Optimising cash flow.

Hi, I’m Rob Lockhart from Westpac’s Davidson Institute here to talk to you about ‘Optimising cash flow’. A while ago I was working with a business that made kitchens. It was a well-respected business with great sales; it was growing rapidly and was making good profits. Yet they had massive cash flow issues. This distracted them from their core activities and in the end almost saw the business go under.

This video aims to provide a greater understanding of what drives cash flow and how it can be impacted by seasonality and sales growth to help you optimise your cash flow.

In this video we will look at the short-term drivers of cash and how seasonality can cause cash gaps. Then we will look at how long-term growth impacts your cash. And lastly what to monitor to keep on top of your cash flow.

We are starting with the short-term impacts on cash which is caused by timing differences between when you complete a job or a sale and when you collect the cash or pay the expenses. A question I always like to ask business owners is, “Why are you in business?” I get a lot of different answers or reasons why people go into business, but there is usually one common theme ‘to make money’.

Let me take this a little bit further, because when you are talking about money, are you talking about cash or are you talking about profits? There is an important difference between these two. Some people say they are in business to make cash; some people say they are in business to make profit. My belief is most people are in business to make profits. What actually happens is you use your cash to help you make profits. This is an important distinction. Cash and profits are not the same thing.

Understanding this, is the first step in optimising your cash flow.

Cash cycles through a business with the aim of generating profits. The Working Capital Cycle is a model that shows how the cash cycles though a business. Every business has a Working Capital Cycle, but they are not all the same. I am going to start with a generic Working Capital Cycle and then I’ll talk about some variations.

You start off with the money or cash sitting in your bank account. Now your money sitting in your bank account is not much good to you. You want to use that cash to make profits. To do this you first need to buy something that you can sell.

In this case you are going to take the cash out of the bank account and go and buy some stock. The stock comes in and you fill up your store, or your warehouse or your garage at home, wherever you put this stock. Then you look to sell that stock as quickly as possible as this is now cash tied up that you cannot use for other purposes.

For some of you when you sell your stock you get your cash straight away either as cash or as credit cards for others though you sell on credit. You issue invoices and create things called debtors or accounts receivable. This is where you become the banker to your customers. What you are doing is lending your customers the money to buy your goods or services.

And what do you hope these debtors do? You hope they pay you eventually and the dollar comes back into the business, with a little bit of profit too.

The reason we are interested in this cycle is because it’s all about how long it takes for your dollar to go all the way around the cycle. The faster you turn the cycle, the more cash you will have available to you; allowing you to grow more rapidly, reduce the risk and cost of using short-term debt, and potentially improve your profitability.

I said at the start of this, not all businesses are the same. The retailers out there are looking at this and saying, “I get everything in cash and credit cards, I don’t have debtors”. You would be right. Your cycle just goes from cash in the bank to stock and back into cash. That’s a bit simpler, however the biggest killer of retailers no matter where you go in the world is poor management of stock. It’s hard to pay the bills when all your cash is tied up in the stock on the floor.

Now, others of you are saying, “Well hold on a second, I’m a service business. I don’t have stock”. And again, I agree with you, however you have something that acts a little bit like stock it’s called work in progress or WIP. Basically, you take on a job from a customer, you do all the work for them, then you send out an invoice. While you’re doing that work, before you can send out the invoice, what do you have to pay out? Do you have to pay wages? Rent? Utilities and so on?

If you do, then it is using up your cash. Then, when you complete the job, you send out an invoice and wait for your customer to pay you … more time before your dollar comes back into the business.

Whatever business you’re in, you have a Working Capital Cycle. There are of course other variations too, but it is important to understand how the cash flows through your business, so you can find where your cash is hiding, and speed up your Working Capital Cycle. Because turns are days, days are time, and time, of course, is money. The timing of this cycle is a key driver of cash flow, and timing differences are why, for many businesses, as your sales go up, your cash goes down.

Let me illustrate how the Working Capital Cycle, and the time it takes for your cash to go around that cycle, can have a major impact on your cash flow. Let’s say you are entering your peak season and your sales are rising. Let me pick a point on this sales line. If you were to look at your profit and loss statement for this point, let’s say you made sales of $100 your Cost of Goods Sold was $80 and you made a profit of $20. But if you looked at your bank account, your cash would be down $40.

How can this be? It is because of the timing of your cash flows, or the length of time it takes for your dollar to go around the Working Capital Cycle.

Let’s assume you sell everything on credit. So, at this point, where you have $100 in sales, you do not get the cash for your $100 in sales you get $100 in debtors. However, you do receive cash at this point from collecting debtors from sales you made in the past. As past sales are lower you do not collect as much debtors as you create. If you have only collected $80 this means you have a cash shortfall of or cash gap of $20.

The same thing is happening with stock or WIP. At the point we have chosen you sell $80 worth of goods or services, but you have to also buy goods for sales you will make in the future. If you know sales are going up, then you will need to buy more goods than you sold. Let’s say you buy $100 worth of stock and you sold $80 worth, you have another shortfall or cash gap of $20.

