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:
- 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.
- 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.
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
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.
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
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.
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.
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.”