Understanding the Drivers of Cash Flow – Accounts Payable

In my last post, we looked at inventory as a driver of cash flow. And we looked at ways to better monitor and manage the impact inventory has on your cash flow.

In this post, I’ll 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 changes is 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.

Suppose you had a graphics designer create a newsletter for your business. The total cost for the service was $500. The work was completed, and you received the newsletter and the invoice for $500 on May 20th. You pay the invoice on June 10th. Under the accrual basis of accounting, your P&L would show the $500 as an expense in the month of May. But the impact on your cash balance in May would be zero because you didn’t pay the invoice until June.

A positive number – A positive adjustment to cash related to accounts payable indicates you recorded more expense in your P&L than you paid out to vendors. (Accounts payable on your balance sheet went up for the month.) Writing your one line explanation of the change is usually straightforward assuming the change is part of the natural ebb and flow of payables. At the end of any given month, it is not unusual for payables to be up a bit or down a bit. For example, you may have entered an invoice from one of your largest vendors during the month and it won’t be paid until the next month. That would increase payables. And payables would go back down next month. If your business is growing and expanding rapidly, your accounts payable balance will naturally grow over time. And you may see it often as one of the three largest drivers of cash.

A negative number – A negative adjustment to cash related to accounts payable indicates you paid out more to vendors than you recorded as expense in your P&L. (Accounts payable on your balance sheet went down for the month.) In most cases, this is part of the natural ebb and flow of payables. On the other hand, if you had a large vendor that reduced your terms, you would see accounts payable come down fairly quickly. Or if you are coming out of a seasonally strong sales period you would see that as well.

Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad depends on whether the change makes sense relative to what’s going on in the business. The first thing I look at when accounts payable has gone up is to ensure the change is not the result of becoming past due with vendors. That would be bad… despite the fact that it increases cash. If the increase is the result of a new agreement with a large vendor where your terms were increased from 20 days to 30 days, then that would make sense. That would be good because the increase in accounts payable is part of an agreement you have with the vendor. When accounts payable has gone down, I look first to see if I believe the reduction is temporary. Or if it had gone up last month and now it is coming back down. I want to make sure that payables are being managed so that vendors are paid in accordance with terms.

Let’s look at Cory’s multi-unit retail business for this example. Last month accounts payable was one of the three largest drivers of cash. The change was a positive adjustment to cash of $65 thousand. When the accounts payable driver produces a positive number in your focus report, that means your accounts payable went up. You owe more to vendors at the end of the month than you did at the beginning of the month. The $65 thousand was a big increase because his normal accounts payable balance is about $250 thousand. It turns out that a check run that would normally have happened near the end of the month was done two days after month end. So, the month end balance showed a big increase over the normal balance. Accounts payable was brought down to the normal level within two days. His one line explanation said: “Payables were up on a weekly check run that happened just after month end.”

He labeled the accounts payable driver as “Good” because the only reason accounts payable was up was because the normal check run was done shortly after month end. He knew the balance would flip back the other way next month.

How to Manage and Monitor Accounts Payable

It is not unusual for accounts payable to get little attention from a business owner. When times are good, it gets little attention because vendors are getting paid on time. It is viewed primarily as an accounting function where vendor invoices are recorded and paid. When times are not so good, it gets more attention because the weekly process of paying vendors becomes challenging. The owner is forced to get involved in the daily or weekly process of deciding which vendors or invoices are going to get paid and which are not.

I pay close attention to accounts payable because I know from experience that it can bite a business owner in the behind… in good times and in bad times. Here are three strategies I use to stay on top of the cash flow implications of accounts payable:

• Measure and monitor DPO (days of payables outstanding)
• Avoid the accounts payable trap when cash is tight
• Think more strategically about accounts payable and vendor relationships

Let’s talk about each one.

Measure and monitor DPO (days of payables outstanding). DPO is a big picture metric for monitoring accounts payable. DPO stands for days of payables outstanding. It is the number of days of expenses that are sitting in accounts payable. It is a measure of the overall terms you have with vendors. For example, if a company had a DPO of 30, you would expect that their average payment terms with vendors was around 30 days. In most businesses, I expect DPO to remain steady over time despite the fact that it will bounce around from month to month. The primary exception is when a company has become past due with vendors. If that is the case, the business owner and I will have goals set to get accounts payable down and get vendors paid on time.

