Adam is the President and co-owner of a small company in the home construction industry. He and his business partner Gena own and operate the company. The company was forced to downsize during a severe recession. Before the recession, annual revenues were $12 million. Today, almost five years later, annual revenues are about $6.5 million.

Adam felt that they had made good progress on becoming profitable over the last few years, but cash was always tight. He didn’t understand why cash continued to be tight given the progress they had made on profitability. Within the last six months, they were forced to put money into the business to pay vendors and cover payroll. They also had to borrow on their line of credit with the bank to the point that the bank line was almost maxed out. Their debt was going up… despite talking for years about their desire to bring the debt balances down. Having to put more of their personal money in the business, and continuing to borrow money and increase their debt load, was causing stress for both of them. Adam wanted to better understand the cash flow of the business so he could identify the disconnect… and begin working to improve their cash flow.

Adam found my understanding cash flow course online in mid-July. He reached out to me for assistance because he wanted to get started quickly. When I assist an owner, I start our work together with a conversation about what the owner is experiencing and what they view as the problem they want to solve. I like to have that conversation before I see any financial statements or cash flow. That way I can focus the discussion on how the owner is feeling about their cash flow and the financial health of their business.

It might seem odd to start with “feelings”, but I have learned from experience that how an owner is feeling about their cash flow, and how they feel about the financial health of the business in general, is the secret to getting to the heart of the problem quickly. It helps define the scope of the challenge. And it helps us define what success will look like as we begin our work to shine a light on cash flow.

After our conversation, we outlined next steps as:

1. Adam would complete the cash flow course. He would watch the one-hour video, read the material, then attempt his first Cash Flow Focus Report for the month of June. June was the most recent month where financial statements were complete.
2. Adam would send me the Statement of Cash Flows from QuickBooks for last year and for the Year-To-Date period this year. This is a fast way for me to see what was driving cash in the prior year… and what is driving cash so far this year. Then I provide a cash flow rating for each period. I compare what I learn in that process to what I learned from my conversation with the owners. I am always curious to discover how the owners’ view of cash flow, and the financial health of the business, compares once I see the key drivers of cash for last year and this year.

The Big Picture View of Cash for Last Year

Let’s look at how my review of cash flow turned out for the prior year.

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The 2-Minute Summary: Cash was down $13k for the year. Capital expenditures were way up on the purchase of three new vehicles. Accounts receivable was down on improved collections that lowered DSO (the average number of days of sales that are sitting in accounts receivable). Depreciation is added back because it is a meaningful expense that did not impact cash for the year. The ending cash balance was $94k.

Cash Flow Rating: 3

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Now let’s look at what the Cash Flow Focus Report reveals about Adam’s cash flow… and how my assessment compares to what I learned in my initial conversation with Adam and Gena.

The first thing to notice in the Cash Flow Focus Report is they started the year with $107k and ended the year with only $94k of cash. That lined up well with Adam’s statement that “cash was always tight.” Running a business with annual sales of $6.5 million and barely having $100k in the bank is pretty much the same thing has having zero cash. My rule of thumb is that the minimum cash level should be at least one month of operating expenses.

The second thing to notice in the Cash Flow Focus Report is that profit is not one of the three largest drivers of cash. The business lost about $11k last year. That didn’t line up well with Adam’s statement that they “had made good progress on becoming profitable over the last few years.”

Capital expenditures – This looks like a big number considering the lack of profitability. I labeled the change as good on the assumption that the purchase of the three new vehicles was a planned investment and that it was not a surprise to the owners. I made a note to “peel the onion” with Adam and learn more about the investment.

Accounts receivable – The reduction in accounts receivable is a good sign because it was driven by a reduction in DSO. Reducing DSO indicates that they are collecting their receivables faster. I labeled the change as good.

Depreciation – This is added back because it is a non-cash expense during the year. It relates to capital expenditures in prior years. I labeled the change as good.

The Big Picture View of Cash for This Year (YTD through June)

Here is what cash flow looked like for the year-to-date period ended in June of the current year.

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The 2-Minute Summary: Cash was up $15k for the year. Profit was $141k on revenues of $3.4 million. Capital expenditures includes purchases to replace and upgrade vehicles used for installation and service. Notes payable was up because the capital expenditures were funded with debt. The ending cash balance was $109k.

Cash Flow Rating: 4

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The Cash Flow Focus Report shows that the cash balance was way too low for a business of this size.

Pre-tax profit – Profit is one of the three largest drivers of cash so far this year which is a nice improvement from the prior year. Although at 4% of revenues, profit is still looking weak. But it supports Adam’s statement that they were making some progress toward restoring profitability.

Capital expenditures – They made purchases to replace and upgrade vehicles that are used for installation and service. This is a big number, especially considering they made sizeable capital expenditures last year as well. I labeled the change as bad because the spending appears too high given the cash flow challenges they are living with.

Notes payable – The capital expenditures were financed with debt. I labeled the change as bad because the company already has a very high debt load and adding more debt to the balance sheet just makes the problem that much worse. They are borrowing the money to make those purchases which is digging a hole that will put an even bigger squeeze on cash flow in the future.

Adam’s Journey

We just looked at the process I used to evaluate the quality of their cash flow for last year and the year-to-date period this year. In my next post in this series, I’ll walk through the process Adam and I used to help him begin using the Cash Flow Focus Report. We will also look in more detail at the process we used to identify the targets and goals for improving the financial health of the business.

Summary and Links to Other Posts in This Series

Here is a short recap and a link to each blog post in this series on making your cash flow simple and easy-to-understand.

Part 1  – The surprising results of my super-short survey that asked: “How do YOU define cash flow in your business”?

Part 2  – “Cash flow” is not a single number on your financial statements. Now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

Part 3  – I use a VERY different, simple approach to defining cash flow. It is an approach where I take my CPA and CFO hat off and speak in a common-sense language that you can relate to.

Part 4  – The Cash Flow Focus Report is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.

Part 5  – The four reasons cash flow has always been so confusing and complicated for business owners (and for bookkeepers and accountants too).

Part 6 – I show you the 4-step process for completing the Cash Flow Focus Report. I walk through each step in the process using a real-life small business example. It’s a cool little company that was founded almost 20 years ago. It has grown nicely over the years and the owners love the business. Last month, the business showed a profit of $32 thousand. But their cash balance went down during the month by $6 thousand (from $116 thousand down to $110 thousand). The Cash Flow Focus Report shows what caused the change in cash.

Understanding the Drivers of Cash Flow – There are a number of different drivers of cash (in addition to profit or loss) that you will encounter as you complete the Cash Flow Focus Report each month. You will not run into all of them in one month because we are only focusing on the three largest changes, or drivers, of cash for each month. But as each month goes by, you will eventually see each one of these drivers impact your cash.

Understanding the Drivers of Cash Flow – Profit or Loss – Over time, profitability is a super important driver of your cash flow. You want to see profit show up in the list of your three largest drivers of cash regularly. While it is not unusual to have a month where profit does not make the list of top three drivers, profit needs to be there often, or you likely have a problem that needs attention. We also look at a number of ways to improve your profitability.