The size of these cash gaps will depend on how fast you turn your Working Capital Cycle. The faster you turn the cycle the smaller the gaps. This process is part of the reason a lot of businesses, when they are growing, are running out of cash.

Interestingly though, at the back end of your season, when sales start to decline, the opposite occurs, and you get cash surpluses. Let’s pick the same level of sales on the way down. If you were to look at your profit and loss statement for this point it would be the same as on the way up. You made sales of $100, your Cost of Goods Sold was $80, and you made a profit of $20. But you would be cash flow positive by $40.

At this point you are still creating $100 worth of debtors, the same as on the way up, but now you are collecting debtors from some time in the past when sales were at a higher level. Let’s say you are collecting $120. This means you have a cash surplus of $20. An extra $20 in your bank account.

The same thing is happening with your stock or Work in Progress. You are still selling $80 worth of stock, but now you are buying for some time in the future at a lower level of sales. So, let’s say you purchase $60 worth of stock. You have another cash surplus of $20. This means as your sales go down your cash balance may go up.

Once you understand this, you can work on speeding up your Working Capital Cycle to reduce your cash gaps and help you to optimise your cash flow. For more information on speeding up your working capital cycle, look for our video on ‘Managing cash flow’.

The Working Capital Cycle and cash gaps gives you an insight into the drivers of short-term cash. To fully understand how to optimise your cash flow you also need to understand the impact of long-term growth on cash too.

To get a better understanding of how business growth impacts cash we’re going to use a model called The Financial Operating Cycle, to gain a deeper understanding of how your business works financially. Let’s have a look.

When you first go into business, what do you do? You break open the piggy bank and get all the money you can together to put into the business to get it up and running. This is Net Worth or Equity. This is your money; the owners’ money invested in your business.

The owners’ money is not always enough to get the business up and running. So then, what do you do? You might buy some stock on credit; you might borrow money from a bank. In accounting terms, the borrowed money is called Liabilities. I like to call it ‘other peoples’ money.

So, you have your money in, Net Worth, the other people’s money, Liabilities, now what are you going to do with it? Spend it, of course. You’ll spend it on things like cash, debtors, stock, plant and equipment, computers, motor vehicles, land and buildings, and so on. The things you need to operate your business, things accountants like to call Assets.

This equation, Assets = Liabilities + Net Worth, is the basis of the financial statement, the Balance Sheet. The Balance Sheet shows what Assets the business owns and where the money came from at a point in time. Continuing with our cycle, what do you do with the assets? You use them to make sales.

Of course, once you are making sales, you are going to have cost of sales and expenses. If you manage this well and your sales are greater than your expenses, you make a profit. If you make a profit, who wants their share of it? The tax man of course. But, at the end of the day, you are left with Net Profit After Tax or NPAT. This equation, of course, is your Income Statement, or P&L.

But this is a cycle, so it doesn’t stop there. There are then three things you can do with your profits. Firstly, you can reinvest them in assets to continue to grow the business. You can use them to reduce debt and reduce the risk to the business. Or you can take them home. You can take profit out of the business to continue to grow your personal wealth.

And so, the cycle continues. This Financial Operating Cycle is how every business in the world operates. It does not matter how big you are or how small you are. It does not matter what industry you are in. They all operate the same way financially.

From a cash flow point of view, it is really important for us to understand this Financial Operating Cycle. Many people see cash flow as having the money to pay the bills. These bills come from our suppliers, and they are called Creditors or Accounts Payable and are part of the Liabilities on the Balance Sheet. Similarly, the elements of the Working Capital Cycle, Cash, Stock, and Debtors, all live on the Balance Sheet as part of the Assets.

The majority of your cash flow lives on your Balance Sheet. If you want to optimise your long-term cash flow, you need to understand how your Balance Sheet works and the impact of sales growth on your Balance Sheet. The long-term aim for any business is to steadily continue to increase Sales and Profits, however to do that there is often an increase in Assets required too.

Let’s say our growing sales are shown by the upward diagonal line on the graph on the screen with our current Sales at point A. At this point we are making a certain amount of Profit and using a certain amount of Assets. If next year we grow Sales by 10% to point B and continue to manage our costs and Assets at the same level of efficiency, then the expectation would be that our Profits and our Assets would also grow by 10%.

However, if the dollar amount of extra Profit is less than the dollar amount increase in our Assets then the business will need to find extra money to fund the increased Assets. It is the increase in Assets that is using up money in the long-term.

Let’s go back to the Financial Operating Cycle and use a simple tool called Financial Gap analysis to help predict how much money you might need to find to achieve your growth target. Financial Gap analysis is about predicting your future funding requirements based on your expected growth in Sales and operating your business at the same level of efficiency. That is, continuing to generate the same profit margin using a proportional amount of Assets while growing your Sales.

Let’s look at an example. Say I am currently making $10,000 in Profit and to make $10,000 in profit I need to make $50,000 in sales. Let’s say to make $50,000 in sales I’m using $100,000 in Assets. At this point I have funded all the Assets from ‘owner’s money’ or Net Worth. So, my Balance Sheet reads ‘$100,000 of Assets equals $100,000 of Net Worth’.

