Cash is ‘Real Money’
“A positive bottom line on the Income Statement, showing that your company is making a profit, is surely a good thing. On the other hand, profitability is no guarantee of success or even survival. Every year, tens of thousands of businesses fail. Some were showing a profit at their demise. What happened? Simple: they didn’t have enough cash to stay in business. They ‘grew broke’. ‘You can operate a long time without profit,’ said Lou Mobley, ‘but you can’t survive one day without cash.’ Cash is real money.”
That short and simple exerpt is from the book, MANAGING BY THE NUMBERS, A Commonsense Guide to Understanding and Using Your Company’s Financials, by Chuck Kremer and Ron Rizzuto with John Case, ISBN: 0-7382-0256-8, Copyright 2000, page 37, Chapter entitled ‘CASH FLOW’.
Let’s take a moment or two and revisit the story of Lou Mobley and IBM, in case you are not familiar with his contribution to understanding the numbers in your business. According to FINANCIAL SCOREBOARD, it is the secret that made IBM a leading global institution. The late Lou Mobley was a member of the fifteen-man team that developed IBM’s first computer. Among his many achievements were the following:
He created and ran the leadership operation that developed IBM’s leaders.
He was the founding director of IBM’s famous Executive School.
He headed the teams that coined the phrase ‘data processing’.
He helped redesign the College Boards (SATs).
He created an interactive values exploration game that could be played by up to 2500 people.
He was trained as an engineer. He loved math and science.
He proposed a universal field theory that built on Einstein’s field equations.
He proposed a comprehensive theory on the four paradigms of society in the next century.
He especially loved matrices for simplifying complexities. (Ben Franklin called them Magic Squares.)
He used a matrix for revolutionizing and unifying mathematics in accounting. His students dubbed it ‘The Mobley Matrix’.
I mention his accomplishments to give you an idea of the creative intelligence Mr. Mobley gifted us with in understanding the numbers in your company’s financial statements.
I would like to dig just a little deeper into that story to give you an insight as to how critical cash is to business survival and success.
Lou Mobley came to the realization that all three of the key financial statements fit together like the pieces of a jigsaw puzzle. Changes made in one statement affected the others. And if you know the connections, you can understand exactly how each change is related. Mr. Mobley found a way to put all the statements side by side to see the connections at a glance. He called it ‘the big picture.’
Here is the background story of how Lou Mobley developed what he called ‘the continuity equation’. He created a simple one page matrix showing the beginning balance sheet, the income statement, the cash flow statement and the ending balance sheet. What his students referred to as ‘The Mobley Matrix’, Kremer, Rizzuto and Case rechristened ‘the Financial Scoreboard’.
As we travel back through how he created his matrix, try to keep in mind his comment about cash--you can’t survive one day without it. That concept drove his thinking and it is a reminder to us to do the same. So how did he figure it all out?
As the story goes Lou Mobley, one of the leading executives at IBM, came to the stark conclusion that he didn’t understand financial statements. If we stop for a moment and reflect on that statement a profound truth emerges. Even the very top management executives in the business world don’t always understand the numbers in business. That fact alone should make us feel less intimidated and embarrassed about not understanding the story our numbers are telling us about our operation. But Lou Mobley didn’t stop there, and neither should we. To Mr. Mobley, the financial managers at IBM spoke a language that the nonfinancial people didn’t understand. When they got into debates, the financial managers always seemed to win, because their opponents didn’t know how to answer the managers’ jargon filled arguments. Lou Mobley wanted everyone to speak the same language so they could work together better.
So, he began teaching himself to understand the financials. What he found surprised and astonished him. He found that most of his assumptions about the financial statements weren’t true. He thought that the company’s income statement had something to do with how much cash it took in and where it went. He thought that ‘cost of goods sold’ must be what a company spent to acquire inventory. The more he studied the basics the more he found himself face to face with an increasingly unsettling realization. He once wrote, “one myth after another had to be washed from my mind.”
He began to understand that conventional financial statements are fragmented and that the connections between them aren’t apparent. If you can understand the cause and effect connections you can begin to see the big picture and know for sure how your business is really doing.
As a side note, he began to realize that the balance sheet and the income statement are built upon opinions, estimates and assumptions. Only the cash flow statement contains indisputable facts you can rely on. That realization is something we will explore in depth in our next blog. That perspective helped him form the belief that cash is real money and you can’t survive without it. Lou Mobley was not alone in discovering the relationship between financial statements. Corporate auditors do much the same thing that Lou Mobley discovered.
But the drawback is that accountants in general don’t talk much about how all the numbers fit together. And our experience has been that many accountants rarely explain the financial connections to business owners and decision makers and don’t present the financials in such a way as to make the connections clear and identifyable so that the information contained in the financial statements can be used to make better informed business decisions. The result is that when faced with making critical choices in their business owners are forced to rely on guessing about what they need to do. Guessing leads to wasted time, effort and money. Sound business decisions are born out of verifiable information and financial reports that are accurate, complete and timely.
