It’s Cash That Counts

(Kevin Callahan, the COO’s Bulldog, is on vacation. This article was originally posted on October 19, 2009)

I was working with an entrepreneur in startup mode recently, and was once again reminded of the difference between profits and cash. Particularly in startups, but also in more mature companies that achieve a breakthrough of some sort, mistaking profits reported on an income and expense statement with cash in the bank could be a crucial error. How do people make this mistake?

They do so by not taking into account the timing of cash flows. Remember, an income and expense sheet is reporting sales and expenses as they are booked for accounting reasons, but the cash flows that accompany the sales often do not happen at the same time.

For example, unless they are in retail, most companies do work on a credit basis (when retail accepts a credit card payment, they deposit slips like cash, so there is no extended term). You may not think about that way, but terms like Net 30 or Net 60 are nothing more than extending credit to your clients. In other words, your company is financing your customers’ purchases. The longer that it takes to be paid by your customer, the larger the debt that you finance.

Every company has a cash cycle, and depending on the business that you are in, there are more or less components to that cash cycle. Let’s take a company that distributes materials to other businesses. Here is a view of their cash cycle:

1. Purchase materials on credit terms (Net 30, 60, etc.) from suppliers
2. Hold in inventory
3.Repackage and sell to customers on credit terms (Net, 30, 60, etc)
4. Paid by customers
5. Pay suppliers

Now, this is a simplified cash cycle, but you get the idea. Obviously, if your customers are slow to pay you and you must pay your suppliers, you could be in for a shortfall of cash. Actually, one of the greatest risks to a startup or small company that is trying to grow is running out of cash while the business is expanding quickly. We should also note that there are other expenses (salaries, benefits, office space or utilities) that must be paid even if your customers are not quick paying you.

That brings us to the concept of Working Capital. Working Capital is the amount of cash that your company needs to have available in order to keep the cash cycle going or better put, to keep the company going. Working Capital is usually tracked in a type of spreadsheet known as a Capital Balance Sheet (which is a bit different than a Balance Sheet).

In a regular balance sheet, capital is kept above and debt below. In a capital balance sheet, a certain portion of debt is brought above. Here is the outline of a how to calculate Working Capital in a simple capital balance sheet:

Receivables (what your customers owe you)
+ Inventory
+ Current Assets
– Payables (what you owe your suppliers)
= Working Capital

Working capital represents the cash that a company needs to keep on hand to operate with receivables, inventory and payables. Receivables represent the cash that you have invested in materials and financing your clients. Payables are what your suppliers have invested in your company.

If the company sells $10,000 worth of materials in a month, 50% at Net 30 and 50% at Net 60, it means that they will not collect any cash for at least 30 days (if the customer pays on time!), and some of it not for 60. Even so, after expenses they might show a net profit of $1,500. There’s the rub, the net profit is not cash in the bank! If the company has bills to pay this month (or salaries) they must use the cash flow from previous sales to pay.

A startup company, in particular, will have problems if as they grow they do not have adequate cash in the bank to pay for expenses while waiting for cash to flow from sales. Often, a portion of the original investment capital in a new company is put aside for Working Capital; other means of having working capital at the ready could include a line of credit.

This is precisely what is meant by being adequately capitalized. Working with investors, bankers and others, the company’s executives must ensure that they have the cash in the bank to operate or they will literally be “out of business”!

4 thoughts on “It’s Cash That Counts

  1. Unfortunately I cannot credit the quote. However, ‘Turnover is Vanity, Profit is Sanity and Cash is Reality’ is one I have always remembered.

    I was mentoring some business students recently who couldn’t understand why their results on a business simulation excericse were so poor. When we looked at the figures, it turned out that not only were they offering greater credit terms to their buyers than they were receiving from their creditors – but they didn’t realise that the bank would charge them for being overdrawn.

    OK, so they had no experience, but a business man (and MBA graduate) I did some work for a few months ago could not tell me which of his invoices had been paid – let alone when. I have also done work for a £5m t/o company which did not realise that one of their divisions was losing them money and had NO CASHFLOW FORECASTS!

    I’m not a financial whizz – but it staggers me how little management information some businesses work with.

    It’s true that many ‘profitable’ businesses go bust, so well done for reminding us that cash really is King!

  2. Great points. In the book, Corporate Canaries, the author Gary Sutton speaks directly to this point – you cannot outgrow losses.

  3. My company is no startup (just over 26 years in business), but cashflow is still a critical item; especially in the current economic times. As a small custom software development / consulting company, we typically have one primary client at any given time.

    If that client is late on payment (or if a contract ends unexpectedly) cash reserves must be used to keep the company going.

    One thing that is rarely mentioned is the tax consequences of holding onto too much cash at the end-of-year (especially when you know you will be spending it shortly).

    Well…time to go check the mail and see if that check has arrived….

  4. “Earnings (or profits) is an opinion, cash is a fact”

    – Anonymous

    Although I suspect few “mature” companies mistake “profits reported on an income and expense statement with cash in the bank” – Kevin’s post from October, 2009 is both excellent advise and timeless.

    Drawing from the “Finance as a Business Catalyst – Creating Value; Not Just Counting It” philosophy – it is incumbent on the part of stakeholders who don’t understand timing differences across the respective cash flows to engage a financial professional who does.

    To Whit: For the year ending December 31, 2009 (one of the worst on record for working capital performance) average days working capital; (measure cash conversion cycle) for the 1,000 largest public companies jumped 8.2% from 35.4 (2008) to 38.3 (2009) days. Translation: Cash reserves must be sufficient to carry operations for 39 days before the aggregate of interim cash events generates enough liquidity to pay run-rate obligations incurred in the normal course.

    Cash Flow is a key to understanding business viability and enterprise value. Stakeholders, business consultants and other interested parties must be commercially aware, adaptable and focused on ensuring that the underlying business model is and remains relevant lest it be left in the dust by the competition.

    Business Viability and Enterprise Value are enhanced by:

    1. Investment evaluation criteria which include cash-driven measures such as PV, NPV and ROI
    2. Maximizing organic sources of funds
    3. Managing capital structure consistent w/optimizing allocation debt to equity to minimize cost of capital and maximize founder’s stake in business.

    Cash Flow is also a leading indicator of cyclical changes of an economic, segment, product line, customer and geographic variety.

    The Golden Rule, i.e. ‘Cash is King’, remains in full effect especially in times of economic downturn. Those companies with adequate to surplus capacity can lever value drivers in the form of:

    1. Greater access to capital (variant of “those who don’t need it benefit from ready access and those who do need not apply”)
    2. Lower cost of capital
    3. Minimize transactional costs
    4. Enter into purchase contracts and sales agreements on more favorable terms
    5. Maximize investment income (although with interest rates at historic lows; cash reserves fetch little return)

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