In my last post in this series, we looked at owner distributions as a driver of cash flow. I shared 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.
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 changes is 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. Instead, it is recorded on your balance sheet as an asset. Then the cost of the asset you purchased is depreciated over the estimated useful life of the asset.
Evaluating a positive or negative adjustment to cash for capital expenditures is similar to how we evaluate the adjustment related to owner distributions. For the most part, it represents actual cash paid out. Although it is possible that a portion of capital expenditures incurred for the month are sitting in accounts payable and have not yet paid out in cash.
A positive number – A positive adjustment to cash related to capital expenditures owner distributions should be rare. It would indicate that there was an adjustment or correction recorded in the accounting system related to capital expenditures. I would get with the Controller or bookkeeper to learn what kind of adjustment was recorded.
A negative number – A negative adjustment to cash related to capital expenditures represents the amount of assets purchased during the month.
Labeling the Change as Good or Bad – In most cases the purchase of capitalized assets would be labeled as good unless the amount is a surprise to you.
Pay Special Attention to Capital Expenditures
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 so important that you manage it closely — very closely.
I worked with a business owner in the past who learned this lesson the hard way. Management did a good job during the year of keeping their expenses in line with the budget. They paid close attention to profit and how profit was tracking compared to budget. The big surprise came at the end of the year when the president realized that capital expenditures had more than doubled during the year. Capital expenditures totaled almost $200,000 for the year compared to less than $100,000 the previous year.
What happened? Management was so focused on profit as shown in the P&L, and keeping expenses down compared to budget, that they let over $100,000 of cash leak out of the company through the “back door.” There was no capital expenditures budget or plan. There was no accountability for capital expenditures during the year.
A Capital Expenditures Plan
Step 1 to controlling capital expenditures is to create an annual capital expenditure plan before the year begins. Here’s what the plan might look like.
A simple and straightforward plan provides benefits like:
- It gets you and your team thinking about capital expenditure plans before the year begins.
- It puts a focus (and a number) on the cash to be used for capital expenditures.
- It lets everyone know you are paying attention (that’s half the battle).
- It makes it easy to compare actual expenditures during the year so you can see how the plan is unfolding.
- When someone wants to buy an asset or something that will be capitalized on the balance sheet they need to explain how it fits into the capital expenditures plan.
I have seen this approach work wonders regardless of the industry a company operates in. And it’s not difficult to create and monitor once you understand that it takes more than a focus on P&L to manage cash flow properly each month.
Here are a few other tips to keep in mind when managing your capital expenditures:
- Don’t wait for your outside CPA firm to review expenditures at the end of the year and tell you which ones to capitalize and depreciate. Your Controller should have a process in place to ensure capital expenditures are properly recorded every month, not just once a year. Otherwise you will be flying blind during the year (and providing inaccurate financial statements each month).
- Most loan agreements have covenants regarding the amount of capital expenditures allowed in any given year. Make sure you consider any loan covenants when you finalize your spending plan each year.
- Include a discussion in your monthly reporting process each month about how capital expenditures are shaping up against the plan. Putting this front and center with your management team every month will create a level of visibility and accountability that pays big dividends.
An annual capital expenditure plan will help you shine the light on this very important component of your cash flow. It’s a great tool for managing (and controlling) the use of cash in your company.
Understanding the Drivers of Cash Flow – Debt
In my next post in this series, I talk about the impact that debt has on your cash flow and how it will show up in your Cash Flow Focus Report. As a driver of cash, debt includes borrowing money, repaying the amount borrowed, and paying interest on the debt outstanding. 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 brings to your business and to you personally.
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.
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.”
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