Understanding the Drivers of Cash Flow – Accounts Receivable – If you sell products or services on terms where customers do not have to pay you at the time you make the sale, you will have accounts receivable. And you will find that accounts receivable show up frequently as one of the three largest drivers of cash each month. I also share four steps for managing accounts receivable wisely.

Understanding the Drivers of Cash Flow – Inventory – If you sell products to customers, then you likely have inventory on your balance sheet. You buy inventory, pay for it, then ultimately sell it to customers. The fact that you buy the inventory weeks or months before you sell it to a customer (and possibly wait even longer before that sale becomes cash), creates a big drain on cash. I also share some tips and strategies for managing your inventory more effectively.

Understanding the Drivers of Cash Flow – Accounts Payable – The rules of accounting require that expenses be recorded in the P&L when they are incurred, not when they are paid. When an expense is recorded, the accounts payable balance on your balance sheet is increased by the amount of the expense. When it is paid, the accounts payable balance is reduced (as well as the cash balance being reduced) by the amount of the payment. I also share some tips on how to avoid the accounts payable trap when cash gets tight.

Understanding the Drivers of Cash Flow – Owner Distributions – Ultimately, the financial success of your business will be defined by the amount of excess cash it generates. That’s why I like to define a Happy Owner as an owner who is receiving healthy and frequent distributions of excess cash from their business. The trick though is how best to define excess cash. I share with you the general rule I use to help business owners think about their cash balance. And how much of their cash they can safely consider “excess” and therefore available to distribute to the owners.

Understanding the Drivers of Cash Flow – Capital Expenditures – A capital expenditure is the purchase of a large asset like a vehicle, or a building, or a leasehold improvement. Capital expenditures do not show up immediately in your P&L. They are recorded on your balance sheet as an asset then depreciated over the estimated useful life of the asset. The expense shows up in your P&L each month as depreciation expense. It’s this accounting treatment for capital expenditures that makes it very important that you manage it closely — very closely.

Understanding the Drivers of Cash Flow – Debt – Debt includes borrowing money and repaying it. Debt can play an important role in business. But it is a double-edged sword that must be managed with care and attention. I’ll share some tips on how to think about debt in your business…. and how to manage the risks that debt creates in your business… and the risks debt creates for you personally.

Understanding the Drivers of Cash Flow – Other Drivers – In addition to the drivers of cash flow discussed above, there other drivers of cash flow that you may see from time to time in your Cash Flow Focus Report. Those drivers include depreciation and amortization, prepaid expenses, accrued expenses (accrued liabilities), and unearned revenue (deferred revenue) and customer deposits.

 

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Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.

Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.

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Understanding Your Cash Flow – In Less Than 10 Minutes

This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.

The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.

It’s a fantastic way to learn the process.

I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.

There are two things that are very unique and exciting about this online course.

1. I’ll show you how to understand your cash flow in less than 10 minutes

2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.

I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.

Here is how one business owner describes the benefits of the course.

“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.

The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it.  And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.

The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.

Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow.  Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”

CLICK HERE TO LEARN MORE ABOUT THE CASH FLOW COURSE

In my last post, we looked at accounts receivable as a key driver of cash flow. And we looked at specific tips to help you better monitor and manage the impact accounts receivable has on your cash flow.

In this post, I show you how to write the one line explanation in your Cash Flow Focus Report, and determine whether the change is good or bad, when one of the three largest drivers of cash is inventory. I also share some specific tips for managing inventory wisely.

A positive number – A positive adjustment to cash related to inventory indicates you sold more inventory during the month than you bought. (Inventory on your balance sheet went down for the month.) Step 1 is to consider what caused the change. And does the change make sense compared to expectation. For example, if the company is a retailer in malls and the holiday selling season was ending, I would expect inventory to be down in a big way. In which case the description might be “Inventory was down as we reduced holiday season inventory.” I also like to look at DIO (days inventory outstanding). DIO is a great metric for looking at inventory relative to how many days of cost of goods sold are sitting in inventory. I almost always have a goal to reduce DIO or at least hold it steady. So, I would be curious to see how that metric ended the month and I might include a mention of it in the explanation if DIO had moved much. I’ll talk more about DIO in just a minute.

A negative adjustment – A negative adjustment to cash related to inventory indicates you bought more inventory during the month than you sold. (Inventory on your balance sheet went up for the month.) Creating your one line explanation is similar to what we just discussed. The question is what caused the change. I look at an increase in inventory very closely. I view inventory as a “necessary evil” so I am leery when inventory goes up. I want to make sure there is a good reason for the increase and that it is consistent with the plan and expectation. If we use the same example where the company is a retailer in malls, but assume their inventory grew, I would be looking to see whether the increase is consistent with the plan. And I would look at the amount of the inventory increase to make sure it was not too much of an increase. Inventory is an asset that must be managed very closely because it is surprisingly easy to lose money if you let inventory get out of hand. I’ll talk more about how to manage inventory well in just a minute.

Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad depends on whether the change in inventory was by design. Most changes will be considered good unless they come as a surprise to you. Or if the change is going the wrong direction relative to your sales plan. I mentioned earlier that I consider inventory to be a necessary evil. It is necessary in that you can’t make the sale to a customer if you don’t have the product in stock. If you bring inventory down too much, you may lose sales. Or make customers unhappy. On the other hand, inventory is evil in that it is an accident waiting to happen (in the form of an additional expense or loss). Inventory can get old, outdated, damaged, stolen or otherwise go down in value and possibly never sold. Buying inventory, then never selling it, or selling it at a steep discount, can be a profit killer.

Let’s look at an example from Cory’s business. Cory and his partner own a small multi-unit retailer. Last month inventory was one of the three largest drivers of cash. The change in inventory was $41 thousand. When the inventory driver produces a positive number in your focus report (a positive adjustment to cash), that means you sold more inventory to customers than you purchased from vendors during the month. His one line explanation said: “Inventory was down in line with our goal to reduce overall inventory levels.”

He labeled the inventory driver as “Good” because Cory and his store managers had been working for the last two months to bring inventory levels down. They had set a goal to get their DIO down from about 70 to 55. The $41 thousand reduction last month was a nice step toward achieving that goal. It was adding to their cash balance at a rate consistent with their plan.

Managing Inventory Wisely

Inventory can be a very fickle asset. One minute it’s your best friend. The next minute it’s your worst enemy. When you buy inventory, the transaction is recorded as an addition to inventory on your balance sheet (not in your P&L). The you hold the inventory for some period of time until it is sold. Then the expense for that inventory is recorded in your P&L at the time it is sold. While you are buying inventory and paying for it, the cash is leaving your bank account… but there is no recognition of those purchases as an expense in your P&L. It’s the timing of buying the inventory and later recording the expense that makes inventory such a unique animal.

When I think about how to evaluate and monitor inventory in a business, I start with a big picture, top down view. And within that view I look at it from two perspectives.

• The impact on cash – The first perspective is how much cash is tied up in inventory and how long is that cash being tied up. As a general rule, the lower the inventory balance and the less time we hold that inventory before selling it the better. The focus here is on the time from purchase from the vendor to sale to the customer.
• The impact on profitability – The second perspective relates to the impact inventory has on overall profitability as well as the many pitfalls associated with how inventory is accounted for.

