Content Type, Financial Insights | October 13, 2016
Written By: Alex Glassey, www.AlexGlassey.com
This we know: 82% of businesses that fail, fail because of cash flow problems. Because of this, business owners are encouraged to become “financially literate”. But what does that mean?
Wikipedia says that financial literacy “…refers to the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources.” Good to know, but financial literacy in business covers a LOT of ground. EVERYTHING that goes on in a business affects its financial performance.
Does that mean that a business owner needs to understand financial statements, ratios, and the effects of pricing and strategy on cash flow? Yes. Eventually. But Rome wasn’t built in a day. So let’s start with the seven basic elements of cash flow:
The seven basic elements of cash flow are a great place to start. The seven elements introduce key terms that the business owner will use throughout their career. They inform him/her about their cash flow and allow him/her to make appropriate, timely decisions. And the seven elements naturally lead to more sophisticated financial literacy topics when the time is right.
Revenue is the source of sustainable cash flow. When you create invoices for your customers, then revenue is the total of those invoices.
If you’re in a cash business, then revenue is the total cash that you receive from your customers.
Rule of thumb: increasing revenue should increase cash flow.
Sales and marketing activities create revenue. They bring appropriate customers to us and convince them to purchase.
There’s always tension in the minds of business owners about these expenses: we must spend money to find new customers and convince them to buy. But spending money reduces cash flow. So we’re always balancing the money we spend on sales and marketing with the revenue that they generate.
It’s very important to track the effectiveness of sales and marketing activities: they MUST generate significantly more revenue than they cost. How to do this is a topic for another day, but the rule of thumb is: healthy cash flow needs sales and marketing activities that generate significantly more revenue than they cost.
When a customer buys a product from us, we incur costs related to acquiring, producing, packaging and shipping that product.
This is also true when we deliver a service to a customer: we have costs related to the labor or technology used to deliver that service.
The rule of thumb is simple: the smaller our costs of goods sold, the better our cash flow.
In addition to sales, marketing and COGS, there are many other potential expenses that reduce cash flow: staff, rent, communications, travel, accountants and lawyers, etc.
The rule of thumb: spend as little as you can without affecting your ability to operate effectively.
Everything in sections one through four above appears on the Income Statement (or Statement of Profit & Loss). Revenue is shown at the top and everything else is subtracted from it to create the “bottom line”. When our revenue is greater than all the expenses, the bottom line is a positive number called profit. When revenue is less than expenses, the bottom line is negative and is called a loss. This leads us to…
The biggest and most misleading cash flow myth: When we have profit, we have healthy cash flow.
Profit is simply a measure of operational effectiveness. It tells us how much cash our operating activities SHOULD generate, but it leaves out two critical things that can dramatically affect cash flow: timing and things that don’t affect operations. Which, if ignored, can kill you.
The rule of thumb? Don’t use profit when thinking about cash flow.
Let’s get back to revenue. You’ve done some work or delivered some widgets. You’ve created an invoice and sent it to your customer. Your revenue proudly shows the total of all your invoices. Good work!
And then your customers don’t pay for one month, or two months or, gulp, three months.
Can you see how the timing of customer payments significantly affects cash flow?
Your accounting system tracks how much money your customers owe you in accounts receivable. Which is great, but wouldn’t it be nice to know when you’re going to get paid? This is where “accounts receivable days” comes in: it’s the average number of days it takes your customers to pay.
Rule of thumb: reduce accounts receivable days to improve cash flow. In other words, get paid sooner.
Just as your customers pay you, you pay your suppliers. And just as your customers sometimes delay paying you (which worsens your cash flow), you can delay paying your suppliers (which improves your cash flow by keeping the cash in your bank account).
Your accounting system tracks how much money your business owes in accounts payable. And the average time you take to pay your bills is known as “accounts payable days.”
Rule of thumb: improve cash flow by increasing accounts payable days. But don’t wait too long to pay your suppliers or they may not want to have you as a customer.
There are several other things that affect cash flow, but keep two in mind for now:
Neither of them shows on your income statement. This makes them easier to forget when you’re thinking about cash flow. But when you forget about your $800 truck loan and the $3,500 you just spent on a new laptop, you can find yourself in a cash flow pickle at the end of the month.
Rule of thumb: loan payments and large equipment purchases don’t show on your income statement but they DO affect cash flow!
Closely and constantly
Cash is the life’s blood of every business. It must be monitored closely and constantly. Spend a few minutes with these seven elements each week and you’ll develop an excellent sense of your business’s cash flow.
Expert Tip: Learn about the cash flow statement
Want to go a little further? Ask your bookkeeper to prepare a cash flow statement for you every month along with your income statement. If you’re using accounting software, it’s very easy to produce.
About Alex Glassey:
Alex Glassey teaches business owners with his blogs, books and online courses. Click here to learn more about cashflow in this free online training session.