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The Effect of Sales Growth on Cash Flow

Posted on May 30th, 2016

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

Continuing in this series of articles, in my previous article, “Which is More Important, Profit, or Cash Flow?” I demonstrated that Profit on an accrual basis is actually a critical component of Cash Flow.  So, looking at Cash Flow on a cash basis doesn’t tell the business owner (or anyone else) what he or she really needs to know about the health of their business.  So now let’s see what effect sales growth, every business owner’s dream, can have on cash flow. For purposes of this discussion, we’ll now call the company “Larry’s Growth Strategies, Inc.”

In this scenario, I started with what the company’s financials looked like after Larry restored profitability, and assumed from there that his sales quadrupled over a 12-month period from (rounding) $98,600, to almost $395,000. At the same time, I assumed that the company’s cost of goods sold increased from 7.7% to 25% of sales, reflecting this exciting new product line that stimulated sales growth. I also assumed that Payroll Expenses increased significantly (let’s call it “sales” salaries), such that the company’s Profit remained the same as the prior year, or about $15,000.

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The first thing that needs to be explained is that on a month-to-month basis, the turnover ratios (see “The Relationship Between Turnover Ratios and Cash Flow”) remained the same as before, except for accounts receivable which I assumed slowed from 30 to 45 days (see Turnover Ratios, Monthly Assumptions).  However, when the annual turnover ratios are calculated, they all appear to be much slower. This is just a mathematical anomaly that results due to the large increase in each of these accounts at year-end that distort the turnover ratios. But this phenomenon is extremely important to keep in mind when calculating turnover ratios.

Now, note in the Pro forma Cash Flow Statement the changes that occur due to the increases in accounts receivable (uncollected sales) and inventory to support this sales growth (uses of funds), which were only somewhat offset by the increase in accounts payable (source of funds). The bottom line change in cash flow was a negative $115,000, which absorbed all of the company’s previous cash surplus and put it into an overdraft situation.

This is precisely the kind of funding scenario for which specialized factoring (accounts receivable finance) companies exist, as funding situations like this are usually not “bankable.” However, to ignore this funding requirement way ahead of the time it’s needed is almost a sure recipe for bankruptcy, or worse, total business failure.  In my next article in this series, we’ll look at a “turnaround” scenario assuming that our budding “entrepreneur” Larry had to learn this lesson the hard way.

 


Which Is More Important, Profit, or Cash Flow?

Posted on May 23rd, 2016

 

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my previous article, “The Relationship Between Turnover Ratios and Cash Flow,”  I demonstrated the impact of improving receivable collections and reducing inventory levels on cash flow.  In this article, I will take it one step further and illustrate the effect profitability has on cash flow.  (And note, in this article I have now appropriately changed the name of the company to “Larry’s Survival Strategies, Inc.”)

In this scenario, I assumed that Larry has very little control over sales, so he needed to control expenses instead, and mainly, Payroll Expenses (and presumably, HIS).  Below is a comparison of his original P&L, with a Pro forma of what it would look like by holding down payroll so as to target a Net Profit of about $15,000 (i.e., 15% of sales):

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The Pro forma Cash Flow Statement now reflects the impact of  the company’s profit, in addition to the improvement in turnover ratios, on its cash position.  Note that by eliminating the cash drain created by the loss and producing a small profit, the company’s cash flow increased $117,000 (rounding) from a negative $232,000, to a negative $115,000, thus leaving a positive balance of nearly $104,000 in its operating account.

So the short answer to the question as to which is more important, profit, or cash flow, is BOTH.   However, “profit” is a critical component of cash flow that is required for the long-term survival of your business. For this particular company, even though the owner paid himself back over $175,000, if the business had been profitable, there was still sufficient cash in the business to allow him to do that.  So the most important thing was to stop (prevent) the “bleeding” due to the operating losses, as that is the most difficult cash flow issue to fix. And unchecked operating losses will, over time, drain all of the company’s cash, so that eventually, it will no longer be able to operate.

And once again, in order to know if your business is profitable, you need to maintain your books on the accrual basis of accounting.  If your books are maintained on a cash basis, you are only seeing the symptoms of your cash flow issues, not the true underlying causes, so you won’t know what needs to be fixed (or, is working well, as the case may be).

In my next article in this “Larry” series, I will illustrate the effect of rapid sales growth on cash flow.

 


The Relationship Between Turnover Ratios and Cash Flow

Posted on May 16th, 2016

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my previous article, Profit vs. Cash Flow Made Easy,” I explained the relationship between the Profit & Loss and Cash Flow Statement.  In this article, I will talk about the impact of accounts receivable, inventory, and accounts payable turnover on cash flow.