Let’s look at some ways to get better at managing inventory.

Measure and Monitor DIO (Days Inventory Outstanding)

My favorite big picture metric for monitoring inventory, and the speed in which we turn that inventory into cash, is DIO. DIO stands for days inventory outstanding. Or days of inventory on hand. It is the number of days of cost of sales that are sitting in inventory. I monitor DIO monthly to see how the metric is trending. If we have specific goals or targets set for DIO, I am looking to see that we are on track to hit or maintain the goal. If we don’t have specific goals set, I am on the lookout for any increase in DIO that would suggest that the speed in which we are turning inventory into cash is slowing.

Cory’s small, multi-unit retail business in shopping centers is a good example. He owns and operates a small, multi-unit retail located in shopping centers. All his revenue comes from the sale of merchandise that he displays and sells in his stores.

Over the past two years Cory’s inventory balances had been creeping up. Never a big increase in any given month. But over time, the amount of inventory, and therefore the amount of cash invested in inventory, was growing relative to their sales volumes. And Cory was starting to see some signs that concerned him, including:

• The amount of inventory that had to be marked down in order to sell it was going up.
• The amount of damaged inventory that had to be sold for scrap was going up.
• Profitability was suffering.
• And the sign that gets most business owners attention… cash was in short supply.

Industry data made it clear he was carrying more inventory than most retailers in his industry. Finally, with the start of the new year, he convinced himself that it was time to look more seriously at the inventory issue and begin working on a plan with his store managers.

One of the goals that Cory and his team set for the second half of the year was to reduce DIO by 15% to 20%. The intent was to free up cash while also improving profitability. He had always believed that being a little heavy on inventory helped ensure he could take good care of customers when they came in one of the stores. He worried that customers would come to the store, not find what they were looking for, and become irritated. But he was becoming more and more convinced that he could do it without causing any disruption in the shopping experience. And he needed to free up some cash!

Sales did not vary a lot from month to month so the number that had the most impact on DIO was the inventory balance. After some discussion, the two of us agreed that the targeted inventory reduction would be $100 thousand. Inventory hovered around $550 thousand and our goal was to get that down to the $450 thousand range. The $100 thousand of freed up cash was going to help beef up the normal cash balance. Cash had been running too low for comfort and the mission was to maintain a healthier cash balance each month going forward.

January through June were typical of most months over the last five years. He had about 70 days of cost of sales in inventory. He and his store managers used the months of April to June to discuss, debate, and plan for how they were going to achieve the inventory reduction target. They carried a variety of product, and each store carried a slightly different mix of inventory, so planning was especially important… and very detailed. Once they had a plan that the team bought into, they got to work in mid-June.

Here is a graph of DIO for each month of the year.

 

On the left side of the graph, you can see where they were running a DIO in the 70 range. They started their work to reduce inventory in June and you can see the results showing up in a reduced DIO over the following six months. They ended the year at 53 which was slightly better than the goal they had set.

Here is a view of the inventory balance across all the stores.

On the left side of the inventory graph, you can see where they were running an average inventory balance of just over $550 thousand for the first half of the year. They began their work to reduce inventory in June and you can see the inventory start coming down over the following six months. They ended the year at $436 thousand. They had freed up over $100 thousand of cash, slightly better than the goal.

Cory felt good about hitting the target. His plan was to maintain inventory levels at the new, lower levels and monitor sales results over the next three to six months. He wanted to make sure that the lower inventory levels did not hurt sales or customer satisfaction. And he wanted to confirm that mark downs and damaged inventory costs were coming down at the rate we expected them to.

Cory’s experience highlights three points I’d like to emphasize as you use DIO as a metric for monitoring inventory.

• Put a dollar amount on your average daily cost of sales so you know how much cash you can free up by reducing DIO by one day.
• When evaluating your DIO, look at your historical DIO trend by month over the last 24 months. And compare your DIO to industry data or other companies in similar industries.
• If you decide to set goals for reducing DIO, translate your goal into a dollar amount of inventory reduction.

Let’s talk more about each of these points.

Put a dollar amount on your average daily cost of sales. DIO is calculated as the inventory balance on your balance sheet divided by average daily cost of sales. In a simple example, assume your inventory balance is $500,000. And cost of sales last month (the last 30 days) was $250,000. (I like to use cost of sales rather than sales because cost of sales equates to the cost of the inventory sold.) Average daily cost of sales would be $8,333. We take the $500,000 divided by $8,333 to get a DIO of 60. The DIO number is saying that, on average, we have 60 days of inventory on hand.

In this example, one day of inventory represents $8,333. If you can improve DIO from 60 to 50, you free up $83,333 of cash. Sometimes putting that number front and center in your mind helps provide the motivation to explore ways to move DIO down over time.

Review your historical DIO trend and compare it to similar businesses. I have to admit I am a big fan of looking at numbers visually in addition to just the raw numbers in a spreadsheet. I frequently look at a company’s DIO as a graph over the last 24 months. I like to see the trend, the trajectory, of DIO in a graphical view because the trends, the trajectory on inventory values, almost jumps off the screen at you. It is a super-fast way to find out if you should be worried about inventory or not. It provides the big picture view of whether you might have an inventory issue that needs attention.

I also compare the overall DIO numbers to industry data. Many businesses have an industry association that provide financial data and metrics that include a DIO metric. Or they include enough information where you can calculate an estimate of DIO for the average business in your industry. I don’t view the industry number has gospel. I just use it as a ballpark number so I have a general idea of what the norm might be for a similar business. If our DIO is way out of line, I consider that a good reason to peel the onion and look more closely at how you are managing inventory levels and look for ways to speed up the flow of inventory through your company.

I also look to see if there are public companies in a similar line of business. Public companies publish their financial statements for all to see. It can be a fantastic way to get DIO and other financial metrics and information to use a reference point. Like industry data, I don’t view it as gospel. It is just additional information that is often helpful as we work on our never-ending goal to survive and thrive in business.

If you are planning to reduce DIO, put a dollar amount on your inventory reduction goal. Once you have decided to reduce DIO, or otherwise free up some of the cash you have invested in inventory, it is important to express your inventory reduction goal as a dollar amount. In Cory’s business, he set a target of a $100 thousand reduction. That helped to clarify for his team the degree of reduction he was after. And it makes it easier for everyone to quickly compare their actual inventory reduction results against the goal each month.

Pay Close Attention to the Accounting for Inventory

I have a great example to share with you that demonstrates the unique nature of how inventory, and the accounting for inventory, can sneak up on you and bite you in the behind. I did some work years back with an owner who did a good job of reviewing the P&L each month. He was very involved in the monthly review of revenues, expenses and profit before the monthly financial statements were finalized. What he had not done quite as well was reviewing the amount of cash his stores were using each month to purchase inventory. Over time, he began to receive requests to rent temporary storage capacity for certain product to make more room in the stores. Which sounded odd to him. And the cash balance was headed in the wrong direction. That’s when the alarm bells began going off in his head.

After digging into the issue, he discovered that the stores had about twice as much inventory on the books as they should have. They had been consistently buying more inventory than they were selling. To the point that some of the inventory had been moved to storage locations because there was not enough room for it in the stores. It became clear that he and his team had not been paying attention to inventory (to put it nicely).