DPO is a metric like DSO (days sales outstanding) and DIO (days inventory outstanding) in that it measures the time between recording a transaction and when the transaction impacts cash. The interesting thing about DPO is it is a measure of how fast you pay vendors. You might think that the slower you pay vendors the better. But I don’t believe that view is healthy… unless you have negotiated with vendors to increase the amount of time you have to pay. In that case, it makes perfect sense. But what usually happens when I see DPO rising is that the business is having a cash problem and slowing payments to vendors is one of their very first responses. I’ll talk more about how this plays out in a minute. The key is to monitor DPO each month to ensure there are no problems brewing in accounts payable. Watch out that you are not improving your cash flow by not paying vendors on time.

Avoid the accounts payable trap when cash is tight. One of the mistakes business owners make when cash gets tight is to slow down payments to vendors. If your accounting department wants to do a check run, but there is not enough money in the bank account to cover the checks or ACH payments, then you have no choice but to reduce who gets paid that week. And it works to relieve pressure on cash… at least for a little while. The problem is it will come back to bite you in ways you may not have considered.

Here is how things unfold when cash gets tight. The business owner or manager gets nervous because it is getting harder to pay all the vendor invoices as they become due. They get even more nervous if they are worried about making payroll. Not making payroll would be catastrophic on many levels. So, they choose the invoices that absolutely must be paid and let the others go unpaid for now. It creates what can feel like an instant fix. It can generate several hundred thousand dollars of cash real quick depending on the size of the business. When that temporary relief happens, it creates a false sense of security for the business owner. They go back to their other priorities because it feels like the pressure is off. But the problem is just beginning.

Accounts payable start aging out to thirty days, forty days, fifty days and more. After a little time passes, vendors start calling. If their problem is not addressed, they start raising hell and threaten to cut the company off and not deliver the products or services you need to run your business. They demand that you create a payment plan. Now you and your team (and your accounting department) are in crisis mode trying to appease vendors… while you are trying to save the business. You have an even bigger cash problem now than when you started slowing accounts payable down in the first place.

Here are two things you can do to limit the damage if you find yourself getting behind with vendors.

1. Treat it like a five-alarm fire from the very beginning. If you are getting behind with vendors, imagine that sirens are blaring at you all day long. The sirens are screaming “danger, danger, danger. We have a problem in the business that needs urgent attention or really bad things are going to happen.” You want to begin a hard-core dive into what is causing the cash flow problem. Was there a sudden event that created the problem? Has a cash problem been brewing for months and you were not paying close enough attention? What steps can be taken quickly to begin addressing the core problem? In addition, you want to look at all your options for freeing up cash. Can you speed up payments from customers, reduce inventory purchases, slow down capital expenditures, reduce owner distributions, or cut operating expenses? One of the big downsides of slowing payables down is that it can feel like a quick “fix” because it eases the cash pain. That initial sense of relief distracts you from the work you should be doing to fix the cash problem. It delays the time when you start working to solve the underlying problem.

2. Put a dollar amount on the size of the accounts payable hole you are digging. When you allow vendor invoices to go past due, you are digging a financial hole that you will have to work your way out of eventually. I have found it super-helpful to put a dollar amount on the size of the hole from the very beginning. Have your bookkeeper or Controller update the dollar amount of unpaid bills for you each week. It could be as simple as using the amount of accounts payable that is past due.

I was brought into a company years back by an owner that was unhappy with the financial health of his business. He had his eye on an investment to help grow the business. But cash was tight, and he was struggling to figure out how to fund the investment because of his cash problem. I had a sneaking suspicion that there may be more going on in accounts payable than just being “a little past due with some vendors.” So, I spent some time in the accounting department to “peel the onion”.

Here is what I found. The dollar amount of accounts payable (vendor invoices in the system to be paid) was three times more than the cash available to pay the invoices. More than half of the invoices were already past due. On top of that, not all the invoices had even been entered in the accounting system. There were recent invoices that were sitting in a stack to be entered in the accounting system later. The staff were in no rush to enter the invoices because they knew they would not be able to pay them anytime soon. The reports that had been printed to show the cash balance and the accounts payable balance (bills to be paid from the cash balance) did not even show these vendor invoices because they had not been entered in the accounting system. These invoices went into a stack I call the “these will be entered closer to when we think they can actually be paid” stack. I have seen this happen in many businesses when they experience a cash flow problem and start slowing down payments to vendors. Make sure that all vendor invoices are entered in the accounting immediately upon receiving them.

