Understanding the Drivers of Cash Flow – Owner Distributions

In my last post in this series, we looked at accounts payable as a driver of cash flow. And we looked at ways to better monitor accounts payable and use it as a strategic opportunity to strengthen your relationship with vendors and suppliers. I also shared some specific advice about how to avoid the accounts payable trap when cash gets tight.

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 owner distributions.

Distributions of cash to the owners of the business generally fit into one of three buckets.

1. The first bucket is distributions to owners so they can pay income taxes on the profits (taxable income) generated by 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 is your responsibility as the owner of the business. The business should distribute enough cash throughout the year so you can make estimated tax payments based on the taxable income the business is expected to “passthrough” to your personal tax return for the year.
2. 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. I’ll talk more about that in just a minute.) These distributions are the return on investment you earn as an investor, an owner, of the business. Healthy and frequent distributions of excess car are the ultimate financial reward for a business owner. It’s your reward for owning a successful business. This is money you can invest in assets outside of your business as part of your plan for growing your personal and family net worth over time. These distributions are an important ingredient for creating happy owners. 😊
3. The third bucket is distributions that are not for the payment of taxes and do not represent excess cash. These distributions harm the business. They divert cash away from the business that it needs to remain healthy. They are usually more about supporting the personal lifestyle needs of the owner rather than the financial health of the business. You should work to avoid these distributions like the plague.

I will never forget the franchisee of one of our most successful locations during my ten years as the CFO of an international franchise company. He operated a single store and did it unbelievably well. The P&L looked awesome. He was making tons of money. But then things started to go wrong. Vendors started complaining, royalties started to be paid late (then not paid at all), and the death spiral began. It turns out that he had been pulling hundreds of thousands of dollars of cash out of the business as distributions to the owner and loans to himself as the owner over the years. He was pulling out more cash than the business was generating.

Evaluating a positive or negative adjustment to cash for owner distributions is different than how we evaluate the adjustments for other drivers of cash like accounts receivable, inventory, accounts payable, etc. Those changes represent more of an adjustment to profit. For example, a change in accounts payable is saying that while you may have recorded an expense in your P&L, it has not yet been paid (or vice versa). Owner distributions is much simpler in that the adjustment represents actual cash paid out to owners.

A positive number – A positive adjustment to cash related to owner distributions should be rare. It would indicate that there was an adjustment or correction recorded in the accounting system related to past owner distribution amounts. 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 owner distributions represents the amount of money distributed to owners for the month.

Labeling the Change as Good or Bad – In most cases the distribution of cash to owners would be labeled as good. Either because it was done with your approval or because it is for the payment of taxes in a passthrough entity or it is the distribution of excess cash.

Distributing Cash to the Owners

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.

Over time, profits are the key to driver of cash. But profits must first be used for the following before they can contribute to the creation of excess cash:

• Pay income taxes (or distribute enough cash for the owners to pay their income taxes if it’s a passthrough entity).
• Fund capital expenditures to maintain or replace fixed assets in your business. I refer to this as maintenance capital expenditures.
• Fund capital expenditures that are used to expand your business and increase your ability to grow revenues and profits.
• Pay down existing debt.
• Build a nice cash cushion that can help you when unpleasant surprises happen.
• Fund acquisitions.

All of those needs must be taken care of before the business can be considered to be generating, or adding to, the amount of cash that can be considered excess cash. Here is 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.

• Minimum cash target. This is the balance you work hard to never go below. I generally set this at about one month or so of operating expenses. Trying to run your business with less than that amount of cash in the bank is dangerous. The smallest hiccup in sales or collections from customers can wreak havoc. It creates unnecessary stress and makes your life much harder than it needs to be because you are constantly dealing with a cash balance that makes it hard to get everyone paid on time. It is much better to accept the reality that you need money in the bank to run a business… and one month of operating expenses is generally a good number to use as a minimum.
• Comfortable range. This is a range of cash balances that you operate the business with most of the time. When you are operating in this range, you are not worried about your cash balance. You are not having to worry about whether you can pay vendors this week. You have a healthy cash balance and you are not sweating bullets managing the cash from day to day and week to week.
• Excess cash. This is the amount that, when the cash balance on your balance sheet goes above this number, you have more cash on hand than the business needs for current or future uses. That excess cash is the amount available to distribute to the owners of the business.

Let’s look at Tim’s business as an example. They do about $3.5 million in annual revenues. His business provides services primarily to manufacturing companies. Much of the work is project driven where customers are invoiced based on project milestones and some are invoiced based on time incurred. They don’t carry inventory but they do have some fairly large accounts receivable. DSO routinely runs at 50 to 60 days.

Here is how Tim sets his cash targets using this approach.

• Minimum cash target. His monthly operating expenses usually come in between $190k and $225k. He set his minimum cash target at $300k. That is about 1.5 months of operating expenses. The cool thing about Tim is that the $300k was a little too low for him at first. Tim is the kind of business owner that likes having money in the bank. He had run the business in years past on skinny bank balances… and learned that wasn’t the approach he was most comfortable with. He decided that 1.5 months of operating expenses was a good place to start as a minimum.
• Comfortable range. He set his comfortable range to be in the $300k to $700k range. The cash balance generally runs in the $400k range during the first part of the year and grows past the $700k range near the end of the year. He makes owner distributions during the year for taxes because the company is an S Corporation. Healthy profits and consistent collections on their accounts receivable add nicely to their cash balance as the year progresses.
• Excess cash. He set the excess cash number at cash over $700k. Unless there was an exciting growth or strategic opportunity on the horizon, he is comfortable considering the cash above $700k to be generally available to distribute to the owners.

I have found this approach to thinking about your cash balances to be super-helpful for business owners and financial people alike. Give it a try and see how you like it.

Understanding the Drivers of Cash Flow – Capital Expenditures

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

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 life of the asset.

As a result, you don’t see the cost of that capital expenditure show up immediately in your P&L. It’s this accounting treatment for capital expenditures that makes it so important that you manage it closely — very closely.

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.

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