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Why Cash Flow is the Truth

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We are surrounded by data all of the time. There are statistics saying, on average, we receive five times the amount of information we were receiving 25 years ago. This makes logical sense; with the advances in technology and the every-expanding social networks and their influence, we are getting more information than ever, even though we must ignore the relatively poor quality of a lot of the content.

One of the questions we have to ask ourselves is what can we believe and what can we trust? The same is a challenge for business owners. With regard to the financial performance of your business, can you trust the information (accuracy) and is the information important (relevance)? In business, we want to make sure the information that we are using to make business decisions is both accurate but relevant. There is no point making sure we are driving in the right direction but will run out of fuel before we get to the destination.

Anthony is a business owner who was confident he was driving down the right road but he wasn’t convinced he was going to have enough petrol to get to his destination. He believed his manufacturing business was going well and heading in the direction, but he was uncertain about how well the business was performing.

The challenge Anthony was facing in his business was simple to diagnose, but, for him, impossible to know. What is the truth? How can he tell definitely that his business was achieving what he wanted it to achieve from a financial perspective and can he trust the information?

In the work which we had done with Anthony’s finance team, I demonstrated to him the financial information that he was being provided by his finance team could be trusted. He also learned how to check the information himself and not just take his team’s word.

Anthony needed to know what was relevant. What is the key piece of information he can rely on to know how well his business is performing? You may have heard this saying before:

“Revenue is vanity,
Profit is sanity,
Cash flow is reality”

This is the saying I shared with Anthony to begin with and explained to him the relevance why.

Me: “Why do you think revenue is vanity?”

Anthony: “There is no context?”

Me: ‘Exactly right, people talk about how they run a million-dollar business or a 50 million dollar business, but nobody cares. If your business has a million dollars in revenue and $150,000 in expenses, that is a very good business. But if your business has 50 million dollars in revenue and 75 million in expenses, then it is a horrible business. Revenue, for this purpose, has no relevance.”

I continued:

Me: “What is wrong with profit and why wouldn’t you rely on profit as the number which you should solely rely on?”
After pausing for a few seconds, he said one of the most insightful things I have heard from anyone, in any field.

Anthony: “Profit is just a promise”.

This answer was better than the one I was going to offer because it was straight to the point. A profit is a promise a business will generate that amount of money but there is no guarantee that it will end up in cash. The vast majority of business finances work on what is referred to an “accruals” basis, which means revenue is included in the Profit and Loss when the client is invoiced, not when it is paid. What if a client doesn’t pay? All of a sudden the revenue which has been included in the profit and loss statement is gone because the client is not going to pay.

After this part of the conversation, I also added:

Me: “Profit can also be faked…not necessarily in an illegal or dodgy way but accountants might put adjustments through which might be done for good reason but the reasons then provide an unfair reflection of what the profit was for the period. A large adjustment for work-in-progress is a classic example.”

Which lead me to the key point: cash flow.

Me: “So cash flow is the reality”

I persisted with the obvious question.

Me: “Why do you think this is the case?”

Anthony: “It’s cash and if you want to do anything, you have to have cash. If you want to pay wages you need cash; if you want to take profits out for yourself, you need cash; if you want to pay the tax man, you need cash. Everything of substance comes back to cash”.

Me: “You have to stop now, you’re wording this way better than what I would have…”

All jokes aside, Anthony is correct. Cash can’t be faked. People aren’t going to give your business money for the fun of it nor can you delay or minimise expenses with tricky accounting. You have to pay them if you want to maintain your end of the bargain as a tax payer, supplier, and employer.

This is when I began to walk Anthony through what I believed to be the number one way to analyse a business’s performance – Cash Flow from Operations. Cash Flow from Operations is a fancy way of saying, “How much cash did we gain or lose from doing what we do?”

The reason this is so important is because we have to see if we are making money the way we are intending to make it. Using Anthony’s manufacturing business (they manufactured and sold boat accessories) as the example, if he had to rely on selling his business’ motor vehicles to pay the bills, then this is obviously not a good sign because the business is incapable of generating enough money through selling boat accessories.

I discussed types of cash movements which would and wouldn’t be included in the calculations with him.

Element 1 – Earnings before Interest, Tax, Depreciation, & Amortisation (EBITDA)

EBITDA is what I refer to as “cash profit” and this is what your business makes as a profit but adding back the interest, tax, depreciation, and amortisation items. These are items which are not cash in nature (depreciation and amortisation) or factored in elsewhere in a cash flow statement (interest and tax).

Therefore, step one is to calculate EBITDA:

EBITDA = Net Profit + Interest Expense + Tax + Depreciation + Amortisation

For Anthony’s business, this calculation was for the month:

EBITDA = $171,038 + $2,951 + $51,311 + $7,875 + $0 = $233,175

Element 2 – Movement in Trade Debtors, Trade Creditors, and Inventory/Work-in-Progress (Working Capital)

The next phase is to look at the working capital of the business and the movement from one month to another. This is a lot easier than what it sounds; all you need is the closing balances for these accounts from the balance sheet of the previous month and the closing balances for these accounts for the current month. As we are doing the analysis for October, we need the September and October closing balances for these accounts.

For items that are assets (Stock, WIP and Trade Debtors): to calculate the cash flow movement, you need to have the prior month’s figure and subtract the current month’s figure. For example, Anthony’s business “gained” cash from its debtors because the debtors’ balance dropped by $208,932 for October. The business lost money on Stock & WIP because the balance increased from September to October.

As trade creditors are liabilities, the calculation is the opposite of assets. As the creditors’ balance has been reduced, a negative has been created on cash flow because it implies we have had to make additional payments to creditors compared to the cash flow benefit of increasing creditors.

Our calculation is now:

EBITDA + Working Capital Movement

$233,175 + ($58,036) = $175,139

Element 3 – Other Operating Items

The third and final section is Operating Other and this is generally made up of the following items:

Company income tax

Payments and refunds received regarding company tax

GST/Sales Tax/VAT

Periodical payments made to the tax man for GST/Sales Tax/VAT

GST/Sales Tax/VAT you receive on revenue

GST/Sales Tax/VAT you pay on purchases

Employee Entitlements

Employee PAYGW

Annual Leave

Long Service Leave

Other Current Assets and Other Current Liabilities

These are generally pretty minor relative to all other items in calculations (e.g. insurance funding)

All these amounts come directly off your balance sheet like describe in Element 2, so there is no need for calculating the amounts you need.

Each of these sections are calculated in the exact same way as the Element 2 items. It is a matter of working out the movement between months for each balance.

Our calculation is now:

EBITDA + Working Capital Movement + Operating Other

$233,175 + ($58,036) + ($87,793) = $87,346

To conclude the conversation, I gave Anthony this advice: looking at one month in isolation is a very sheltered view because there are certain months (such as October) in which there are a lot of tax payments to be made in comparison to other months.

So what do you make of it? Ultimately, you want the cash flow from operations for a year to be not too dissimilar to the profit for the year. For example, Anthony’s business for the month of October had a profit of $171,038, but cash flow from operations was only $87,346, which is a significant difference. However, over the course of the financial year so far, Anthony’s business had a profit of $832K and cash flow from operations of $798K, which is an acceptable variance.

Here’s the question:

If your business that had cash flow operations over a period of time a lot higher than your profit, or if your cash flow from operations was a lot lower than your profit, what is the significance? If your business has a higher cash flow from operations than profit, it can mean your financials are understating your profit or a lot of the money coming into your business is not yours.

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