assigns each account to a type of activity: operating, investing or financing.

It’s helpful to compare your company’s cash position today to prior periods. But you may also want to benchmark these results against other companies in your industry. Many services, such as Dun & Bradstreet and the Risk Management Association, publish tables of financial data drawn from thousands of companies; you can use them to compare your company’s performance with others in your industry and size category.

The first calculation of your cash-flow statement will involve a fair amount of work and possibly require the help of an accountant or financial professional. Once accounting software has been set up, however, monthly or even weekly reviews of your cash position and future projections should be relatively easy.

Maximizing cash flow

Once you’re equipped to keep a close eye on your company’s cash position and future cash needs, you can focus on making sure enough cash is always on hand. The goal is to maximize cash flow, which enables you to take advantage of vendor discounts, pay down debt and add inventory, equipment and people to grow your company. Having extra cash on hand also helps when there’s a sudden, unanticipated outlay, such as a big order or the breakdown of a key piece of equipment.

The first step in maximizing cash is to look at inventory and receivables, which usually are a company’s biggest cash drains:

  • Get rid of excess invento

  • Reduce working inventory, and dump the stuff that’s been sitting on the shelves gathering dust.
  • See if suppliers will warehouse more of your raw materials, delivering and invoicing only when you are ready to use them.
  • Carefully control receivables, and speed up the collection process.
  • Require credit applications from new and existing customers, and run credit checks before shipping.
  • Require partial payment in advance from poor risks or slow-paying customers.
  • Offer a discount for prompt payment.
  • Make sure invoices are correct and mailed to the right department, so your customers don’t have an excuse to delay processing.
  • If an invoice is not paid when due, get a commitment for payment in full.
  • Deposit checks daily.
  • Have payments mailed or wired to a bank lock box to speed deposits.

Controlling payables also helps to generate cash. Wait until the due date to pay bills. Some vendors will allow you to stretch another 15 or 30 days if you are an otherwise good customer. Ask for terms on anything you buy; sellers who give terms are providing you with free financing, so take advantage of it.

There may be other ways you can modify your operations to reduce the outflow of cash:

  • Consider leasing or renting equipment instead of buying it.
  • Use commission-based sales reps instead of a salaried salesforce.
  • Bring in temps to meet peak needs, rather than hiring more permanent workers.
  • Subcontract some of your manufacturing rather than doing it all in-house.

All of these steps involve tradeoffs — some loss of control or higher operating costs. These costs must be weighed against the benefits of having more cash on hand.

When the piggybank’s empty

Even after careful planning, a fast-growing company may not be able to generate all the cash it needs to fuel growth. A few options to consider if your pockets are empty:

Bank loan. With a strong balance sheet, solid collateral and good cash flow, you may be able to get a bank to give you a line of credit for working capital. Of course, that increases your level of risk because you must generate enough cash to make the loan payments, and the interest that you’ll be paying on that loan raises your break-even point.

Factoring. Selling your receivables at a discount of 4% to 7% is a more costly but readily available source of cash. Factoring receivables allows you to turn invoices into cash literally overnight. It is a costly form of financing; typically the factor will give you 90% of the face value of the invoice immediately, and another 3% to 5% when your customer pays the bill.

Factors also provide some useful services, such as checking your customer’s credit and handling collections. If it’s the only way to get the necessary cash to grow your company, you may decide that the cost of factoring is worthwhile.

Sell stock. You can also raise cash by selling stock in your company to an investor. But that raises a host of other issues, such as finding the right investor, placing a fair valuation on your company and surrendering some of your control. Rarely is cash alone a good reason to bring another owner/partner into a small company.

Slow down. An option that many second-stage entrepreneurs don’t like to consider is simply to slow down. Growing a little slower and turning away business you’d like to have but simply can’t handle with your cash flow isn’t very appealing. But it’s certainly more palatable than having to tell your employees, landlord or the IRS that you can’t pay what you owe.

Writer: Alexander Auerbach