Much of the product had to be marked down 60–80 percent in order to sell it and clear out the excess inventory. The good news was they were able to generate some cash. The bad news was they had to do it at a big loss. And it was only at this point that the reality of this loss was shown in the P&L.

Here is the important point. During the time this inventory train wreck was happening the P&L looked great. The business was showing a consistent profit and he and his team felt good about it. The accounting for inventory puts it on the balance sheet when it is purchased. It is only moved to the P&L as a cost of goods sold when the product sells. You have to pay close attention to inventory balances and DIO, in addition to profitability, in order to make sure you are not tying up too much cash in inventory.

Here are three principles to keep in mind:

• Understand how inventory creates expense in your P&L.
• Pay attention to cost of goods NOT sold.
• Treat inventory like its cash.

Understand how inventory creates expense in your P&L. Most of the costs associated with inventory show up in the cost of goods sold line in your P&L. These include the cost of the product itself as well as costs associated with inventory spoilage, obsolescence, damage, and theft (to name a few). There are other costs associated with inventory including the cost to store, finance, protect, insure, move, and manage inventory that may or may not be recorded as cost of goods sold.

In many businesses, cost of goods sold is the single largest expense in the business. Sales minus cost of goods sold is gross profit. A strong gross profit is the key to creating a healthy business. It is almost impossible to bring a nice profit down to the bottom line without a healthy gross margin.

My favorite metric for tracking the health and direction of gross profit is gross margin. Gross margin is simply gross profit divided by sales. In many businesses, improving gross margin by even two points can be the difference between making money and losing money. I monitor this very closely every month to see that it is trending in the right direction (or at least remaining steady).

Make sure the process for recording cost of goods sold in your P&L is proper (and accurate). Sometimes accountants will use estimates to record cost of goods sold (which means an estimate is being used to record the value of the inventory that was sold). If that is the case, it is wise to do a physical count of your inventory on a regular basis to make sure the inventory on your balance sheet, and the cost of goods sold in your P&L (and therefore your gross margin), is accurate.

Pay attention to cost of goods NOT sold. I like to refer to inventory costs like spoilage, obsolescence, damage, and theft as cost of goods not sold. It’s what happens when you bought inventory with the intent to sell it at specific profit, but something happened along the way to spoil those plans. And it hurt your profit as a result. Either because you could not sell the product at all or because you had to mark it down and sell it at a discount which reduced your gross margin.

These costs tend to sneak up on people. Here is how it usually happens. Inventory slowly builds for a while. The slow or non-moving inventory gets pushed aside and ignored because the focus is usually on the faster moving inventory. Management can’t see the scope of the problem because they are focused on the P&L and not on the balance sheet. They may be paying attention to cost of goods sold, but they aren’t paying attention to the cost of what’s NOT being sold. Why? Because it is sitting on the balance sheet where it is not so obvious that a problem is brewing.

Eventually though, reality raises its ugly head and you have to do the work to dig into the inventory detail, figure out what product has gone bad, mark it down, take a big inventory write-down that flows through the P&L, then get rid of the old inventory in an attempt to salvage at least a little bit of the cash that was used to buy the inventory in the first place.

You would be surprised how many business owners are making important business decisions based on what their P&L says about gross profit only to discover later that the gross profit number was wrong. The revenue was correct. But the cost of goods sold was wrong. And the error is almost always on the side of showing cost of goods sold that is lower than the real cost. The result is an inflated gross profit… and misguided decisions (especially about pricing).

Treat inventory likes its cash. Let’s say you have inventory in a store or warehouse that you bought for $100,000. Over time you ordered the product, paid for the product, and that $100,000 is no longer in your bank account. In its place is $100,000 of product that you have available for sale to customers. Just for fun, think about that inventory as stacks of $100 bills sitting on shelves and pallets in your store or warehouse. A total of $100,000 of cold, hard cash sitting there in boxes. Would you protect and safeguard it differently if it was actual cash? Would you carefully monitor how much went in and out of the warehouse? Would you ensure it is accounted for accurately? Absolutely.

Here is a fun way to take a first step toward paying closer attention to inventory. Print a listing of your entire inventory by date purchased. Take a walk with the person in charge of inventory and physically look at and touch all the inventory. Ask questions about anything that looks old or has been around for a while. Make a mental note about the answers you get. You will get people’s attention when you do that.

Make an honest assessment of which inventory items are damaged, worthless, or obsolete. Have questionable inventory segregated so it is easy to monitor going forward. Identify inventory that is slow moving. Not only will you discover some worthless inventory you need to write off and get rid of, you will also be reminding yourself how important it is that you manage your inventory very, very closely. Consider writing down the value of questionable inventory so you have a more accurate inventory number on your balance sheet.

Spend some time with the person responsible for buying inventory. Evaluate the process they use to make buying decisions. Buyers are sometimes conflicted when it comes to buying. Especially when it comes to buying in quantity to get better pricing. Buying in large quantities can reduce per unit costs. But it can also drive inventory levels up too high. And when inventory levels are too high you end up eating a lot of that inventory in the form of spoilage, obsolescence, damage and other hard to swallow surprises. Consider putting additional controls in place at the point of each order if you believe the buying process needs improvement. That’s the point in the process where you can save yourself loads of cash and avoid big write-downs in the future.

Understanding the Drivers of Cash Flow – Accounts Payable

In my next post in this series I talk about the impact accounts payable has on your cash flow and how it will show up in your Cash Flow Focus Report.

You have accounts payable when you record a vendor invoice in your accounting system but have terms that allow you to pay the invoice later. An example might be a utility bill. You receive an invoice for the services provided in the prior month but have ten or more days to pay the invoice.

When accounts payable is one of the three largest drivers of cash, the number you will be entering is the change in your accounts payable balance for the month. Entering this amount “adjusts” for the expenses or purchases that did, or did not, get paid during the month.

Summary and Links to Other Posts in This Series

Here is a short recap and a link to each blog post in this series on making your cash flow simple and easy-to-understand.

Part 1  – The surprising results of my super-short survey that asked: “How do YOU define cash flow in your business”?

Part 2  – “Cash flow” is not a single number on your financial statements. Now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

Part 3  – I use a VERY different, simple approach to defining cash flow. It is an approach where I take my CPA and CFO hat off and speak in a common-sense language that you can relate to.

Part 4  – The Cash Flow Focus Report is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.

Part 5  – The four reasons cash flow has always been so confusing and complicated for business owners (and for bookkeepers and accountants too).

Part 6 – I show you the 4-step process for completing the Cash Flow Focus Report. I walk through each step in the process using a real-life small business example. It’s a cool little company that was founded almost 20 years ago. It has grown nicely over the years and the owners love the business. Last month, the business showed a profit of $32 thousand. But their cash balance went down during the month by $6 thousand (from $116 thousand down to $110 thousand). The Cash Flow Focus Report shows what caused the change in cash.

