Risks of cashflow are partly an illusion. Agreed – the definition of insolvency is the inability to meet obligations when they are due, and so cashflow … BUT
What is Cash
What is cash? Fundamentally, cash or money is a measuring tool. Apples and shoes are difficult things to compare. When I want to replace my shoes, I find a cobbler who is need of apples, and we negotiate a trade, bartering his labour and leather, for my labour and investment in trees. This works, but barter systems require that there be some face-to-face interaction for negotiation. This confines the geographic scope of our cobbler and orchardist, but it also ties the exchange in time, since the cobbler is not much interested in trading his shoes for my rotten apples. If only I had swapped my apples when they were fresh, for some chickens … Then I could offer the cobbler some eggs, instead of having to go barefoot in the snow! Money is an abstraction – a device that we have agreed will be a medium of exchange. What underpins it is trust, and value. We trust that others will accept our store of cash in the future. We trust that the source of the money (usually the government mint, but not always) will preserve that trust. We also assume that others will provide some input to the economy in exchange for their money, and so contribute value. Cash then is a storage mechanism for value.
The folding paper in your sock under the mattress – stored value. That teeny balance in your current account – stored value. That G.I.C. in the safety deposit box (near cash) – stored value.
What is Flow
That is what happens when it rains on a hill.
Well, pretty much, yeah. So the water flows downhill, then into a stream, to a river, to the ocean. Once there, the sun evaporates it into steam, the wind flows it back across the land, it goes up over the hill – and presto – more rain, and the water flows downhill, then ….
This is a cyclical flow, and exactly the same happens in every business. You collect from the sale of your apples in these pretty round flat wafers, put them in your sock as your cash reserve, then pay them to the cobbler, who deposits them in his bank, who lends it to the grocer, who buys your apples and pays for it in . . .
What is Cashflow
Cashflow is a conspiracy launched by the cabal of anti-business activists which include, of course, bankers, gubbermint types, and anti-capitalists. Worst of all are the accountants. Clearly they are the master-minds of our conspiracy, since they appear to have invented cashflow. Note the clever coining of the new word, joining two innocent and beneficial things into one ominous concept. Ummmm, okay . . .
These accountants sit down from time to time (usually when it is time to account for your life to the government), and ponder all of the pieces of paper in the shoe box. They then produce two pieces of paper and plunk them down in front of you. The first is the income statement – which describes a summary of your selling and buying activities in perhap’s the past year. The second is a balance sheet, which simply sets out what good stuff you have, and what you owe to other people, at the end of the year.
You look at the balance sheet, and you ask – what happened to all my good stuff. The accountant wanders away, and after a time (another $100) returns to show you the balance sheet last year. You then compare the two, see the changes, and ask for an explanation and summary of the changes from last year to this year. Cleverly, the accountant whips out a third piece of paper, brandishes it around, and says HERE ! Your Cashflow Statement.
You study it, and it says things like Loss from Operations, less non-cash items in above loss, and Net Operating Cash. Then it mumbles about change in balance sheet accounts, investing activities, and finance activities, and the very bottom sets out the change in the bank account.
That is a Cashflow Statement – pretty helpful, right?
For a few hundred dollars more, your accountant or your financial advisor will cheerfully calculate any number of arcane ratios – Return on Assets, Average Days Outstanding of Collectibles, Cashflow Efficiency, Liquidity, Quick Ratios, slow ratios, turtle rations, army rations - - - you begin to cry.
What is NOT Cashflow
Cashflow does not mean that you can’t pay your bills on Monday, nor does it mean you can pay your bills next Friday. It is simply a description of changes between two snapshots in time, reconciled to the Balance Sheet and Income Statement. On a very global basis, it does provide the reader with some suggestions of the cash position behavior of the business, but that is about it. Despite this, it is widely used by people other than the business owner to quantify credit risk, and even debt servicing ability.
Entrepreneurs Cash Information Needs
What the business entrepreneur needs is to know if they can pay the bills more or less on time, offer a new customer some trade credit to close a sale, pay for the new machine, and when might the owner possibly get some food.
What the business entrepreneur needs is a cash behavior model. What is that ? Come on, don’t play dumb with me – you do it every day either in your head, or on the back of the envelope that the bank statement came in. Here’s my cash in pocket, plus what’s in my sock, plus the cash I can collect from the cobbler (eggs, glad to see you took my advice) on Wednesday, and the grocer (next Friday). Now I have to pay for those shoes (on Tuesday), and the fancy Cocoa Puffs breakfast cereal needs to be replaced on Thursday at the grocers… hey that leaves me just enough to get some beer - - -uh,uh, uuuhhhh You forgot the payroll and the remittance of withholdings to the government.
A cash model is a chronological list of cash coming in, and obligations payable to others. It starts with the balance in the bank account, and projects how much cash you will have at the end of every day for, lets say the next three months. This is how a controller manages a businesses cash.
Are there Cashflow Risks ?
Well, not really – more correctly – all risks sooner or later show up as cashflow stress, simply because cash is the measurement tool for everything. Ninety-five times out of a hundred, what appears to as a cashflow crisis is a fever induced by some other disease. It’s a symptom. Treating the symptom is at best a very short term bandage – find the cause and fix it if you can. Here are some causes;
My customer didn’t pay on time
My supplier won’t ship until I pay bills not yet due
My accounts receivable are growing because of business growth
Lost my money in a poker game
There is an unexpected bill, not in the normal course of business
My credit line was cancelled because of a panic in the banking sector
Then there is the most typical causes – my business is not sufficiently profitable.
