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Cash Flow 101

General Business News

April 2003


Cash Flow 101

Where's the beef, the little old lady is saying in front of me...

Wait, this isn't a commercial and I am not in Wendy's. In fact, I am in my very successful client's office trying to explain why he can't double his salary after his profits skyrocketed to well over $1 million a year.

That's the scene that played out time and again when Wendy's ran it's very successful Where's the beef,advertisement. During that time, Where's the beef,became the standard phrase whenever my clients wanted to know why they couldn't take more cash out of their businesses. After all, the companies were growing and making a ton of money. Well, they were showing high profits and paying the IRS a ton of money, but that's about as far as the cash went and most clients didn't really understand how they could have such great bottom lines and no cash to show for it.

Before you take your own Where's the beefwalk, let's talk about where your company's cash comes fromâ?¦and where it goes. First, let's establish some ground rules. For our purposes, we're going to assume that your company is growing like the weeds in your yard. Sales are out of sight and the IRS gets so much money out of you they should be sending you a Christmas present each year to keep you as a customer. Oops, I forgot they're a soul-source supplier.

There's only one problem with your business right now no matter what you do, there never seems to be enough cash and you want to know why. Well, there are a few reasons.

First, you have to remember that you are on the accrual basis for financial and tax reporting purposes. That means you record your sales income when the widget goes out the door, not when you receive the cash. If you buy inventory, you get to show it as an asset, but if you pay cash, guess what? That's right, your raise just went out the window to pay for that inventory.

Also, every time you pay insurance or some other bill that covers a full year, you don't show it as an expense. Instead, you show it as an asset and expense it over 12 months. The same goes for any equipment you may buy and your creditors like to see you have a lot of assets, but that cash you spend on these assets increases the seller's salary, not yours.

The news isn't all bad; at least your personal income taxes won't skyrocket. Additionally, what the accrual basis taketh away, it also giveth back. In most instances, when you originally record an asset purchase or expense under the accrual basis, you don't automatically spend the cash. Instead, you record a payable for the asset. For example, assume you bought a new $50,000 widget maker and the seller is letting you pay it out on 30-day terms. What that means is you get to record the new machine on the books as an asset, show that you owe the seller $50,000 and keep your cash for the next 30 days. Hopefully, between now and then, you will collect enough in receivables to pay the $50,000 you owe.

Notice I said hopefully, so don't go buy a new Mercedes just yet. Don't you remember you bought $40,000 in inventory last month and those bills are coming due now? Sorry, you'll have to keep the old car a while longer.

Hopefully, by now you're getting the idea that your net income isn't exactly what you have left over to spend on yourself. That is rarely the case. Many companies either start a business or expand without adequately understanding the impact their actions will have on their cash flow and, after all, cash is king! A thorough understanding of your cash needs is critical if you are to survive.

This is particularly important if you are going to finance your new or expanded venture through the bank. It's not enough to borrow money to buy equipment and maybe start-up inventory. You will have to forecast how long it will take you to get the product to market and collect the cash. This, in turn, will involve making a number of assumptions about the normal time it takes to collect receivables in your industry and how fast your suppliers are going to want their money.

Your banker knows all of this and he/she also knows that your suppliers will generally want their money sooner than your customers are willing to give you your money. That's why the banker is going to ask you for a business plan that includes cash projections.

Now, I could spend the next month explaining the ins and outs of preparing a good business plan, but I won't. Suffice it to say that the bottom line is you have to generate enough cash to run your company and you have to take into account a simple rule the amount of cash you have on hand is equal to your net income plus the change in your liabilities and capital minus all the change in all of your assets other than cash. You get to add back depreciation to this equation also, but the point is you can't just look at the bottom line and expect to be able to keep the creditors happy.

So how do you control this equation? There are no magic tricks, just hard work. Assuming sales are good and you are controlling your expenses, you will need to take a look at how you move your cash. Are you working your accounts receivable to make sure customers pay on time?

How about accounts payable; are you paying bills as soon as they come in? A good general rule of thumb is you should always pay your accountant's bills when you receive them and pay the rest according to terms. This means that if you can pay a bill in 30 days without incurring a penalty or losing a discount, hold onto your cash. You can probably get by without paying your accountant's bill immediately also, but don't tell anyone I said so.

Many people have always taken pride in the fact that they were able to finance their fixed asset purchases with their own cash. It is an admirable position to be in, but not always the best position. Suppose you bought that widget maker for $50,000 cash and you're saving 4 or 5 percent in interest, but you don't have enough cash to pay your widget materials bills in the 2 percent discount period of 10 days. It doesn't take a rocket scientist to figure out that saving 2 percent on purchases every 10 days saves a lot more than 4 or 5 percent a year. Take a look at the economics and if you can save a great deal on discounts by borrowing for long-term purchases, maybe that's what you should do.

Our space is running out for the month, but if you have never sat down and seriously considered the sources and uses of your cash, we respectfully suggest you do so now. Does the task seem daunting? It should because you are going to need to make a lot of estimates and guesses, but it may not be too difficult. Just know that your guesses and estimates will be imperfect and try to be as accurate as you can.

If the task still seems daunting, why not give us a call and let us help you map out a good game plan. Our expertise in financial reporting combined with your knowledge of your industry will help you create a plan that will keep you, your banker and your checkbook happy.

As we go to press, our troops are in Iraq trying to rid the world of a tyrant. Join with us in praying for a swift end to the war and quick return of our troops to their families.

Have a great April.


These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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