Understanding the Drivers of Cash Flow – There are a number of different drivers of cash (in addition to profit or loss) that you will encounter as you complete the Cash Flow Focus Report each month. You will not run into all of them in one month because we are only focusing on the three largest changes, or drivers, of cash for each month. But as each month goes by, you will eventually see each one of these drivers impact your cash.

Understanding the Drivers of Cash Flow – Profit or Loss – Over time, profitability is a super important driver of your cash flow. You want to see profit show up in the list of your three largest drivers of cash regularly. While it is not unusual to have a month where profit does not make the list of top three drivers, profit needs to be there often, or you likely have a problem that needs attention. We also look at a number of ways to improve your profitability.

Understanding the Drivers of Cash Flow – Accounts Receivable – If you sell products or services on terms where customers do not have to pay you at the time you make the sale, you will have accounts receivable. And you will find that accounts receivable show up frequently as one of the three largest drivers of cash each month. I also share four steps for managing accounts receivable wisely.

 

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Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.

Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.

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Understanding Your Cash Flow – In Less Than 10 Minutes

This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.

The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.

It’s a fantastic way to learn the process.

I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.

There are two things that are very unique and exciting about this online course.

1. I’ll show you how to understand your cash flow in less than 10 minutes

2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.

I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.

Here is how one business owner describes the benefits of the course.

“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.

The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it.  And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.

The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.

Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow.  Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”

CLICK HERE TO LEARN MORE ABOUT THE CASH FLOW COURSE

There are many different “drivers” of cash flow in your business. By “drivers”, I am referring to the primary financial categories in your financial statements that influence and reveal the flow of money into and out of your business.

This image shows the general categories of cash flow drivers.

 

These are the different drivers of cash that you will encounter as you complete the Cash Flow Focus Report each month. You will not run into all of them in a particular month because we are only focusing on the three largest changes, or drivers, of cash for each month. As each month goes by though, you will eventually see each one of these.

This is the part of understanding your cash flow that requires some work. Understanding each of the drivers of cash flow means that you will learn a bit about how financial statements work. I know that might sound boring and painful. That’s why I created the Cash Flow Focus Report.

The beauty of the Cash Flow Focus Report is that you get to learn about each driver in bite-sized chunks. A little bit each month. Trying to learn about all of them at once is like trying to drink water from a firehouse. It doesn’t work (and it’s not real smart). We’ll do it in baby steps. A little bit at a time.

I will talk briefly about how each driver works in this post. My objective is to make this discussion more of a reference guide that you can come back to when you need it. You can come back to it when you are completing your focus report and you have a question about one of your three largest drivers of cash.

Here is a short description of each driver of cash.

Profit or Loss – I am defining profit or loss here as sales minus expenses. The “bottom line” on your P&L. You will also see this referred to on your P&L as net income or pre-tax income. I am simplifying the term a bit and just referring to it as profit or loss. Over time, profit is the most important driver of cash. Consistently making money and turning those profits into cash in a speedy fashion, is the key to generating a healthy cash flow. But remember, profit does not equal cash. And this is especially important to consider when looking at cash flow for a particular month. You can show a nice profit for the month and still see a decline in your cash balance for that same month. Consider a business that sends an invoice to their customer for services provided and that customer has thirty days to pay the invoice. The invoice to the customer may have contributed nicely to your overall profitability. But if the invoice was not paid by the customer in the same month, then that profit in your P&L produced zero cash for the month.

Accounts Receivable – Accounts receivable represent amounts billed (invoiced) to customers. It means you are recording sales and profit before you actually get paid for the sale. It is not unusual for customers to have thirty days or more to pay invoices. If you invoiced your customer $10,000 on March 31, you might not receive payment until April 30 or after. In your Cash Flow Focus report, when accounts receivable is one of your three largest drivers of cash, the number you will be entering is the change in the accounts receivable balance for the month. Entering this amount “adjusts” for the sales and profit that did, or did not, turn into cash for the month.

Inventory – When you buy inventory that you will later sell to customers, the purchase of that inventory is recorded as an asset on your balance sheet. It does not become an expense in your P&L until the inventory is sold. You are buying inventory, paying for inventory, then selling it to customers. The time between paying for the inventory and ultimately being paid by your customer can tie up a lot of cash. When inventory is one of the three largest drivers of cash, the number you will be entering is the change in the inventory balance for the month. Entering this amount “adjusts” for the net impact of buying more, or selling more, of your inventory than what landed in your P&L as an expense for the month.

Accounts Payable – You have accounts payable when you record a vendor invoice in your accounting system but have terms that allow you to pay the invoice later. An example might be a utility bill. You receive an invoice for the services provided in the prior month but have ten or more days to pay the invoice. When accounts payable is one of the three largest drivers of cash, the number you will be entering is the change in your accounts payable balance for the month. Entering this amount “adjusts” for the expenses or purchases that did, or did not, get paid during the month.

Capital Expenditures – A capital expenditure is the purchase of a large asset like a vehicle, or a building, or a leasehold improvement that is not recorded as an expense in your P&L at the time you buy it. It is recorded on your balance sheet as an asset. When capital expenditures is one of the three largest drivers of cash, the number you enter is the amount of those “capitalized” assets you bought during the month.

Owner Distributions – Distributions of cash to the owners of the business generally fit into one of two buckets. The first is distributions to owners so they can pay the income taxes on the profits (taxable income) coming out of the business. If you are a sole proprietor or your business is set up as a “passthrough” entity, like an LLC or S Corporation, then the payment of income taxes falls to the owners of the business. Not the business itself. The second bucket is distributions of excess cash to the owners. I define excess cash as money that is not needed in the business for reinvestment or growth. Distributions of excess cash are the return on investment you earn as an investor, an owner, of the business. It’s the secret to creating Happy Owners.

Debt – I include debt with third parties as well as debt with the owners of the business in this category. Borrowing money brings cash in the door but it does not impact profit. It is recorded on your balance sheet as a liability. Paying that money back (the principal portion) sends cash out the door but it does not impact profit either. It “pays down” the liability. It reduces your debt. When debt is one of your three largest drivers of cash, the amount you enter is the net impact of debt for the month on cash. If you borrowed $150,000 on a new loan and paid $5,000 of payments on existing debt, the amount shown for the month would be $145,000. Debt is unlikely to appear as one of the three largest drivers unless you are paying down debt aggressively (high five if you are) or borrowing heavily each month.

Other “Timing” Differences – There are a number of other categories of financial transactions that create “timing” differences between when an item impacts your profit and loss and when it impacts cash. Things like depreciation and amortization, accrued expenses, deferred revenues, changes in other asset and liability accounts, and more.

Understanding the Drivers of Cash Flow – Profit and Loss

In my next post in this series, I go into more detail about how to write the one line explanation in your Cash Flow Focus Report, and determine whether the change is good or bad, when one of the three largest changes is profit or loss.

And I share some tips and strategies to help you improve your profitability.

Summary and Links to Other Posts in This Series

Here is a short recap and a link to each blog post in this series on making your cash flow simple and easy-to-understand.

Part 1  – The surprising results of my super-short survey that asked “How do YOU define cash flow in your business”?

Part 2  – “Cash flow” is not a single number on your financial statements. Now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

Part 3  – I use a VERY different, simple approach to defining cash flow. It is an approach where I take my CPA and CFO hat off and speak in a common-sense language that you can relate to.