To begin, these are the turnover ratios (expressed in days):

Accounts Receivable

Turnover

Inventory

Turnover

Accounts Payable

Turnover

____365____   

Sales

AR

 

________365_________   

Cost of Goods Sold

Inv.

______365______

_Inv. Purchases *

AP

* (Inventory Purchases = COGS – Beginning Inventory + Ending Inventory)

Below is a comparison of these turnover calculations based on the original data, with  (working backwards through the math) a pro forma based on the assumption of 30 days, 60 days, and 30 days, for accounts receivable, inventory, and accounts payable turnover respectively:

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Finally, below is a comparison of the original Cash Flow Statement, with a Pro forma Cash Flow Statement that is based on the accounts receivable, inventory, and accounts payable balances that result from the above assumptions:

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As can be seen, there is a dramatic improvement in cash flow from simply better managing accounts receivable collections, reducing inventory levels on hand, and as a result, keeping trade creditors current (and keeping the supplies coming in).

And one final note, as was discussed in several previous articles, if your books are maintained on a cash basis, then what is being shown as “sales” on your P&L is actually just your receivable collections – “apples and oranges” when if comes to understanding the true profitability of your business.  Instead, you should maintain your books on an accrual basis, and your true profit or loss is then reflected in your Cash Flow Statements as either a source of funds (profit, or funds flowing in) or a use of funds (loss, or funds flowing out).

 


Profit vs. Cash Flow Made Easy

Posted on May 7th, 2016

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In a previous article, “Can Paying Taxes be a Good Problem?”I mentioned a client that made this comment to me:  “I wish I knew where the money went!  I didn’t take any more salary, but I’m paying a lot more in taxes.”  I then went on in that article and briefly explained the importance of profit, and how it differs from “cash flow,” and financial reporting for tax purposes.

Another thing I did for that client was to create a set of financial statements in a format that he could see more clearly the relationship between his Profit & Loss Statement and his Cash Flow Statement, and it was almost like an “ah HA” moment for him.  The financial statements I gave him were like those of this fictitious company:  “Larry’s Bankruptcy Strategies, Inc.”  This name was chosen (with a little tongue in cheek, of course) because of the various accounting transactions I built into the financials in order to illustrate many of the things a business owner can do to drive his company into bankruptcy:

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First note the $70,351 “Loss” on the company’s P&L. This should be fairly self-explanatory.  Obviously (assuming an accrual basis of accounting), their expenses exceeded their income.  And note in particular the Payroll Expenses.  It’s not often that you see the payroll exceeding the total sales of the company, unless it’s a start-up company and very well capitalized by the owner as this company was (at first, stay tuned).

Next, refer to the Balance Sheet.  This is where the special formatting comes in.  Notice the “variances” between year one and year two.  You don’t often see these calculations on CPA-prepared balance sheets for third-party users such as banks, but this is where the other components of the cash flow statement come from.  These are the rules that apply:

  • An increase in an asset account is a use of funds (i.e., money out, such as an increase in accounts receivable reflecting uncollected sales, the purchase of an asset, or money lent out to the owner)
  • A decrease in an asset is a source of funds (i.e., money in, such as a net decrease in accounts receivable reflecting collected sales, the sale of an asset, or money paid back to the company such as on loans to the the owner)
  • An increase in a liability account is a source of funds (i.e., money in, such as an increase in accounts payable to fund inventory purchases, a loan to the company, or equity from the owner)
  • A decrease in a liability account is a use of funds, (i.e., net payment of accounts payable, principal payments on loans, or money taken back out by the owner).

Now, look at the “Statement of Cash Flows.”  It starts with the profit or loss from the profit and loss statement, then, all of the above changes in the balance sheet accounts are added to or subtracted from that number.  So following down the cash flow statement, in addition to losing money, our “entrepreneur” here, Larry, allowed a large amount of accounts receivable to go unpaid, and bought an excessive amount of inventory on credit from suppliers and credit cards (more on accounts receivable, inventory, and accounts payable turnover in a future article).  And this was all while paying himself back the $175,516 loan he originally made to the company, leaving a negative balance in his checking account of $13,152 (i. e., book or bank overdraft).

And there you have it.  That’s all there is to it.  Once more, the main lesson to learn from this exercise is that a “loss” truly is a use of funds, and the importance of profit in helping to fund your other balance sheet uses of funds.  Sooner or later if these financial relationships continue to be ignored, it’s going to hit your pocketbook, or that of a critical supplier, or your bank.  So beware, if all you’re focused on is avoiding taxes, ultimately, the joke is on YOU.  But in order to truly understand what’s going on in your business, you have to look at both profit AND cash flow.