The Relationship Between Turnover Ratios and Cash FlowPosted on August 29th, 2018
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):
Cost of Goods Sold
_Inv. Purchases *
* (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:
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:
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 EasyPosted on August 23rd, 2018
Outsourced Accounting Department, Inc.
In a previous article, 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:
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.
Analyzing the Components of Cash FlowPosted on August 13th, 2018
Outsourced Accounting Department, Inc.
In our previous article, “Managing Cash Flow is the Key Secret to Business Success,” we provided a broad definition of cash flow and stressed its importance: the sooner you learn how to manage your cash flow, the better your chances of survival. Furthermore, you will be able to protect your company’s short-term reputation as well as position it for long-term success.
The first step toward taking control of your company’s cash flow is to analyze the components that affect the timing of your cash inflows and outflows. A thorough analysis of these components will reveal problem areas that lead to cash flow gaps in your business. Narrowing, or even closing, these gaps is the key to cash flow management.
Some of the most important components to examine are:
- Accrual profit or loss. Your profit or loss is a critical component of cash flow, and if it is a loss, over time it will act as a cash drain and threaten your company’s survival. Thus your (accrual) profit is the lifeblood of your business, NOT “just what you pay taxes on.” Do not ignore this number. Is your mark-up too low? Is your overhead too high? Whatever the cause, if you are showing a loss, get to the root of it and fix it.
- Accounts receivable. Accounts receivable represent sales that have not yet been collected in the form of cash. An accounts receivable balance sheet is created when you sell something to a customer in return for his or her promise to pay at a later date. The longer it takes for your customers to pay on their accounts, the more negative the effect on your cash flow.
- Credit terms. Credit terms are the time limits you set for your customers’ promise to pay for their purchases. Credit terms affect the timing of your cash inflows. A simple way to improve cash flow is to get customers to pay their bills more quickly.
- Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy – neither too strict nor too generous – is crucial for a healthy cash flow.
- Inventory. Inventory describes the extra merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be used for other cash outflows. Too many business owners buy inventory based on hopes and dreams instead of what they can realistically sell, and ultimately, must sell it at a loss or simply write it off. Keep your inventory as low as possible.
- Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable at some point in the near future – “near” meaning 30 to 90 days. Without payables and trade credit, you’d have to pay for all goods and services at the time you purchase them and prior to selling your product and receiving payment from your customer. For optimum cash flow management, examine your payables schedule.
- Matching sources and uses of funds. The general rule in corporate finance is that long-term assets should be financed with long-term sources of funds, and short-term assets should be financed with short-term sources of funds. Long term uses of funds include plant and equipment purchases, “permanent working capital” requirements, such as that required to fund sales growth, or to expand its line of business. Short-term uses include temporary or seasonal increases in inventory, accounts receivable, etc.
Some cash flow gaps are created intentionally. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerate cash outflows to take advantage of significant trade discounts. For other businesses, cash flow gaps are unavoidable. Take, for example, a company that experiences seasonal fluctuations in its line of business. This business may normally have cash flow gaps during its peak season and then later fill the gaps with cash surpluses when sales (and therefore, receivables) come back down from the peak part of its season. These types of cash flow gaps are short-term in nature, and are often filled by external financing sources. Revolving bank lines of credit, and obtaining extended terms on trade credit, are just a few of the external financing options available that you may want to discuss with your bank or suppliers.
The type of cash flow need described under “Matching sources and uses of funds” above, should always be financed with long-term sources of funds such as long-term debt, intermediate sources such as “asset-based” (accounts receivable and inventory) credit facilities, or an equity infusion. To ignore this rule by trying to support these kinds of long-term investments out of cash flow is to potentially create a severe strain on accounts payable causing them to become past due, inviting almost certain financial disaster.
Finally, do NOT take your operating losses or any of the other cash mismanagement symptoms in the above list to your bank and ask them to fix it. Why? Because banks are looking to your profit and cash flow in the first place to repay their loan, and an astute business lender will see right through it. Consequently, your business management skills may become tainted in the bank’s eyes for a long time to come.
Managing Cash Flow is the Key to Business SuccessPosted on August 8th, 2018
Outsourced Accounting Department, Inc.
Cash flow is the lifeblood of any small business. Some business experts even say that a healthy cash flow is more important than your business’s ability to deliver its goods and services.
While that might seem counterintuitive, consider this: if you fail to satisfy a customer and lose that customer’s business, you can always work harder to please the next customer. If you fail to have enough cash to pay your suppliers, creditors, or employees, you are out of business!
What is Cash Flow?
Cash flow, simply defined, is the movement of money in and out of your business; these movements are called inflow and outflow. Inflows for your business primarily come from the sale of goods or services to your customers but keep in mind that inflow only occurs when you make a cash sale or collect on receivables. It is the cash that counts! Other examples of cash inflows are borrowed funds, income derived from sales of assets, and investment income from interest.
Outflows for your business are generally the result of paying expenses. Examples of cash outflows include paying employee wages, purchasing inventory or raw materials, purchasing fixed assets, operating costs, paying back loans, and paying taxes.
Note: An accounting professional is the best person to help you learn how your cash flow statement works. He or she can prepare your cash flow statement and explain where the numbers come from.
Cash Flow versus Profit
While they might seem similar, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS, but more importantly, it’s a gauge for monitoring the health of your business.
Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more important, it is concerned with the times at which the movement of the money takes place.
In theory, even profitable companies can go bankrupt. It would take a lot of negligence and total disregard for cash flow, but it is possible. Consider how the difference between profit and cash flow relate to your business.
Example 1: If your retail business bought a $1,000 item and turned around to sell it for $2,000, then you have made a $1,000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? You may not have the cash to pay the bills despite the profits you earned on the sale. Furthermore, this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and create debt. If this mistake is repeated enough times, you may go bankrupt.
Example 2: Another example is a business that is growing rapidly, such that its increased spending on inventory and overhead expenses to support sales growth surpass its incoming receivable collections creating a negative cash flow, which continues until the rate of growth tapers off to a sustainable level of sales (net positive receivable collections). This negative cash flow phenomenon, is often referred to as “permanent working capital.” Left unchecked, this scenario can also lead to bankruptcy, even if your Profit & Loss Statement reflects a decent profit.
Monitoring and managing your cash flow is important for the vitality of your business. The first signs of financial woe appear in your cash flow statement, giving you time to recognize a forthcoming problem and plan a strategy to deal with it. Furthermore, with periodic cash flow analysis, you can head off those unpleasant financial glitches by recognizing which aspects of your business have the potential to cause cash flow gaps. In our next article we will analyze these gaps in greater detail.