In my last post in this series, we looked at capital expenditures as a driver of cash flow. I shared an example where a small business owner was so focused on profit as shown in the P&L, and keeping expenses down compared to budget, that the company let over $100,000 of cash leak out through the “back door.” And I walked through five tips and strategies for managing your capital expenditures wisely.
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 debt (borrowing and repaying money).
I include debt with third parties as well as debt with the owners of the business in the debt category. Borrowing money brings cash in the door. Paying that money back sends cash out the door. When debt is one of your three largest drivers of cash, the amount you enter is the net impact of debt for the month. 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 a positive change of $145,000. Debt is unlikely to appear as one of the three largest drivers on a regular basis unless you are paying down debt aggressively (high five if you are) or you are borrowing heavily each month. Debt can also show up frequently if you have an asset-based line of credit and your debt goes up or down based on your accounts receivable and/or your inventory balances each month.
A positive number – A positive adjustment to cash related to debt reflects the net amount of money you borrowed during the month.
A negative number – A negative adjustment to cash related to debt reflects the net amount of debt you repaid during the month.
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 your plans for managing debt. I mentioned the example of a small business owner in Part 3 of this series that is a great example. Their change in the Cash Flow Focus Report related to debt was a negative $100k. That repayment of debt represented the final step in their mission to become debt free in their business. They had begun their journey to becoming debt-free three years ago. Over that three-year period, they had paid off almost $500k of debt. Now they have zero debt. They felt absolutely on top of the world. They proudly labeled the negative change related to debt as good.
Assume a scenario where you have a line of credit in place with a bank and they unexpectedly called the loan. You were forced to repay $750k in short order. You put $400k of your own money into the business in the form of a loan because you didn’t have enough cash in the business to fund the full bank payoff. Your negative adjustment related to debt was a net of $350k. The good news is you have less debt now. The bad news is that it was a complete surprise and you had to scramble to pay the bank. I would label the change as bad because it left the business weaker as a result of the unexpected need to repay the bank.
Let’s look at Delta Air Lines as an example for how to label a positive change related to debt. (The Cash Flow Focus Report does a great job of making even a large company’s cash flow a little easier to understand.) The COVID-19 pandemic has had a big impact on lots of companies…. especially the airlines. Delta reported a huge $12 billion loss for the nine months ended September 2020. But their cash balance was up $19 billion. They had $3 billion of cash on their balance sheet at the end of December 2019. The cash balance rose to $22 billion at the end of September 2020. One of their three largest drivers of cash was net borrowings of $26 billion. You can see the Cash Flow Focus Report for Delta here. I labeled the change as bad because, while borrowing the money helps them survive for a while, the need to bring on such a heavy debt burden highlights the dire financial future they are facing.
Managing Debt Wisely
As a business owner, what is your position on the proper use of debt? Most things in life and in business are not black and white. Most questions have more than one right answer. And whether, or how, you should use debt in your business is no different. It depends a great deal on how you assess risk when using debt.
To me, the biggest downside of using debt is you could get your head cut off! Borrowing money includes the obligation to repay the money. You give the lender the right to take specific actions if you don’t (or can’t) hold up your end of the bargain. You basically hand the lender a meat clever and give them the right to start chopping off limbs if you don’t do what you promised. The problem with debt is it works when it works… and it fails painfully when it fails. When debt doesn’t work, it becomes an anchor around your neck (and your cash flow). Here’s a quote from the legendary investor Warren Buffet quoted in a great book Seeking Wisdom, by Peter Bevelin:
Whenever a really bright person who has a lot of money goes broke, it’s because of leverage… It’s almost impossible to go broke without borrowed money being in the equation.”
I like to measure financial health in my personal life as a strong net worth… and no debt. In business, in addition to having a strong net worth, financial health includes the ability to generate excess cash… with no debt, or a modest amount of debt. To me, creating and improving financial health in your personal life and in your business, and doing it with very little, if any, debt is a worthy goal. When I think about debt, I am usually thinking about how to avoid it, or if there is debt existing in the business, how to pay it off on an accelerated schedule. That’s how I am wired.
Here are some tips and strategies for managing debt in your business.
- Recognize that most small business debt is personal debt
- Consider the downside scenario when borrowing
- A revolving line of credit should, well, revolve
- Reducing debt is the goal
Let’s talk about each of those topics in more detail.
Recognize that most small business debt is personal debt. Most lenders require a personal guarantee from the owner when they lend to a small to medium size business. In some cases, the lender may even look more to the credit quality of the owner rather than the business. Many landlords require a personal guarantee on leases. Certain suppliers and vendors require personal guarantees as well. As a result, many of the largest debts and financial obligations of a small business are really personal debt of the owner.
Most businesses are run inside a legal entity like a corporation or limited liability company (LLC) in order to provide some liability protection for its owners. Legal entities have assets and liabilities separate and apart from those who own the entities. A personal guarantee wipes away those protections. With a personal guarantee, you are taking personal responsibility for a specific debt or obligation of the business. If the company files bankruptcy, or fails to pay the obligation, you are personally responsible to pay the debt. This is very different than how debt works in a large company. In a large company, on officer of the company is not going to sign a personal guarantee. In fact, the Board of Directors, as the representatives of the shareholders (the owners), generally forbid anyone in the company from signing a personal guarantee.