I would also count the number of weeks since you began delaying vendor payments. For example, if it has been four weeks since you were forced to delay payments, I suggest you have a note on your desk that says in big letters: “4 Weeks and $250,000 past due.” Make sure you always know how long you have been digging the financial hole… and how deep the hole is getting. As quickly as possible, you want to heed Will Rogers advice: “If you find yourself in a hole, stop digging.” And remember, the hole is going to have to be filled in with cash in the form of paying those past due invoices. The smaller the hole the faster you can repair the damage.

Also, you will need to create a good forecasting process as you work on getting your cash flow back under control. I am a huge believer in the value of a reliable forecast. I use a reliable financial forecast in good times and in bad times. It helps create a view through the financial windshield of your business. It will force you to think very clearly and simply about what you need to accomplish in order to get vendors paid and begin improving the financial health of your business.

Think strategically about accounts payable and vendor relationships. Your business interacts with vendors and suppliers almost every day. You send purchase orders, record invoices, process credits and discounts, and pay the vendor. But too often accounting is doing their work in the context of trying to stretch out payments to suppliers as long as possible. That’s how most bookkeepers and accountants were taught very early in their careers.

Think for a minute about your overall strategic goals (as a company) when it comes to vendor and supplier relationships. You want vendors who stand behind their products and services and keep their word. You want them to provide accurate and timely deliveries, consistent quality, and excellent service. Vendors who go above and beyond to help you grow and succeed. You want vendors that keep their word and that treat you with respect and integrity. You want reputable vendors who are going to be around for a long time. In short, you want vendors who are good at what they do.

The strategic opportunity is to say to yourself: “How can we take our obligation to pay vendors and actually use the accounts payable process to help us achieve our company’s larger relationship goals with suppliers”? You have a beautiful opportunity to manage accounts payable in a way that strengthens your relationship with vendors.

Here are four ways you can use the accounts payable process to achieve your larger goals with vendors and suppliers.

1. Consistently pay vendors on time (or early) – This goes against conventional wisdom with most accountants. Most of us were taught that proper cash management means slowing down the payment of vendor invoices. But slowing down payments to vendors as a principle is unwise. You don’t want to be out there working closely with vendors to strengthen relationships and improve the quality of the products and services you buy from vendors while at the same time accounting is poking a stick in their eye by purposefully paying slow.

2. Develop a relationship with the vendor’s accounts receivable team – The accounting team needs to develop a strong relationship with the vendor’s accounts receivable staff. Especially if your company is growing or has lots of different locations where orders are being placed. The more activity on the ordering and invoicing front, and the more people involved, the more important it is to have developed a relationship, so communication is easier and more effective.

3. Deal with errors or problems fast – You want to teach and remind your accounts payable staff to address problems or errors super-fast. With all the invoices being received, credits being processed, payments being made, adjustments being recorded, you can bet that issues or questions arise frequently.

4. Periodically remind the vendor’s CFO and CEO of your track record – You want to gently remind senior management at the vendor that you are treating them with respect. That you are paying them promptly and consistently as part of your commitment and how you do business. Done properly, and with some modesty, this can be surprisingly effective. It helps set you apart from almost every other customer they do business with.

Understanding the Drivers of Cash Flow – Owner Distributions

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

I like to put owner distributions in the category of the good, the bad, and the ugly. The good owner distributions are those that provide cash to owners to pay the income taxes that the business generates (assuming the business is a pass-through entity like an S corporation or LLC). And distributions of excess cash that represent a return on investment that you earn as an owner of the business. The bad owner distributions are those that don’t represent excess cash. They divert cash from the business that it needs to remain healthy. And finally, the ugly owner distributions. These are the distributions that the business can’t afford. They are driven more by supporting the personal lifestyle needs of the owner rather than the financial health of the business. These distributions harm the business.

One of the very important concepts we will discuss is how to define “excess cash” in your business. This is the secret to making smart decisions about how much cash to distribute to the owners.

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.

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