How to Build Cash Flow: Lesson 4 – Measure What Matters Most
Are you keeping score in your business?
Are you ahead or behind in the game?
How do you know when you win?
Your business reflects the decisions you have made, are making and will make in the future. Are you making informed decisions or guessing about what you need to do when facing critical choices?
Your numbers are keeping score of your business performance, productivity and profitability. Are you listening to the story they are telling you?
Your management effectiveness measures your ability to change course when necessary. Can you recognize the ‘red flag’ warning signals that foretell impending danger so you can avoid it? Or are you trapped in the downward spiral of continually having to solve one problem after another?
If you don’t know what really matters, then you won’t know what is actually happening in your business financially, why it is happening, or perhaps more importantly, what you can do about it.
What does winning in business look like? It’s the picture of a profitable, cash flow generating business. How is that accomplished? You achieve it by moving from awareness to action.
From Awareness:
Focusing on what matters most
Setting your priorities accordingly, and
Targeting your objectives to realize your goals.
To Action:
Acting on your strategic plan
Documenting your results
Evaluating your progress, and
Making adjustments where necessary.
By measuring what matters most, you will:
Know if you’re moving in the right direction
Know if you stray off course, and
Know how to get back on track if you do.
Your performance, productivity and profitability matter in surviving and thriving in business. But how do you measure what matters most in each area?
By knowing how to keep score; knowing where you’re and in which direction you’re moving; and by knowing what to do and when to do it, you put yourself in a position to win the game called business by building your cash flow. It all comes down to understanding what really matters and measuring it accurately and effectively.
Keeping Score: Focusing on What Matters Most
The first step in measuring what matters most in your business is to keep score so that you know where you stand and if you’re ahead or behind in the game. Keeping score will tell you if you’re moving in the right direction, when you stray off course and how to get back on track if you need to.
Bankers keep score. Seeing your business the way bankers do, is the secret to keeping score. To them each of your financial statements tells a story. Outlined below are the key indicators they track:
Your Profit Story
Revenue
Gross Margin
Operating Profit
Net Profit Before & After Tax
Your Balance Sheet Story
Accounts Receivable Days
Inventory Days
Accounts Payable Days
Working Capital Days
Your Cash Flow Story
Your change in cash position – are you making or losing cash
Dividends and distributions paid – to owners and/or others
Changes in working capital
Changes in other capital assets
Outstanding bank loans due within one year
Outstanding bank loans due greater than one year
Net debt [The change in total debt less the change in cash]
In addition, they break your business operations down into four main areas of activity to dig deeper into each:
Profitability
Working Capital
Fixed Assets and Other Capital
Funding
Here are the major points of interest to them in evaluating your performance, productivity and profitability:
Profitability
Variations in trends – they look for any obvious anomalies
Directional trends – in which direction are the trends moving
Revenue growth vs. growth of cost of goods sold
Revenue growth vs. overhead growth
Profitability ratios
Working Capital
Days outstanding trends – changes from one accounting period to another in accounts receivable, inventory and accounts payable
Cash conversion cycle – how much cash you need to operate your business
Working capital timeline – the time gap between when you pay cash out and bring cash in
Gross margin vs. your working capital – to determine if you’re ‘growing broke’ [growing too fast to retain stability]
Working capital ratios
Fixed Assets & Other Capital
Return on capital trend analysis
Asset turnover
Return on capital employed ratio and other asset ratios [especially return on assets]
Schedule of capital assets and schedule of depreciation
Free cash flow
Funding
Is your funding coming from debt or equity? [Are you funding your business growth through your operational cash flow, or is the bank?]
The changes in your business equity
How much debt are you carrying?
How much debt can you handle?
How much interest are you paying?
Profit vs. cash flow
Operating cash profit vs. operating cash flow
Funding ratios
Fair market business valuation
By tracking these indicators, you can identify your business’s strengths and weaknesses.
The recurring theme throughout their evaluation process is their concentration on your cash and debt balances. Your financial focus should always center on your cash and debt. “The only indisputable facts in any set of financials are the numbers that relate to cash. Banks recognize this and use these numbers to determine your performance (Scaling Up!, p.220).
Seeing your business the way bankers view it gives you an edge in measuring what matters most. Having a checklist of what they look for in evaluating your business performance empowers you with the critical information you need to strategically plan moving forward. It enables you to keep score, and know whether or not you’re on target to your objectives.
Know Where You’re and in Which Direction You’re Moving
The second step in measuring what matters most in your business is to know where you’re and in which direction you’re moving so you can act accordingly and change course when necessary.
It begins with awareness and ends with action. The awareness of knowing where your business is at any given moment in time gives you the ability to act responsively to changing conditions, marketplace fluctuations and/or competitors’ initiatives.
The question you need to address is this:
Where are you in relation to what?
The answer is:
In relation to your cash and debt balances since they’re the only two indisputable facts in your financial statements.