Part 4  – The Cash Flow Focus Report is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.

Part 5  – The four reasons cash flow has always been so confusing and complicated for business owners (and for bookkeepers and accountants too).

Part 6 – I show you the 4-step process for completing the Cash Flow Focus Report. I walk through each step in the process using a real-life small business example. It’s a cool little company that was founded almost 20 years ago. It has grown nicely over the years and the owners love the business. Last month, the business showed a profit of $32 thousand. But their cash balance went down during the month by $6 thousand (from $116 thousand down to $110 thousand). The Cash Flow Focus Report shows what caused the change in cash.

 

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Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.

Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.

---

Understanding Your Cash Flow – In Less Than 10 Minutes

This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.

The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.

It’s a fantastic way to learn the process.

I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.

There are two things that are very unique and exciting about this online course.

1. I’ll show you how to understand your cash flow in less than 10 minutes

2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.

I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.

Here is how one business owner describes the benefits of the course.

“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.

The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it.  And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.

The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.

Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow.  Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”

CLICK HERE TO LEARN MORE ABOUT THE CASH FLOW COURSE

In Part 4 of this blog post series on making cash flow simple and easy to understand, I introduced you to the Cash Flow Focus Report. It is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.

In Part 3 of this blog post series, I talked about a VERY different approach to defining cash flow. It is an approach where I like to take my CPA and CFO hat off and speak in a common-sense language that everyone can relate to.

In Part 2 of this blog post series, I showed you that “cash flow” is not a single number on your financial statements. And I talked about why now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

In Part 1 of this blog post series, I shared the surprising results of my super-short survey that asked “How do YOU define cash flow in your business”?

Here’s Why Cash Flow Has Always Been So Confusing

In this post, I want to take a couple minutes to talk about why cash flow has always been so confusing and complicated for business owners.

Understanding each of these factors will help you see why the Cash Flow Focus Report is so different from anything you have ever seen. The focus report is designed to overcome each of the four reasons cash flow has always been so messy and confusing for business owners.

Reason #1 – Profit (or Loss) Does Not Equal Cash Flow

I routinely hear business owners say, “I know my business is profitable… but for some reason cash is always tight.” Or they say “I showed a nice profit last month… but I have less cash in the bank as a result. How can that be?”

It creates confusion in their mind and makes them feel like they have some sort of “cash flow leak” somewhere in their business. But they are unsure where the leak might be. Or why it was happening. Or how to fix it.

It also creates a question in their mind about whether the financial statements they get from their bookkeeper or accountant are accurate. Or reliable. With no good answers or solutions to their concerns, the tendency is to “punt” on understanding what is going on with the cash, and just hope that the cash flow will eventually take care of itself.

It seems logical to assume that if you “made money” last month then you must have more money, more cash, as a result. But showing a profit in your P&L does not mean you created any cash. By the same token, showing a loss in your financial statements does not necessarily mean you lost any cash. Profit or loss does not equal cash flow in any given month.

You can prove it to yourself real fast. Grab your P&L for last month and compare your profit number to the change in cash for the month. They will never be the same. The accounting rules that govern the creation of a P&L are about measuring profit or loss – not cash flow.

Over time, profit is a very important driver of cash. That is absolutely true. But it does not change the fact that profit does not equal cash flow. Even a P&L prepared on the cash basis of accounting does not change the fact that the amount of profit or loss in your financial statements does not equal cash flow. This is an important fact to get your arms around.

Reason #2 – There is No Clear Definition of Cash Flow

Most people understand profit or loss because it is a single number you can see on your P&L. But cash flow is not that simple.

In a recent blog post, I asked “how do YOU define cash flow in your business?” Here is the list of potential answers I provided in the survey:

You can see the survey responses here.

When you go to your favorite search engine and look for an official definition of cash flow, you get a variety of answers. Here are four different sites and their definition of cash flow:

Merriam-Webster’s online dictionary: “A measure of an organization’s liquidity that usually consists of net income after taxes plus noncash charges against income.”

Dictionary.com: “The sum of the after-tax profit of a business plus depreciation and other noncash charges: used as an indication of internal funds available for stock dividends, purchase of buildings and equipment, etc.

Wikipedia: Cash flow is “payments into or out of a business, project, or financial product.”

Investopedia.com: “Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows.”

The Merriam-Webster and Dictionary.com definitions are along the lines of putting a single number, a single dollar amount, on cash flow.

The Wikipedia and Investopedia.com definitions are more along the lines of describing cash flow in terms of money moving into and out of a business. Although you can put a number on those two definitions if you assume that “Payments into and out of a business” and “Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business” to mean that cash flow is the increase or decrease in the cash balance for the period. The net of the money coming in minus the money going out (net cash flow).

Here is a quick example of how these various definitions produce different results for “cash flow” when looking at a company’s financial statements.

I have a set of financial statements for a small business in front of me right now. When I use the Merriam-Webster definition of cash flow, I come up with an answer that says cash flow for the month was $55,863. It is calculated as “net income after taxes plus noncash charges against income”. The number does not appear by itself in the financial statements, but I can calculate it from the P&L, balance sheet, and statement of cash flows.

Using the same company financial statements, when I use the more “flow” related definitions of cash flow from Wikipedia and Investopedia.com, I get an answer that says cash flow for the month was ($87,120) – meaning the cash balance went down (it was negative) for the month by $87,120. Using this definition, I calculated cash flow as the change in the cash balance for the month. I can get this number from the statement of cash flows. I can also calculate the number by subtracting the end of month cash balance from the beginning of the month cash balance on the balance sheet.

Here’s the rub. In one definition, cash flow was a positive $55,863. In the other definition, cash flow was a negative $87,120. That’s pretty much the definition of confusion.

Most business owners are surprised to learn that the two words “cash flow”, by themselves, do not show up on their financial statements. You will NOT see a line item labeled “cash flow” on your P&L, balance sheet, or even on your statement of cash flows.

When you run the Statement of Cash Flows in QuickBooks, the words “cash flow” appear only once in the report (as “cash flows”)… and that’s in the title of the report. The title of the report is “Statement of Cash Flows”. That is the only place on the report where the words “cash flow” appear.

There is no line item in QuickBooks with a description or dollar amount associated with the two words “cash flow” in the Statement of Cash Flows. Or your P&L. Or your balance sheet.

In the Statement of Cash Flows, you will see line items like “Net cash provided by operating activities”, “Net cash provided by investing activities”, “Net cash provided by financing activities”, “Net cash increase (decrease) for the period”, etc. Each one of those line items has a dollar amount associated with it. But none of those line items are labeled “cash flow”… and the two words “cash flow” don’t even appear in those descriptions.

No wonder the definition of cash flow confuses so many business owners (as well bookkeepers and accountants).

If you run the Statement of Cash Flows report in the online accounting software Xero,  the words “cash flow” appear more often. You can read more about what Xero shows here.

Reason #3 – The Statement of Cash Flows is Difficult to Understand

Here is the reality of the beautifully named, but woefully misunderstood, statement of cash flows:

• Business owners rarely see it, never use it, and don’t understand it.
• Bookkeepers never prepare it and don’t understand it.
• Accountants and CPAs rarely prepare it (except when required to), seldom use it, and don’t know how to make it useful for business owners.

