“Cash is king” is a catchy phrase and it’s very easy to remember. It conveys the importance of cashflow in the overall fiscal health of a business. For some it can become more than just a slogan, but a very painful reality as the credit lines become unavailable and the economy takes a downturn.
A few of my clients have experienced this very problem in the past year. It has nearly cost them their business.
So, you would expect that after such an introduction I am going to talk about cashflow – forecasting it, reporting it, measuring it, etc, etc. Sure, that’s one direction I could certainly take. But I would rather do something slightly different, something less obvious.
When people realize just how important cashflow is, everyone starts talking about it. People want to see their Profit and Loss statements on cash basis only, cash becomes the primary focus. And yet you may be surprised to hear that it’s not how the problem of cashflow gets resolved…
When a reasonably established (older than 3 years) company has cash flow problems, it is usually a symptom of a wider issue. It is an indication that this company’s financial health is failing. And financial health is seldom a result of a single factor.
Sources of Healthy Cashflow
Financial health comes from strong profitability and sound asset management.
To measure and keep an eye on profitability, you need accurate, periodic income statements, preferably prepared using the accrual basis of accounting. And here you probably begin to see why I made my previous statement that over focusing on cashflow is not the answer to your cashflow problem.
Strong Profitability
You see, to properly measure your profitability, you need to match your costs with the revenues the costs helped to produce. That’s not done if you use cash basis of accounting. To analyze where you might be losing your profits, you need to analyze your margins, either by product your company sells or by service it provides. Here again, you need accrual basis of accounting and a monthly profit and loss statement. That’s why looking at a cash basis profit and loss statement misses the whole point.
In order to properly analyze your operating expenses, you also need to match them to the revenues and record them on a consistent basis from one period to another. Only in this way can you obtain meaningful comparisons from month to month and some benchmarks for forecasting and budgeting. And that’s also done only when using accrual system of accounting, not cash.
That’s just a general commentary on the profit side of the business. If you pay attention to your numbers on the profit and loss statement, chances are you will be in a very good shape, because you will not miss all the red flags accurate profit and loss statements are able to provide.
Sound Asset Management
Now, let’s turn to your asset management. That’s where your balance sheet comes into play. How often do you look at your accounts receivable balance and dive into your accounts receivable aging? This has to be done monthly, in conjunction with the review and analysis of your monthly profit and loss statement.
If you also keep an eye on your ratios, you will notice a potential cashflow problem long before you actually feel it in your bank account. That’s what liquidity and solvency ratios are for. It doesn’t take more than a few minutes to have them calculated and to evaluate them. They are very simple numbers telling a very simple story, but they have to be looked as part of a whole.
A business is like any other organism – it is composed of interrelated parts. Every one of those parts has its proper function and has the power to influence the whole.
Cashflow Statement and Forecasting
And now, finally, we turn to the cashflow statement, for which you have been holding your breath…Yes, I’m going to talk about it, but at this point, it has assumed its proper place in the “financial statements triad” – it’s not the King, it’s just one of the three key instruments at your disposal – profit and loss statement, balance sheet and the cash flow statement.
If you properly manage your business using your profit and loss statement and the balance sheet (including ratios), your cash flow statement will simply be an informational tool, a tool you can use to do cash planning, to evaluate different options when contemplating timing of expansion, when seeking financing, etc. It will not be and should not be a tool used in panic to figure out which bills you will be able to cover this week.
So, let’s get back to the basics – that’s where all the answers lie…
