Watch The Cash Flow

Written by Joe Driscoll

November 22, 2009

USX Corporation records a loss in excess of several hundred million dollars. The Bank of America and other corporate giants do the same. Not so long ago, the former International Harvester Company, now Navistar, recorded nearly a 1.5 billion dollar loss on a sales volume of approximately five billion. The independent businessman shakes his head and wonders how these big guys can do it and still be in business. He knows for sure what comparable losses of that magnitude would mean for his business. A large part of the answer lies in cash flow.

A small and successful company develops an innovative product that is well received by the market place. The company builds staff and gears up to meet the high demand for its new products. Floor space, equipment, personnel, inventories, receivables, payables and visions of limitless profitability all grow rapidly. Troubles soon follow, but why? All too often the answer lies in cash flow.

What is this thing called cash flow and why is my banker so interested in it? If sales and profits are on the rise, everything will turn out OK, right? Well maybe, but sales can be bought and and profits can be manipulated. But cash, cash is king. If your business is generating a positive net cash flow you have flexibility and you can survive forever. If you don’t have a positive cash flow, regardless of how impressive your sales and profits are, you must have a plan to meet the shortfall or big trouble lies ahead.

Peter Drucker, the foremost management scholar of our time, recently enunciated what he believes to be the five key indicators of corporate performance. Responding to the widely held concern that short term earnings are a grossly misleading indicator of a company’s health, Drucker suggests that how well a business is doing can evaluated by looking at market standing, innovation, productivity, cash flow and profitability. That’s right, cash flow right up there in the top five.

Concerning cash flow as an indicator of corporate health, Drucker notes that a business can run without profits indefinitely as long as the cash flow is adequate. However, the opposite is not true. He observes that there are far too many businesses, both large and small, that have to abandon their most profitable developments because they run out of cash. He warns that increased profits through rapid expansion of sales volume is a danger signal because it weakens rather than strengthens liquidity and cash position. The rapid expansion can be an indicator that the company has bought rather earned its additional sales. Bought sales, being accompanied by non-sustainable discounting and overly generous financing, can’t last for long.

In the closely held company, cash flow takes on even greater importance. With no outside investors to impress, the recording of profit is most favorably received by the tax collector. Management of the closely held corporation should nearly always place a higher priority on insuring a positive cash flow than on profitability.

Given the importance of cash flow, how do we calculate it and where do we find it? A company’s financial statement has three major sections, the balance sheet, the income statement and a statement of source and application of funds. It is the statement of source and application of funds that is commonly referred to as the cash flow statement.

The cash flow statement is generally divided into two parts. The first part looks at what sources provided funds for the business and the use of those funds. Net after tax profit plus non-cash expenditures such as depreciation comprises the majority of the cash generation. Other sources of funds can include new equity investments and additional long term debt. Uses of funds will include such items as dividends payed, capital expenditures, research and development expense and repayment of debts.

To determine the adequacy of your cash flow you subtract the total funds used from the total funds provided. The resulting answer will indicate whether you had an increase or decrease in working capital for the period. An increase in working capital indicates that your cash flow was sufficient to meet the cash requirements for your business. Regardless of what your income statement says, a net negative cash flow as indicated by a decrease in working capital is a situation which is non-sustainable and requires management attention.

The second section of this statement is an analysis of the changes in working capital. This section will tell you what items of working capital have changed during the current period. Regardless of whether your working capital is increasing or decreasing, this analysis will tell you where you are investing your money in the business.

The importance of cash flow is beyond question. Because its your business, make sure that your accountant regularly prepares a cash flow statement and that you spend as much time with it as you do with your income statement.

Joe Driscoll is a management consultant whose column appears regularly in the Monday Herald.

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