Money DayFrom Profit to Cash: Over the River and Through the Woods
From Profit to Cash: Over the River and Through the Woods
The content in this session is taken from a book by Greg Crabtree entitled Simple Numbers, Straight Talk, Big Profits! Greg is a CPA and founding partner of Crabtree, Rowe & Berger,a Huntsville, Alabama, consulting firm. Greg is also a delegate to the EO Standing Finance Committee and a past member of the EO Global Board of Directors.
Positive cash flow occurs in most businesses in a later timeframe than profitability. That timeframe can be days, months, or even years. Knowing when that timeframe will occur for your business requires analysis of your current situation and a forecast of your future. The first step is organizing and examining your Profit & Loss data and Balance Sheet numbers. Once you’ve done this, you can assess the impact of profitability on your business’s cash flow.
In this session, we’ll continue the planning and forecasting activity you started in the module, “Approach Your Business Strategically by Getting’Jiggy with Your Numbers.” We’ll see how Greg Crabtree’s Cash Flow Model can take you beyond simple, one-month forecasting to a year-long, rolling 12 months of data that allows you to manage your cash flow rather than react to it.
“As you become more profitable, prioritization of your cash flow becomes a strategic endeavor instead of a fire drill with no exits.”– Greg Crabtree, Simple Numbers, Straight Talk, Big Profits!
Ultimately, cash flow is crucial to a business’s survival. A company can fail due to a lack of cash even though it’s profitable. Your goal is to keep your business healthy so it rewards you with profits.
Objectives
After completing this session, you will be able to:
Define the four forces that affect your cash flow
Apply a cash flow model to your business and analyze the results
Develop a cash flow management plan that works for you
Understanding the Basics
Before you begin your journey to cash flow wellness, you need to understand some of the fundamental concepts and terms we’ll be using in this session.
Cash flow is the movement of money into or out of a business. It is usually measured during a pre-defined period of time.
A cash flow statement is a financial document that shows how changes in balance sheet accounts and income affect cash and cash equivalents.It excludes non-cash transactions (such as depreciation) that do not directly affect cash receipts and payments.
Cash flow management, in its most basic form, is the process of delaying outlays of cash as long as possible while taking in cash from anyone who owes you money as quickly as possible.
And cash flow forecasts help you build a model of the way in which cash moves within your business. A model can help you predict whether the sales or income you forecast will cover the costs of operation.
Cash flow is broken down into three categories. These cash flow categories pertain to both businesses and business owners:
Operational Cash Flows– Cash received or spent as a result of a company’s business activities. For instance, it’s “cash in” from sales, “cash out” to employees and suppliers. For the business owner, it’s salary to the owner’s personal account.
Investment Cash Flows– Cash received or spent through investing activities. Purchasing and selling assets that will help grow the business is one example of an investment cash flow. For the business owner, it’s assets that will help increase the owner’s personal net worth.
Financing Cash Flows– Cash received through debt or paid out as debt repayments. For the company, it might mean issuing stock, paying down debt, and repurchasing shares. For the business owner, it’s cash coming from loans and payments to pay down personal debt.
If a business comes up short on cash and is unable to meet its obligations, it’s called a cash flow crunch.If severe enough and prolonged enough, a cash flow crunch can lead to business insolvency and personal bankruptcy.
This is where a Cash Flow Model can help you. It offers two particular advantages when analyzing your business data.
The first is the ability to look at data over a long period of time. Historical data helps you identify trends that tell you how to manage cash flow in future months.
The second is the ability to calculatemetrics. Greg suggests several key metrics in his book: Revenue, Operating Cash Flow, Salary Cap, etc. When business owners see changes occurring in these metrics over time, they can seek to understand the causes and act to avoid future problems.
Before we move on, there’s another question to answer. Who, besides you, has an interest in your cash flow wellness?
Potential investors, who need to decide for themselves if your business is financially sound
Potential lenders or creditors, who want to determine your ability to repay debt
Potential employees or contractors, who will require compensation
Shareholders of the business
All of these entities will have an interest in your cash flow projections, particularly bankers and investors who will want to see a detailed forecast, balance sheet, and cash flow statement from your business.
A Word of Caution“There are a lot of people who sell very expensive, very detail-oriented cash-flow projection systems that allow you to create massive spreadsheets. Don’t buy or create a system that requires far more effort to update than the value you get from it. If you spend all of your effort updating the system, you’ll spend very little time analyzing the data.”