In the early days of building a business it can be difficult to avoid personal guarantees. But as you grow and become more successful, you have more leverage, and more reason, to purposefully begin reducing your personal guarantees. Most entrepreneurs and business owners rarely consider how much they have personally guaranteed. If you were to add up what you have personally guaranteed you would be shocked at the total dollar amount you are responsible for. One reason the number is so surprising, and so big, is because the guarantees have occurred over the years as the business has grown. You financed some new equipment, and the lender asked for a personal guarantee. You signed a new lease, or renewed an agreement with an important supplier, and a personal guarantee was part of the deal. Over time, the number and dollar amount of guarantees goes up. But as you grow your business and become more successful, it’s wise to think more strategically and thoughtfully about how you handle personal guarantees. You do that in two ways.
First, quantify the amount of your existing guarantees. The image below is a format you can use to list and quantify your existing personal guarantees.
Second, slowly begin reducing the number of guarantees. One of the best places to start is to refuse to sign any new vendor or supplier guarantees. Most vendors put the guarantee on their credit form but that doesn’t mean you have to sign it. They will almost always set up credit with the business as the only responsible party.
The bottom line with debt in a small to medium size business is that it is really personal debt. Keep that top of mind as you consider how you manage debt in your business.
Consider the downside scenario when borrowing. Here’s the big question you should ask yourself before you borrow money. “What are the consequences if I’m wrong?” Suppose you want to buy a new piece of equipment that will help you attract larger customers. You want to borrow $250,000 and pay it back over 5 years.
It is wise to think through and quantify what happens if you don’t get the new customers. If the investment turns out to be a bad decision, can you still make the payments? What implications will that have on the financial health of your business? What impact will it have on you personally (if you have personally guaranteed the debt)? Remember, just because you can borrow money doesn’t mean you should. The standard should be that you don’t borrow money if you can’t survive your idea or investment failing to achieve its objectives. Here’s another quote from Warren Buffet in Seeking Wisdom, by Peter Bevelin:
If we can’t tolerate a possible consequence, remote though it may be, we steer clear of planting its seeds.”
Managing the downside scenario is about being wise with debt and ensuring you take risks in a measured, calculated fashion. And making sure that you consider downside scenarios as you grow your business. The last thing you want to do is create a healthy company… only to have it wiped away with one bad decision that was funded with borrowed money.
A revolving line of credit is meant to, well, revolve. With a revolving line of credit, you borrow on the line in order to meet seasonal demands or address other short-term cash needs. Then, once those short-term needs have been met, the bank line should be paid back down to zero. A good example of a revolving line of credit is a company that carries inventory and whose sales are highly seasonal. Ahead of the busy selling season it needs to increase inventory levels. The bank line can be drawn on to fund the inventory purchases. As the seasonal selling ends, and the increase in inventory has been sold and converted to cash, the company can pay down the line. It had a temporary need to borrow money and the bank line gave the company the flexibility to meet its cash needs.
The problem is that many businesses borrow on their bank line for other than temporary cash needs. Sometimes it’s used for capital expenditures. Sometimes to fund losses. Sometimes to fund owner distributions. The availability of cash from the line can easily lead to decisions that have serious consequences later. The discipline of forcing yourself to pay off your bank line at least once a year (or more) will help ensure you are using the bank line the way it was intended.
If you have an asset-based line of credit in place, you should consider whether the amount you owe is beginning to look more like permanent financing than short-term financing. If you owe way more than you could pay back in short order, you may be creating unnecessary risk. Most asset-based lines have short maturities. If the lender or the bank decides not to renew the line, you could find yourself in crisis mode, scrambling to try to pull enough cash together to payoff the line. From time-to-time, take a good look at your debt level and consider whether a more traditional loan, with monthly payments and a fixed maturity, might be the more appropriate way to finance the business.
Reducing debt is the goal. Paying your debt down on an accelerated schedule is an important step toward improving the financial health of your business. This becomes increasingly important (and doable) as your business matures financially. Debt can be helpful in building your business. But as you become more and more successful over time, it becomes easier to pay your debt down faster. You don’t have to go crazy driving the debt down. Just consider bringing it down faster than it is currently being amortized. It might feel strange at first. But you will come to love the feeling of strength and accomplishment watching your debt shrink. It’s one of the many rewards for creating financial health and wellbeing in business.
Have you ever sat down and thought about how much debt you are comfortable having in your business? At what point would your debt levels start to worry you? I encourage you to pull out your balance sheet, take a look at your financial position and your debt levels, and give those questions some serious thought. One of the benefits of that exercise is it will cause you to think through how you measure financial risk in your business (especially if you have personally guaranteed a portion of the debt.) Here is an interesting quote from the book Antifragile by Nassim Nicholas Taleb (he is also the author of The Black Swan):
The world as a whole has never been richer, and it has never been more heavily in debt, living off borrowed money. The record shows that, for society, the richer we become, the harder it gets to live within our means.”
That quote is a reminder of how tempting it can be to keep increasing your use of debt as you grow and taste success. The question to consider is whether you are inadvertently increasing risk beyond a level you are personally comfortable with. Debt is leverage… and leverage creates risk. Risk is certainly a part of doing business and a part of growing a business. But it should be prudently managed and thoughtfully considered.
I encourage you to set specific goals for paying down your debt on an accelerated schedule. Then consider becoming your own bank for short-term cash needs.
Understanding the Drivers of Cash Flow – Other Drivers
In my next post in this series, I talk about other drivers of cash that you may encounter. These include drivers like depreciation and amortization expense, unearned revenue, prepaid assets, and accrued expenses.
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.
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.”