Financial statements are prepared using the rules of accounting. The rules of accounting are about measuring profit or loss and financial position. The rules of accounting are not designed to measure the flow of money through a business. In fact, most accounting transactions recorded by bookkeepers and accountants have no impact on cash. Consider an example where you invoice a customer for a product or service they bought from you.

Recording an invoice that you just sent to a customer creates revenue and profit in your P&L. And it creates an accounts receivable on your balance sheet. AND, here is the really weird part, it also shows up on your statements of cash flows… even though your cash balance is unaffected. Creating that invoice had absolutely zero impact on cash… but it still shows up in all three of your financial statements.

The rules of accounting are such that an accounting transaction that has nothing to do with money coming in or money going out, still creates “cash flow” in your statement of cash flows. That’s because the rules of accounting are focused on measuring revenues, expenses and financial position. The rules are about recording the flow of accounting transactions not the flow of cash through your business. We accountants like complexity and confusion. 😊

There are two more reasons the statement of cash flows is difficult to understand. The first reason is that the statement of cash flows is a reconciliation. It reconciles net income (your profit or loss) from your P&L to the change in your cash balance for the period being presented. It is an accounting exercise that takes a bit of a “shortcut” approach to identifying how changes in the P&L and balance sheet ultimately reconcile to the change in the cash balance.

It’s a report created by accountants… for accountants… and for those who have a deep understanding of the rules of accounting and a deep understanding of how the three financial statements fit together. The interesting thing is that most bookkeepers don’t understand how to prepare it (and therefore don’t provide one). And many accountants are not comfortable creating it either. The reconciliation component of the statement of cash flows creates some brain damage even for those who understand the rules of accounting.

The second reason the statement of cash flows is difficult to understand is that it presents too much information on the report. It’s not unusual to run a statement of cash flows in QuickBooks and it show multiple pages of positive and negative numbers flying around that ultimately reconciles net income to the change in your cash balance for the month.

As an example, I just pulled up a statement of cash flows in QuickBooks for a small business with 15 employees. The statement of cash flows has 41 lines on it.

People mistakenly believe that more information equals greater clarity. From jury instructions to instruction manuals, we’re witnessing an epidemic of overexplaining. This seems to be based on the fallacy that if you provide people with more information, it will yield greater understanding. In fact, the opposite is true: Too much information overwhelms people. It creates fuzziness, not clarity. When inundated with information, people are apt to lose sight of what’s important and stop paying attention.”

Simple: Conquering the Crisis of Complexity, by Alan Siegel and Irene Etzkorn

More is not better when it comes to understanding and managing your cash flow. The Cash Flow Focus Report is going to help us solve this problem.

Reason #4 – An Increase in Cash is Not Always Good… and a Decrease in Cash is Not Always Bad

In Part 2 of this blog post series, I shared an example from a small business where their cash balance went down last month, but they were delighted with their cash flow. Here is the result of their review of cash flow for the month.

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The 2-Minute Conversation: “Cash was down $50k for the month to $150k. The primary drivers of cash were a strong profit that came in better than our expectations, good collections on our accounts receivable from customers, and we paid off the final $100k of our debt.”

Our Happiness Rating for the Month: 10

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The payment of their last $100k of debt is what made their cash balance go down for the month. They had been focused on becoming debt-free in their business for three years. Over that three-year period they had paid off almost $500,000 of debt. Now they have zero debt. They felt absolutely on top of the world.

In another business, the cash balance was down for the month because their bank had threatened to pull their line of credit unless they paid the debt down ASAP. Being forced to pay their debt down so abruptly put them in bind financially. That was a bad thing.

Your cash balance can be down for the month for lots of good reasons like making a big investment to grow your business and serve more customers, making distributions of excess cash to the owners of the business, and paying down debt.

And your cash balance can be up for the month for lots of bad reasons like borrowing money to fund losses (digging a financial hole), the owner being forced to put more money into the business, not making payments on existing debt, and paying vendors late.

When you look at the increase or decrease in your cash balance for the month, the critical question is: “What caused the change”? When you can answer that question simply and quickly, you will know whether the change in cash is good or bad.

Also, it is important to recognize that the cash balance on your balance sheet is the balance at a specific point in time. If you were looking at your June balance sheet, the cash shown there is the balance at the end of the day on June 30. The balance would be different the day before and the day after.

For example, in one business the owner’s cash balance was down $6,000 in May. The primary reason for that reduction was that one of his larger customers had not paid a $20,000 invoice on time. The good news is the $20,000 arrived on June 1. The cash balance at May 31 did not look so good… but everything was fine with respect to cash flow because the cash came in the very next day.

Keep in mind when deciding whether an increase or decrease in cash is good or bad that your cash balance is being measured on a specific date.

Putting the Cash Flow Focus Report to Work

In my next post in this series, I will walk you through the step-by-step process for creating the Cash Flow Focus Report.

For me, it’s the secret to making cash flow simple and easy to understand each month.

 

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Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.

Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.

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Understanding Your Cash Flow – In Less Than 10 Minutes

This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.

The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.

It’s a fantastic way to learn the process.

I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.

There are two things that are very unique and exciting about this online course.

1. I’ll show you how to understand your cash flow in less than 10 minutes

2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.

I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.

Here is how one business owner describes the benefits of the course.

“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.

The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it.  And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.

The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.

Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow.  Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”

CLICK HERE TO LEARN MORE ABOUT THE CASH FLOW COURSE

In Part 2 of this blog post series on making cash flow simple and easy to understand, I showed you that “cash flow” is not a single number on your financial statements. And I talked about why now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

In Part 1 of this blog post series, I shared the surprising results of my super-short survey that asked “How do YOU define cash flow in your business”?

In this post, we get to the fun part. It’s time to show you how to understand your cash flow in 10 minutes or less each month.

A Simple Definition for Cash Flow

I take a VERY different approach to defining cash flow. I like to take my CPA and CFO hat off and speak in common sense language that everyone can relate to.

Here is how I define cash flow – Cash flow is happiness!

That’s the definition of cash flow I would like you to use from now on. And I would like you to rate your cash flow on a scale of 1 to 10. Your Cash Flow Happiness rating is a fast and simple way to gauge the quality of your cash flow for the month. It provides information about whether your cash flow was good or bad. Whether you should feel confident or concerned about your cash flow.

Cash is a specific dollar amount.

But cash flow? Cash flow is Happiness. And we measure it on a scale of 1 to 10.

Sound crazy? Maybe. But the process for rating your cash flow can be fast and fun… and do wonders to help you create confidence and peace of mind in business. 😊

The Super-Fast Approach to Understanding Your Cash Flow

Here is the simple monthly process for understanding your cash flow.

Rate the quality of your cash flow on scale of 1 to 10. Ask yourself: “On a scale of 1 to 10, to what degree am I happy (satisfied) with my cash flow last month?” Where 1 is very unhappy (dissatisfied) and 10 is very happy (satisfied).