Lou Mobley developed a tool that works for any company, anywhere, and any size. It doesn’t matter if the company is big or small. It doesn’t matter whether the business is manufacturing, service, retail or whatever. It doesn’t matter if it is a for profit organization or a nonprofit entity. Entrepreneurs use it. Global corporations use it. And small businesses should heed the lesson and use it too.
What makes ‘The Mobley Matrix’ work is the thread that weaves the financial statements together—cash.
Cash, as Lou Mobley asserted, is real money. Cash isn’t an abstract concept. Cash is a concrete asset. Cash is what you have in the bank. Your cash flow statement tells you how much you deposited into your bank account, how much you spent and what the difference was over a given period of time. Cash tells you what you can afford to buy and if you can still meet payroll next week. Cash information tells vendors and suppliers if you can afford to pay them for goods and services. Cash, and more particularly cash flow, tells lenders how creditworthy you are and if you are a good lending risk.
It might be well to note right here that lenders have a designed formula to define cash flow. Most of the owners and decision makers we have experience with have trouble articulating what cash flow really is and how to figure it. Bankers and financiers define cash flow as the change in cash and debt balances across a given period of time. In our next blog we will delve into that formula and how it affects your company’s perception in the marketplace. To bankers the only two indisputable facts in any set of financials are cash and debt balances. The more your company grows the more you need continual financing.
Whether or not that funding comes from internal generation or outside financing, cash will serve as the foundation to build on moving forward.
Since your cash flow statement is the one statement you really need to understand the story your numbers are telling you, let’s take a closer look into that statement. Some background information here may prove helpful.
In 1987 the Financial Accounting Standards Board (FASB--pronounced faz-bee) ruled that all financial statements prepared by CPAs must contain a statement of cash flow. Their ruling allowed accountants to prepare the cash flow statement in one of two formats--an indirect cash flow statement or a direct cash flow statement. The difference between the two is simply this: indirect cash flow statements include noncash items such as depreciation. Direct cash flow statements only record actual cash deposited and spent. Think of the direct cash flow statement as a checking account and checkbook.
Today, most accountants and software packages don’t compile a direct cash flow statement. The benefit of a direct cash flow statement is that it shows you the cash that is actually coming in and going out. It organizes these in’s and out’s into categories that help you manage your business. It also clearly shows causes and effects and just like Lou Mobley discovered and taught to the executives at IBM, it helps you understand how to correct any cash flow problems you may have.
As we move forward this year we are going to concentrate on cash--how to understand it, manage it and maximize it. We are going to look into how you are leveraging your assets into profit, how well you are turning your profit into cash and how best to use cash to grow your business and build wealth. We are going to explore financial ratios and target the ratios that deal with cash and debt.
Those will include the following ratios and financial concepts:
1. Tracking cash balances daily
2. Preparing and utilizing a cash flow forecast
3. Operating cash flow--the lifeblood of your business
4. Cash drivers
Core capital
Cash flow (bank calculation)
Marginal cash flow
Free cash flow
Cash conversion cycle (how much cash you need to run your business)
Working capital (traditional method and alternative global method)
Risk management ratios (current ratio & quick ratio)
Principal reduction and interest paid
Owner withdrawals and distributions
Taxes paid
5. Capital purchases and depreciation
To get a head start into controlling your cash I thought the following information on cash flow statements might prove beneficial.
Cash Flow Statement Format
DIRECT CASH FLOW STATEMENT—Only records actual monies into and out of the business during the accounting period. It is analogous to a checkbook. It organizes the cash flows into three categories: Operating, Investing and Financing, useful in managing the business.
CASH FLOW FROM OPERATING ACTIVITIES: Shows cash actually coming in and going out from operating the company
CASH INFLOWS
Add: All Monies Inflowing from Operation of the Company
Subtract: All Cash Outflows paid out in Operation of the Business
NET CASH PROVIDED BY OPERATING ACTIVITIES: The net figure arrived at from cash coming in and going out, specifically from company operations
CASH FLOW FROM INVESTING ACTIVITIES: Shows cash actually coming in and going out from investing activities of the company
CASH INFLOWS
Add: Monies received from Investments
Subtract: All Cash Outflows for Capital Investments, All Cash Outflows for Marketable Securities, Monies paid out in Investments
NET CASH PROVIDED BY INVESTING ACTIVITIES: The net figure arrived at from cash coming in and going out, specifically from investing activities
CASH FLOW FROM FINANCING ACTIVITIES: Shows cash actually coming in and going out from financing activities of the company
CASH INFLOWS
Add: All Cash Inflows from Borrowing
Subtract: All Cash Outflows paid out to Reduce Principal
NET CASH PROVIDED BY FINANCING ACTIVITIES: The net figure arrived at from cash coming in and going out, specifically from borrowing and repaying financing activities
CHANGE IN CASH POSITION: Increase or Decrease
BEGINNING CASH POSITION: At the start of the accounting period
ENDING CASH POSITION: At the end of the accounting period
11 Key Consideration Points For the Cash Flow Statement
Consideration #1
In 1987, the Financial Accounting Standards Board (FASB, pronounced faz-bee) ruled that all Financial Statements prepared by Certified Public Accountants (CPA’s ) must be accompanied by a Cash Flow Statement. They allowed CPA’s to prepare them in one of two type formats—DIRECT or INDIRECT. Although FASB recommends the DIRECT METHOD most accountants prefer the INDIRECT METHOD (probably due to the convenience of use). From a business perspective the DIRECT METHOD is by far and away more preferable. The principal reason is that the DIRECT METHOD does not contain any non-cash items to distort the picture, such as depreciation. If at all possible use the DIRECT CASH FLOW STATEMENT. The DIRECT CASH FLOW STATEMENT is analogous to a checkbook. It portrays the actual cash flowing in and out of the company, and it organizes the information in a way that businesses can utilize to make sound decisions.