The next question to ask is this:
Where do you look to find out your balances regarding cash and debt?
The answer is:
Your cash flow statement [Remember that your direct cash flow statement, as opposed to the indirect cash flow statement, is the one you really need.]
If you want a shortcut in determining where your business is currently, a few simple tests using the information in your cash flow statement will tell you.
“Once a company is past the start-up phase, the key test of its cash flow health is its operating cash flow (OCF). You want to hold this number up to the light and look at it carefully. You want to compare it with other numbers to ensure it’s moving in the right direction. When financial analysts look at a company, one of the first things they’re likely to do is dig up the OCF numbers and apply four tests” (Managing by the Numbers, p.90).
Here are the four tests: [Remember that operating cash flow (OCF) is the net cash provided by your business operations, and is calculated in the first section in your Cash Flow Statement.]
Is OCF positive? If not, you need to find out why!
Is OCF greater than your net profit before tax? If not, you need to know why you’re not turning your profit into cash?
Is OCF greater than your capital purchases? Are you funding your growth internally or from outside financing?
Is OCF trending in the same direction as your net profit before cash? This is critical to understand. If your net profit before tax is increasing, but your OCF is declining, you have a problem. (Managing by the Numbers, p.90-91)
Take a moment and look at test number 3. Is OCF greater than your capital purchases?
Free cash flow is defined as the net cash generated from business operations (OCF) less the amount invested in capital purchases. “The hot metric to watch is free cash flow. Some companies have looked at free cash flow for years. Warren Buffett’s Berkshire Hathaway is the best-known example, though Buffett calls it owner earnings” (Financial Intelligence, p.141).
Free cash flow is a comparison of the cash from the business itself to the cash required to keep it healthy over the life of the business.
The other thing bankers look for on your cash flow statement concerns interest and principal payments. How much are you paying in interest and how much debt do you have and can you afford?
Debt can be addictive. Used wisely, it can help you build a profitable, cash flow generating business. Used indiscriminately, it can destroy your company.
Unfortunately, many business people have never learned this all-important lesson:
“You can’t build wealth until you get out of debt. And make no mistake, getting out of debt really does help you build wealth. You can’t get from $1 million to $5 million in revenue on borrowed money” (Simple Numbers, Straight Talk, Big Profits!, pp. 58, 30).
The danger of debt to cash flow is that it can only be repaid with after-tax profits. Measuring your cash and debt balances accurately and effectively will help you avoid the impending dangers of excessive debt.
But to track your cash and debt, you need to get accurate, complete and timely financial reports. This means you need to know what reports you need and when you need them.
“Reporting Rhythms: The Right Data at the Right Time
Your numbers are talking… are you listening?” (Simple Numbers, Straight Talk, Big Profits!, p.111)
If you’re struggling to know what financial reports you need to look at, when you need to look at them and why they are critical to your survival, step three in measuring what matters most in your business gives you the answers.
Listening to the story your numbers are telling you will help you position your business to survive and thrive.
Here is the roadmap we use to guide us in what to do and when to do it:
DAILY – Cash balances in all accounts
WEEKLY – Review of age reports: accounts receivable and accounts payable
BI-WEEKLY – Cash flow forecast
MONTHLY – Calculating the movement in our cash and debt drivers (Our ’11 Milepost Numbers’)
QUARTERLY – Trend analysis of our performance, productivity and profitability (A complete evaluation of our cash flow story and variance report)
SEMI-ANNUALLY – Debt and capital asset analysis (A review of our principal and interest payments and projection of our capital asset needs moving forward. A review of the depreciation schedule is also conducted.)
ANNUALLY – Analysis of distributions, capital purchases and taxes paid plus a forecast of our business model for the coming year.
This roadmap focuses on the movement of cash and debt throughout the year. It tells you:
DAILY – How much available cash you have at your disposal
WEEKLY – Who owes you money and to whom do you owe
BI-WEEKLY – Expected sources of cash inflow and cash outflow over the next two weeks
MONTHLY – Where you’re and in which direction you’re moving
QUARTERLY – If you’re on the right path or off course (if you’re off course, how to get back on track)
SEMI-ANNUALLY – How much debt you’re carrying and what capital purchases you need to make over the next six months
ANNUALLY – How much cash has been taken out of the business and for what purposes
This checklist will show you what to do and when you need to do it in order to control your cash and debt balances. You don’t seize control of your business – you build it over time!
A Final Thought: Your Call-to-Action
If you can understand and measure what really matters to surviving and thriving in business and can interpret the story your numbers are telling you, you can position yourself to win the game we call business.
If you can build a profitable, cash flow generating business, you win; not only for yourself but for all those connected with your business. It’s up to you to measure your performance, productivity and profitability accurately and effectively. It’s the proven path that takes you from today to where you want to be tomorrow.
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