Let’s say next year I want to double my profit’s and make $20,000. If I manage my Sales and Expenses at the same level of efficiency as this year, this means I will need to make $100,000 in Sales to make my $20,000 in Profit. If I manage my Assets at the same level of efficiency, I will need $200,000 in Assets. An increase of $100,000.

Where will the money come from for this additional $100,000 Assets? Given the business is aiming to make $20,000 in Profit and I retain all the Profit in the business, this $20,000 will be added to the Net Worth and be used to fund the increase in assets. However, I am still short $80,000. This means if the business grows to $100,000 in sales next year, I will need to find an additional $80,000, which will potentially be new Liabilities.

My Balance Sheet would then read ‘Assets of $200,000 equals Liabilities of $80,000 plus Net Worth of $120,000’.

In simple terms, sales growth often means we need more assets which means we need more money to pay for them. This draws on our cash and often creates more liabilities as well. If your business is growing rapidly, by using a simple tool like Financial Gap analysis you can estimate the money you may need to grow your business. You can then work out the best way to optimise where this money will come from.

For more information on Financial Gap analysis, watch our ‘Managing business growth’ video on the Davidson Institute website.

Now that we have looked at the short-term and long-term impacts on cash, how do you keep an eye on your cash to ensure it is being optimised? A useful tool to measure cash flow performance is a set of financial ratios.

Firstly, the Current ratio This ratio gives you an indication of your ability to pay your bills on time. It is calculated by dividing Current Assets by Current Liabilities. The result tells you ‘for every dollar you owe in Current Liabilities (those you need to repay in the next 12 months) you have this much available in Current Assets to pay them’. This of course needs to be a minimum of 1, and you would want to see this stay stable over time or increase.

The next ratio to look at is Net Margin. While I have said most of your cash flow is in your balance sheet, it is still impacted by Profits over time. For this reason, I like to keep an eye on my Net Margin, which tells you ‘for every dollar of sales, you are making this much profit’. In other words, how efficiently are you converting all your sales activity into profits.

Our third ratio is Sales to Assets. This ratio measures how efficiently you are using your Assets to generate Sales. It’s calculated by dividing your Sales by your Assets and the result is read as ‘for every $ of Assets, you are making this much in Sales’. You would like to see this ratio remain stable or increase over time.

The next three ratios are about the Working Capital Cycle and your cash gaps. They measure how long it is taking for your $ to go around your Working Capital Cycle. The stock days ratio gives you an indication of how many days, on average, your stock sits on the shelf for before you sell it. It’s calculated by dividing Cost of Sales by Stock, then converting the number of turns into days. You would like to see this ratio remain stable or decrease.

The debtor days ratio gives you an indication of how many days, on average, it takes your customers to pay you. It’s calculated by dividing your credit Sales by Debtors, then converting the number of turns into the number of days. You would like to see this the number of days within the credit terms you provide, and for it to remain stable or decrease.

Lastly, I like to look at creditor days. This ratio gives you an indication of how long you take to pay your suppliers. It’s calculated by dividing your Cost of Sales by your Creditors, then converting the number of turns into days. You would like to see this ratio at about the terms your Creditors offer. If it decreases, that is the number of days is lower than the terms offered, this means you are using up cash.

If it increases this may mean you are hurting your relationship with your suppliers due to slow or late payments.

There is more information on ratios in the ‘Measuring financial performance’ video on the Davidson Institute website. These ratios are useful as they act as an early warning system and help you to optimise your cash flow. However, the most important tool in optimising your cash flow is your cash flow budget or forecast.

The cash flow budget is an important tool in optimising your cash flow as it helps you understand how the cash flows through your business and it can forewarn you of when cash may be low or negative, giving you time to make a considered decision on how to react.

Without a forecast and time to react, often when you hit a negative cash position the only option available is to go the bank and get a temporary overdraft. This is generally costly and sometimes stressful. However, if you have time, which the cash flow forecast gives you, you may be able to collect your debtors faster, negotiate better terms with suppliers, or change the timing of some purchases, to reduce or avoid the negative cash position.

Even if you are still going to have a negative cash flow, you have time to go to the bank and arrange appropriate financing rather than a temporary solution. It is also important to compare actuals against your cash flow forecast each month. This helps to not only see if things have changed, but also to keep learning about how the cash flows through your business.

As we have seen, to optimise your cash flow it is important to understand both the short-term and long-term drivers of cash. In the short term, get to know your Working Capital Cycle and start to reduce your cash gaps. In the long-term, forecast the impact of growth on your cash with the Financial Gap analysis, and work on your asset and profitability efficiencies to optimise your cash. Putting together a cash flow forecast and monitoring it regularly will all help to optimise your cash flow.

Thanks for watching ‘Optimising cash flow’’. I trust you found the information helpful, and I encourage you to check out the other resources on the Davidson Institute website to help build your financial confidence. Bye for now.