To rate the quality of your cash flow you need to answer these two questions:

1. How much did the cash balance change?
2. What caused the change?

The answer to question #1 is a dollar amount. And it is easy to calculate. It is the amount that your cash balance changed during the month. If the cash balance on your balance sheet at the end of June was $125,000 and the cash balance at the end of May was $100,000 then your cash was up by $25,000. Very simple and easy to get.

Your answer to question #2 is what I call the 2-minute conversation. The 2-minute conversation is where you understand your cash flow for the month so well that you can explain it to your business partner, banker (maybe even your spouse) in a simple 2-minute conversation. You do that by identifying the three largest drivers of cash for the month using the Cash Flow Focus Report. This is the secret to truly understanding your cash flow. Simple, fast, and focused.

The 2-minute conversation is similar to how you might answer the question: “How was the weather at your family reunion yesterday?” Your response to that question would be short and it would quickly communicate your “rating” of the weather yesterday. You might say: “The weather was awesome. It was 75 degrees, there wasn’t a cloud in the sky, and the breeze felt wonderful. We had a fantastic day.”

The 2-minute conversation is just like that… except we are quickly and confidently describing “what caused the change in cash last month”? Then your Cash Flow Happiness rating seals the deal by stating whether you are happy with your cash flow for the month. You are rating the quality of your cash flow in a simple, common sense fashion.

Here is what the 3-step process looks like.

A Real World Example

In Part 2 of this blog post series, I shared an example from a small business where their cash balance went down last month, but they were delighted with their cash flow. Here is the result of their review of cash flow for the month.

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The 2-Minute Conversation: “Cash was down $50k for the month to $150k. The primary drivers of cash were a strong profit that came in better than our expectations, good collections on our accounts receivable from customers, and we paid off the final $100k of our debt.”

Our Happiness Rating for the Month: 10

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The payment of their last $100k of debt is what made their cash balance go down for the month. They had been focused on becoming debt-free in their business for three years. Over that three-year period they had paid off almost $500,000 of debt. Now they have zero debt. They felt absolutely on top of the world. Their happiness rating was a 10.

This is a great example of how the 2-minute conversation provides a simple and fast understanding, explanation, and rating of your cash flow for the month.

The Cash Flow Focus Report

In my next post in this series, I will introduce you to a unique, you will never see this from your bookkeeper or accountant, tool that gives you a fun new superpower. It’s the Cash Flow Focus Report.

After you use the Cash Flow Focus Report for a few months, something interesting will begin to happen. The mystery around cash flow will begin to disappear.

You will find yourself spending less time worrying about what’s going on with the financial side of your business. You will begin making more confident business decisions because you have a better understanding of how your day-to-day decisions impact your cash flow (and your cash balance).

And best of all, you will free up more of your time to do the things you really enjoy in the business.

And it all starts with learning how to use the Cash Flow Focus Report.

Summary and Links to Other Posts in This Series

Here is a short recap and a link to each blog post in this series on making your cash flow simple and easy-to-understand.

Part 1  – The surprising results of my super-short survey that asked: “How do YOU define cash flow in your business”?

Part 2  – “Cash flow” is not a single number on your financial statements. Now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.

Part 3  – I use a VERY different, simple approach to defining cash flow. It is an approach where I take my CPA and CFO hat off and speak in a common-sense language that you can relate to.

Part 4  – The Cash Flow Focus Report is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.

Part 5  – The four reasons cash flow has always been so confusing and complicated for business owners (and for bookkeepers and accountants too).

Part 6 – I show you the 4-step process for completing the Cash Flow Focus Report. I walk through each step in the process using a real-life small business example. It’s a cool little company that was founded almost 20 years ago. It has grown nicely over the years and the owners love the business. Last month, the business showed a profit of $32 thousand. But their cash balance went down during the month by $6 thousand (from $116 thousand down to $110 thousand). The Cash Flow Focus Report shows what caused the change in cash.

Understanding the Drivers of Cash Flow – There are a number of different drivers of cash (in addition to profit or loss) that you will encounter as you complete the Cash Flow Focus Report each month. You will not run into all of them in one month because we are only focusing on the three largest changes, or drivers, of cash for each month. But as each month goes by, you will eventually see each one of these drivers impact your cash.

Understanding the Drivers of Cash Flow – Profit or Loss – Over time, profitability is a super important driver of your cash flow. You want to see profit show up in the list of your three largest drivers of cash regularly. While it is not unusual to have a month where profit does not make the list of top three drivers, profit needs to be there often, or you likely have a problem that needs attention. We also look at a number of ways to improve your profitability.

Understanding the Drivers of Cash Flow – Accounts Receivable – If you sell products or services on terms where customers do not have to pay you at the time you make the sale, you will have accounts receivable. And you will find that accounts receivable show up frequently as one of the three largest drivers of cash each month. I also share four steps for managing accounts receivable wisely.

Understanding the Drivers of Cash Flow – Inventory – If you sell products to customers, then you likely have inventory on your balance sheet. You buy inventory, pay for it, then ultimately sell it to customers. The fact that you buy the inventory weeks or months before you sell it to a customer (and possibly wait even longer before that sale becomes cash), creates a big drain on cash. I also share some tips and strategies for managing your inventory more effectively.

Understanding the Drivers of Cash Flow – Accounts Payable – The rules of accounting require that expenses be recorded in the P&L when they are incurred, not when they are paid. When an expense is recorded, the accounts payable balance on your balance sheet is increased by the amount of the expense. When it is paid, the accounts payable balance is reduced (as well as the cash balance being reduced) by the amount of the payment. I also share some tips on how to avoid the accounts payable trap when cash gets tight.

Understanding the Drivers of Cash Flow – Owner Distributions – Ultimately, the financial success of your business will be defined by the amount of excess cash it generates. That’s why I like to define a Happy Owner as an owner who is receiving healthy and frequent distributions of excess cash from their business. The trick though is how best to define excess cash. I share with you the general rule I use to help business owners think about their cash balance. And how much of their cash they can safely consider “excess” and therefore available to distribute to the owners.

Understanding the Drivers of Cash Flow – Capital Expenditures – A capital expenditure is the purchase of a large asset like a vehicle, or a building, or a leasehold improvement. Capital expenditures do not show up immediately in your P&L. They are recorded on your balance sheet as an asset then depreciated over the estimated useful life of the asset. The expense shows up in your P&L each month as depreciation expense. It’s this accounting treatment for capital expenditures that makes it very important that you manage it closely — very closely.

Understanding the Drivers of Cash Flow – Debt – Debt includes borrowing money and repaying it. Debt can play an important role in business. But it is a double-edged sword that must be managed with care and attention. I’ll share some tips on how to think about debt in your business…. and how to manage the risks that debt creates in your business… and the risks debt creates for you personally.

 

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Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.

Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.

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Understanding Your Cash Flow – In Less Than 10 Minutes

This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.

The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.

It’s a fantastic way to learn the process.

I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.

There are two things that are very unique and exciting about this online course.

1. I’ll show you how to understand your cash flow in less than 10 minutes

2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.

I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.

Here is how one business owner describes the benefits of the course.

“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.

The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it.  And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.

The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.

Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow.  Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”

CLICK HERE TO LEARN MORE ABOUT THE CASH FLOW COURSE