– Greg Crabtree, Simple Numbers, Straight Talk, Big Profits!
The Four Forces of Cash Flow
The problem with cash flow is that it lags behind profit for most businesses. What this means is that unless your customers pay you and you pay your vendors at exactly the same time, there will be a lag between profit and cash.
If your business is profitable, you’ve made it “over the river.” Now you have to get “through the woods” to a state of cash flow wellness. Greg Crabtree has developed a method to help his clients prioritize their use of cash and build value into their business. He refers to these uses as “cash flow forces,” and regardless of whether your business makes a profit or loss, the four forces will apply to you.
Cash Flow Force #1 –Pay Taxes
“The hardest thing in the world to understand is the income tax.”– Albert Einstein
The first priority you must address is taxes, which Greg Crabtree calls Cash Flow Force #1.
Every entrepreneur wishes this force was at the bottom of the list. To keep it from winding up there, you should set aside 40% of your taxable profits as you earn them on whatever basis your tax return is prepared under. In the US, this percentage should be sufficient to cover both federal and state income taxes, and still provide you some cushion (unless the US has a significant change in the tax rates, up or down). Once the fourth-quarter estimate is calculated or the return is filed, you can use any of the excess left over for Cash Flow Force #2.
The trick to paying taxes is timing – don’t pay them until you absolutely have to without incurring a penalty. If you wait until the end of the year to pay and haven’t set the money aside, you may not have enough cash on hand. Greg recommends pulling this money out of the business and setting it aside in a separate savings account. Once it’s out of your business at the end of each quarter, you can decide how to distribute the remaining 60%profit.
It’s Tax Day– Surprise!In the US, if your business is an S corporation, LLC, or partnership, it may be a “pass-through entity.” All of these legal entities pay no tax at the company level, and they “pass through” the profits or losses to the owners based on their ownership percentages. The big confusion is that most people think they do not owe the tax on the profits unless they get a distribution. Unfortunately, they have to pay taxes on the profits whether they take a distribution or not. Check with your accountant or tax professional for the best way to handle this.
Cash Flow Force #2 – Pay DownDebt
After taxes, your next priority should be to pay down all debt. Once you have no debt and hit your targeted cash levels, you have immense flexibility to distribute profits or take advantage of opportunities only available to those with spare cash.
Recession-Proof“People who take a low- to no-debt approach can handle bad economic news because they live more stable and productive lives. I have clients who are doing quite well – even in the midst of a struggling economy – because they’ve stuck to this principle.”
– Greg Crabtree, Simple Numbers, Straight Talk, Big Profits!
Term Notes versus Line of Credit
For starting businesses, consider setting up term notes over using lines of credit. If the owner has a good track record of managing irregular cash flows and has the discipline to repay the loan before spending cash on other discretionary items, then a line of credit may be appropriate.
Mature businesses can use term notes for equipment purchases where the note covers the term of the asset’s useful life. But this is still second-best to having no debt. Remember, to stop interest expense is to make interest income. Most of us would love to invest in CDs that paid the same interest rate as a bank gets on a business loan.
Using Debt Effectively
If a situation arises where you’ve exhausted your cash reserves but still need cash, you’ll have to find a way to keep your business going. If you’re managing your cash flow appropriately, this situation should not be a regularly-occurring problem but rather an “unusual disruption.” This is when you should use your line of credit. You’re not incurring this debt because you’re funding a losing business – you’re incurring it to get over an unexpected bump in the road with a reasonable expectation that cash will come into the business in the future.
Cash Flow Force #3 – Build to a Core Capital Target
When it comes to cash, the more of it you have, the more psychological advantage you have with your customers, competitors, and employees.
When is enough enough? A good “spare cash” target for a business is two to three months of operating expenses after all other debt has been paid. You adjust this number up to six months if your business does not have significant receivables or equipment that can be leveraged in a crisis. You would also add to this amount any major equipment purchases or acquisition plans.
Greg reminds us that history is the best predictor of the future. If your business experiences a downstroke, you will want to make sure you have enough cash available to handle that downstroke if it happens again. If you can anticipate that next downstroke, you won’t need to draw on a line of credit to cover it.
