In a previous post, I discussed the need to know your numbers. Today, I’m going to expand on that notion to knowing your cashflow. Richard Branson said “Never take your eyes off the cashflow because it’s the life blood of business. As I have said before, I’m not a fan of relying on historical financial statements to manage your business, but the one statement within those financial statements that I believe has tremendous value is the cashflow statement. In fact, when I’m presenting financial statements to an owner or a board of directors, I always start with the cashflow statement, after all, as Branson says, it is the life blood of the business.
In gaining an understanding of your cashflow you must start with knowing the silos in which cash is provided by or used in your business. There are three distinct silos: operations, investing and finance as depicted below:
Operations cash flow is the cash provided by or used by what you do as a business, such as, manufacturing and selling widgets. The cash generated by selling the widgets versus the cash spent producing, maintaining inventory, selling and operating the business determines the cash flow from operations.
The second silo is investing. Investing cash flow is the cash used to purchase new equipment or build a new facility, it is also the purchase of securities or other investments with excess cash. Investing activities provides cash through the selling of old equipment or other fixed assets and proceeds from the sale of securities or other investments.
The third silo is financing. Financing cash flow is the cash provided via borrowings or equity infusions from owners/shareholders and the cash used for paying principal payments on debt owed and dividends or distributions paid out to owners/shareholders.
Knowing your cash flow means understanding how your business is performing in each of these cash flow areas. It is important to track month over month, quarter over quarter, or at a minimum year over year. Once you have an understanding and working knowledge of these cash flow areas and you are tracking the results you can take a deeper dive into what is driving your cash flow (good or bad).
As an example, consider this scenario: You have been experiencing some difficulty with your line of credit, it just doesn’t seem to be going down or certainly not at the rate you would like, maybe your banker has even mentioned about it being a little stale and they would like to see some movement. You are frustrated because you feel like your business is going well and you just don’t understand why you are unable to get the line down.
You dive into your cash flow breaking it out into the silos mentioned above. Your operations have been generating a steady positive cash flow, although not growing, it is steady and positive. You’ve invested in some new equipment each of the last two years which has caused your cash flow from investing activity to be a negative and your financing section has provided some positive cash because of the draws you’ve taken on the line of credit. When you combine all three silos your cash flow is a slight decrease each of the prior two years, but nothing too alarming.
DIAGNOSIS AND ACTION
I see two issues in this scenario. The first issue is the company purchased new equipment and the purchase used more cash than was provided by operations, thus the draws on the line of credit. A line of credit is intended to be used as a short-term financing tool to help even out cash flow periods. By drawing on the line to cover the purchase of assets you’ve used a portion of your short-term capital for long-term financing.
The equipment should be re-financed into installment loans and the proceeds used to pay down the line-of-credit.
The second issue is an operations issue. Generally, when you invest in new equipment you expect a return on the investment. The new equipment should be providing additional capacity or opportunities that you didn’t have prior to the purchase. Why else would you make the purchase other than to have a positive impact on the business? However, as mentioned in the scenario, cash flow from operations has stayed steady, the new equipment did not provide an additional uptick in cash flow. There are several reasons why e.g. errors in initial purchase analysis or unpredicted upstream bottlenecks preventing you from scheduling the equipment to be fully utilized.
Knowing your cash flow in the way discussed above and empirically tracking the information provides business insights that become a powerful tool to help plan and manage. These business insights minimize day to day stresses being a business owner can create. I’ll leave you with yet another quote to consider in the importance of cash flow, this one from Peter Drucker: “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”
Post by Todd Williams.
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