There is ONE true cashflow risk – and that is the failure to manage cash behaviour, so that you are caught by surprise with no plan to handle the underlying problem.
That is a risk that is readily manageable. Sure would be nice if all our problems were that simple.
11 Comments
What Pilot, you have it in for the profession now!? Hey, it is not the accountant’s fault that the reader does not understand what a cashflow statement is! I mean, we are supposed to educate ourselves a bit, right!
As for the cash behaviour approach, yes that is very useful, but its use tends to be more for those who need a finer detail tool than the acccounting cash flow statement. Businesses that are flush with cash, and have enough to meet all of the next months cash requirements at the beginning of the month often don’t need better tools. So we have looked after the needs of a lot of businesses with our basic approach. And who do you think invented the cash behaviour approach anyway!
A little sensitive today Found the Penny! Come on - the cashflow statement was developed because people wanted to tie the two main statements together. And it is also needed for certain performance metrics on investment vehicles, agreed. But, find me a controller who does not use a more refined tool, and I’ll show you a business which is either underinvested, or overcapitalized (typically with debt). Both are bad practices for an independent business, let alone an investment level operation. Good controllers do model cash behaviour, if only to preserve the near cash positions that they have in play for funds that are surplus to immediate requirements. That is part of the responsibility of a controller after all.
As to who invented it - be serious! Long before double entry book-keeping came into its own, or accurual accounting, business people projected actual cash behaviour. We have always done it. Just now, we have in some ways, stronger tools to work with. How many independent business people actually produce a full set of statements on a monthly basis? Maybe an I/S and B/S, but a rigourous cashflow? And by the time it is ready, it is obsolete anyway! So, no - not a great tool for entrepreneurs who tend to shove every spare dollar back into their operations in the form of investments in people, equipment, opportunities and so on.
I’m not picking on accountants, just telling it like I’ve seen it.
Well, Pilot, I take your point from elementary economic theory, but at the end of the day, most people do use the concept of “cash” as having its own reality. To many, the idea of cashflow risks are elliptical for risks that are associated with cashflow, not neccessarily caused by cash.
Not sure we are disagreeing here ‘guv. Fact is, I went into this because a lot of people seem to think that the cure for a cashflow problem or risk is simply to add more cash. And their favourite mis-used tool is a credit card advance, or a short term revolving line of credit. Well, there is a time and a place for that.
Most of the time the actual source of the risk or problem is not cashflow or cash balances. I say that because if you want the symptom (cash crunch) to go away and stay away, you need to fix whatever caused it. And that is not typically cashflow. It is either fundamentally insufficient revenue, or excessive expenses. Sometimes it is a timing problem, other times it might be over-investment. What it is not is cashflow. Cashflow is the MEASUREMENT of those other things. The problem may present itself as a shortage of cash, but you need to determine the why of it. Look elsewhere, my friend.
I run into this problem from time-to-time.- I have played around with a variety of approaches, but there is a problem for me in doing these things. In my business, everything is cash, meaning all of mysales are small, and are collected in cash. I don’t offer a customer credit at all. So I have no window to collect receivables, because they don’t exist. Now I can guess receipts, but that’s it. Sometimes I get caught short.
Sure cupcake, and that is a different type of challenge, but in some ways easier than it is for those who must offer credit to customers, since they are also unpredictable. What you do k now to a high level of confidence is what your cash outflows will be - overheads, payrolls, and materials. On the inflow side, you need to do a couple of things. The first is, make absolutely certain that you have monthly sales figures for at least the past couple of years. Secondly, you need to make notes on things that impacted the months sales to push it off the average. For instance, if you run a sports bar, and certain months have a playoff season for a sport that your demographic follows - baseball’s pennant race, or soccer’s world cup, or hockey’s Stanley Cup - you have a source of what influences sales differences. A lot of such operations keep a daily log to track those kinds of things, so that the staffing manager can look back and see if there might be an annual event that will require extra staffing. Use this at the beginning of the month to estimate what a conservative inflow of cash might be. Then keep track daily of what the actual cash deposited proved to be. Sit on top of that cashflow on a daily basis - it takes only about 10 minutes at the start of the day. You will soon feel that you are back in command of the bank balance, and less open to unpleasant surprises.
Umm, Pilot - remember me? I’ll take this for the library thank you very much, and ahh, when might I expect it?
Dewey? never heard of ya.
I used to do this with pencil and paper - what a bloody nuisance this was. It never tied into my boooks, because back then, my books showed up about three weeks after the end of the month, when it was completely meaningless and useless. So I tracked it all by hand. Took me hours I could have spent growing the business. tried to farm it off to other people, but they just didn;t have the judgement and knowledge of my business to tackle it for me. Of all the management things, this is the one I dislkied the most. Took me years before I had enough cash reserves to be able to breathe comfortably without watching it like a hawk. The tools we have now make it a completely new world.
This is the reason I got the computer to begin with - I hate the thing, but I’d hate even more being without it now. You may not remember, but this is the problem that got mr involved in the first place. Kudos to Pilot for getting me going on doing this better back then - its still the most important change I made to my business. Haven’t had one of those empty stomach phone calls in over a year, and when I go fishing for a few days, I don’t panic about what is happening while I’m away.
I am working up another post on this subject that goes into the kind of thing that kenny is talking about. Might take me a day or two, things are a little hectic right now. And yes Dewey, given some time, you will get it for your little storage tank.
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