Consideration #2
The CASH FLOW STATEMENT is designed to show the CHANGE IN CASH POSITION from the Beginning to the End of the accounting period in question. It will show if there has been a net increase or decrease.
Consideration #3
THE CASH FLOW STATEMENT is divided into three (3) distinct areas of business concern. The first is NET CASH (FLOW) PROVIDED BY OPERATING ACTIVITIES. Financial and accounting people often refer to this area as OPERATING CASH FLOW (OCF). OCF is one of the three Bottom Lines in business. In fact, of the three, OCF is the most important in many respects. It is considered by many to be the “LIFEBLOOD” of any organization.
Consideration #4
The second area addressed by the CASH FLOW STATEMENT is NET CASH (FLOW) PROVIDED BY INVESTING ACTIVITIES. This area details investments the company makes in its own future. They may consist of Capital Expenditures or investments in Marketable Securities.
Consideration #5
The third area considered is NET CASH (FLOW) PROVIDED BY FINANCING ACTIVITIES. It includes all activities related to borrowing and repaying of capital. It may include mortgages, capital leases and dividends paid to shareholders.
Consideration #6
The hot metric on Wall Street today is “Free Cash Flow”. Perhaps the main reason for this is Warren Buffet’s company Berkshire Hathaway. They have used this concept for years and it is possibly one reason for their success. (Mr. Buffet refers to it as “Owner Earnings”.) FREE CASH FLOW is simple to calculate. Take the NET CASH FROM OPERATING ACTIVITIES and subtract the amount invested in Capital Equipment (Capital Expenditures), found in the INVESTING ACTIVITY section. It’s that easy. FREE CASH FLOW is nothing more or less than the cash generated by operating the business less monies invested to keep it vital.
Consideration #7
OPERATING CASH FLOW (OCF) can be used as an indicator of the general overall health of a company. It can also tell you if a company merits your purchase of stock in it. Four tests can be applied to OCF to determine its efficacy. The 4 tests are:
OCF should be positive
OCF should be greater than NET PROFIT
OCF should be greater than Fixed Asset Investment
OCF should be trending in the same direction as NET PROFIT
OCF is one of the most important things for a business to watch, because it will help you manage Cash Flow as well as profit.
Consideration #8
The BEGINNING CASH POSITION & the ENDING CASH POSITION can illustrate a major concept in Financial Statements that is crucial to understanding them accurately. Consider this: The INCOME STATEMENT & the CASH FLOW STATEMENT cover the entire accounting period in question. The BALANCE SHEET, however, covers only one day in time, usually the last day of the accounting period. If you take two BALANCE SHEETS and “bookend them” you will have the same period of time covered as that of the other two statements. By doing this you can track the differences from one BALANCE SHEET to the other by using the INCOME STATEMENT and the CASH FLOW STATEMENT. In essence is allows you to see how the statements fit together like a puzzle.
Consideration #9
NET CASH (FLOW) PROVIDED FROM OPERATING ACTIVITIES will include all disbursements for operating the company. So monies paid by the company during the accounting period for such things as raw materials for inventory production, that is as of yet unsold, will show up in this section. Always compare this section of the CASH FLOW STATEMENT to the costs and expenses found on the INCOME STATEMENT.
Consideration #10
The ENDING CASH POSITION should be compared to NET PROFIT. It will tell you the actual dollars the company has to spend. Think of it as your checkbook balance.
Consideration #11
The NET CASH (FLOW) PROVIDED BY FINANCING ACTIVITIES may contain an item that every business should track faithfully—Dividends paid to stockholders. Over the course of time you want to know if a company is capable of generating enough profit to make the owner’s investment worthwhile.
Sample Cash Flow Statements
One final note to consider:
Don’t let the above information on cash flow statements overwhelm you. We will break it all down in simple and easy to understand steps as we move forward this year. For now the main point to remember is that cash is real money. It is one of the only two indisputable facts in your financials. It is the lifeblood of your business and it will determine the destiny of your operation.