Cash Flow Force #4 – Pay Profit Distributions
After the first three priorities have been addressed, it’s finally your turn. This is the point at which you can pull cash out or sell or – well, your options are many.
“This ties back to the basic philosophy that if you pay yourself a market-based wage, you can live off that salary. Then you can leave the after-tax profits in the business until it is healthy and you reach your core capital target. After that, you can start to take distributions that are beyond the tax expenses.”– Greg Crabtree, Simple Numbers, Straight Talk, Big Profits!
The company is now a profitable enterprise that has paid all its taxes, is debt-free, and has anywhere from two to six months of operating expenses in the bank. This is a business that somebody would buy. But you also have a business that is spinning off a return to its investors (you!), which means that your choices are wide open.
In short, you have used the company’s own cash to build value in the company. When and how you decide to realize this value is up to you. You may want to sell the company, continue to reinvest earnings in the company, or invest in other opportunities. All of which is the result of using your cash wisely so the business is free and clear of all claims.
Case Study #1 – A Good Example of a Good Example
“Springfield ReManufacturing Corp (SRC) was established in 1983 when 13 employees of International Harvester purchased a part of that company that rebuilt big-vehicle engines, with $100,000 of their own money and $8.9 million in loans. By 1988, SRC's debt to equity ratio was down to 1.8 to 1, and the business had a value of $43 million. The stock price, $0.10 in 1983, had increased to $13 a share.
Since 1983, SRC has founded and invested in more than 35 separate companies that do everything from consulting to packaging to building high-performance engines. SRC has sales of over $400 million per year, with more than 1,200 employees.
SRC is known as being an employee-owned company and the culture of ownership permeates the entire organization from the CEO to the shop floor. A key part of this is business education that is regularly promoted throughout the company to help everyone in the company understand the financials, which are published in lunchrooms and other visible locations throughout the plants. This culture has made the company very successful in their business as everyone in the company is involved in improving the quality of their workplace and the value of the company.”
– Wikipedia
Greg Crabtree notes in his Simple Numbers book that on a two-day tour at SRC he met employees of the company who could explain a balance sheet, a Profit & Loss statement, and a cash flow statement better than most accountants.
He writes, “Springfield ReManufacturing had a simple process. They would draw up a plan for the entire year, but more importantly, they would forecast for the entire year. The plan was drawn up once, but the forecasts were updated each month as actual results became known and better information was available to forecast expectations for the remainder of the year. When they began the month of April, they would know the actual numbers from January through March. Then they would make a weekly projection of what they thought was going to happen in April. Then they projected data on a month-to-month basis so they had a forecast for the rest of the year. They knew, based on three months of actual data and nine months of forecasts, where they thought they were going to be by the end of the year.”
Case Study #2 – A Good Example of a Bad Example
April 13, 2012, SAN FRANCISCO (MarketWatch.com) — If you’re thinking Groupon Inc. might be closer to being a buying opportunity, now that its market capitalization is below $9 billion, first take a look at a couple of items in the cash-flow statement of its amended annual financial report. Those items highlight the risk that a young company like Groupon, with a limited operating history in a nascent market, might be making the same type of erroneous assumptions in cash-flow calculations that it did in income-statement items that ultimately proved inaccurate.
Follow the cash flow
Let’s turn to the cash-flow statement. The company said in its most recent filing that it generated operating cash of $169 million in the fourth quarter and $290 million for the full 2011.
Groupon started off its cash-flow process in a big hole, of course, given that its net loss was just short of $300 million. That huge net loss was turned into cash flow mostly with two items: $165 million for “adjustments in noncash items” and a whopping $423 million for “changes in working capital and other activities.”
Regarding the first item, the biggest noncash adjustment was $93.6 million related to stock-based compensation expenses. Those of you who were around for the first Internet stock boom will remember this accounting twist, which allows a company to write off the cost of its employee equity compensation in a way that turns it into cash. Once employees exercise options or sell restricted stock grants, though, those transactions put more Groupon shares in the market and dilute the stake of common shareholders. This is partly why Groupon’s cash-flow statement looks better than its income statement to owners of its common stock.
Very large assumption
The other item that helped generate most of Groupon’s cash flow is called “changes in working capital and other activities.” It consists mainly of a huge entry for an “increase in merchant payables,” according to its amended annual report. That item is worth $380 million to the good side of Groupon’s cash flow.