A business goes bankrupt when it is unable to meet its payment obligations when they fall due, that is, bankruptcy is caused by a shortage of cash. However, a shortage of cash is not necessarily related to profitability. In fact profitable businesses can go bankrupt, while companies making losses can have substantial cash.

Cash is king, but what is cash flow and what is the difference between profitability and cash flow? What are the sources of cash and how do we improve cash flow?

WHAT IS CASH FLOW

Cash flow is the difference between cash coming into the business (cash receipts, inflows or sources of cash) and cash going out of the business (cash payments, outflows or uses of cash). Cash flow is thus positive (a net inflow/ source) if receipts are greater than payments or negative (a net outflow/ use) if receipts are less than payments.

PROFIT VERSUS CASH FLOW

Sales (selling) less expenses (purchases) = profit or loss.

While, cash receipts less cash payments = cash inflow or outflow.

The difference between a profit or loss and a cash inflow or outflow is essentially a difference in timing.

We will use a simple example to illustrate this concept.

If you buy a cool drink for R7 and sell it for R10 then you have made a profit of R3. If this cool drink was sold for cash then you would receive payment of R10 from the buyer. However, if the cool drink was sold on credit/ account you would not receive any payment at the time of the sale, but would hopefully receive payment sometime in the future. In both cases the profit is the same (R3), but the timing of the receipt of cash is very different.

SOURCES OR USES OF CASH

There are 4 sources or uses of cash:

1) OPERATIONS

Cash inflow or outflow from the primary business operations or trading activities of the business, that is, through the buying and selling of products or services.

2) CHANGES IN WORKING CAPITAL

Working capital consists of current assets (stock/ inventory and debtors/ accounts receivable) and current liabilities (creditors/ accounts payable). An increase in stock and receivables is an outflow/use of cash, while an increase in payables is an inflow/ source of cash and vice versa. When stock/ inventory is paid for, it affects cash flow, but it only affects profits when sold.

3) INVESTING ACTIVITIES

Here we primarily refer to capital expenditure and investments in operational fixed assets (motor vehicles, equipment, machinery, etc.), although investing can also include investments in shares or other financial assets.

When assets are bought there is an outflow of cash and when the assets are sold there is an inflow. Investing activities affect cash flow when paid for, but are charged against profits over the useful life of the asset in the form of depreciation.

4) FINANCING ACTIVITIES

Finance or capital is typically raised from a combination of shareholders equity and loans. Raising equity or loans will result in an inflow of cash, while the repayment of equity (including the payment of dividends) and loans (both capital and interest) will result in an outflow of cash. Cash flow from operations is derived from the income statement, while changes to working capital, and investing and financing activities are reflected in changes in the balance sheet figures from one period to the next

IMPROVING CASH FLOW

Ironically cash flow is not necessarily improved by an increase in sales. As sales increase a business needs more capital and ties up more cash in inventory and receivables, and often fixed assets. The rate at which a business can grow is largely determined by the amount of capital it has to support this growth. When a business grows too quickly it will burn cash and thus have a negative cash flow

Cash flow can be improved by:

• Reducing costs and expenses → if costs are reduced you pay less and thus use less cash,
• Reducing assets → a source of cash and improves cash flow,
• Improving processes and efficiencies → reduces costs, assets, re-work, waste, scrap and delays/ waiting thereby improving cash flow, and
• Sales

1) REDUCING COSTS AND EXPENSES

Costs can be divided into fixed and variable costs.

Fixed costs remain unchanged irrespective of the level of production. Examples include depreciation (essentially the cost of fixed assets), leases, rental, insurance, rates and taxes, and certain salaries.

Variable costs change in proportion to the level of production. Examples include raw materials, labour and sales commission.

Fixed costs

Fixed costs are often linked to the level of fixed assets. Although the level of fixed costs and assets is often a function of the industry, companies can still choose between more capital equipment (fixed cost and asset) or more labour (variable cost). This choice should be based on which option is more productive and has the lowest cost.

It is difficult to reduce fixed costs and assets in the short term, however, since companies with high levels of fixed costs and assets tend to be more risky than those with lower levels, the objective is to keep fixed costs as low as possible.

Purchases of inventory or raw materials

Purchases are the biggest cost for most businesses. Retailers and wholesalers purchase inventory, while manufacturers purchase raw materials.

To reduce the cost of purchases:

• Develop relationships with your key suppliers and discuss your specific needs with them.
• To prevent outages and to test prices, ensure that you have more than one supplier for most items, especially your key and expensive items.
• Regularly test prices to ensure you are getting the best possible price.
• If possible, take advantage of discounts on large purchases and early payment.

Also see Inventory Management and Payables/ Creditor Management below.

Labour

Labour is another substantial cost for companies, especially manufacturing companies.

The objective is to increase productivity by:

• Improving business processes,
• Establishing performance and productivity standards,
• Comparing actual performance with the established standards,
• Using bills of materials and job cards,
• Improving quality in order to reduce rework and scrap, and
• Ensuring staff are properly trained and qualified for the position.

The net result is a shorter, more efficient production cycle, which reduces costs, assets, re-work, waste, scrap and waiting thereby improving cash flow.

2)  Reducing assets

Assets consist of fixed assets and working capital (current assets less current liabilities). Fixed assets include property, plant, equipment, motor vehicles etc. Current assets include stock/ inventory and debtors/ accounts receivable, while current liabilities include creditors/ accounts payable.

Fixed assets

Fixed assets, like fixed costs, are difficult to reduce in the short term and are typically a function of the industry the business operates in.

With a view to reducing your fixed assets:

• Assess your level of vertical and horizontal integration in the value chain.
• Determine where the value is in the value chain.
• What assets in the value chain should you own and how do you control the other assets.
• Are there opportunities for outsourcing or sale and leasebacks?
• Consider leasing instead of buying.

Working capital management

The management of working capital is critical to a business. The objective of working capital management is to reduce the cash cycle.

Reducing the cash cycle is achieved by:

• Reducing inventory/ stock – reducing the time (days) between buying and selling inventory.
• Reducing receivables/ debtors – reducing the time (days) between selling inventory and receiving payment for the sale from your customer.
• Extending payables/ creditors – extending the time (days) between purchasing and paying the supplier for the purchased inventory.

In a best case scenario, you will be able to sell and be paid for the goods you sold, before you have to pay your supplier.

• Inventory management

Here we want to reduce the amount/ quantity and costs of inventory. Inventory costs consist of:

• Carrying or storage costs → rent, insurance, material handling, obsolescence, and
• Ordering and shortage costs → time spent ordering, paying and receiving the goods, transport, and loss of goodwill, sales revenue and production time.

There is an inverse relationship between these costs – carrying costs increase with higher inventory levels, while ordering/ shortage costs decline and vice versa. The goal of inventory management is to minimise the sum of these two costs.

• Sell old or obsolete stock → selling at cost would be great, but the objective is to get rid of the stock, even if that means selling below cost price, and to generate cash while reducing your holding costs.
• Reduce the production cycle → in manufacturing companies reducing the production cycle will reduce inventory levels since the time between purchasing the raw materials and selling the finished product will be shortened.

The ABC inventory management system

Divide all inventory items into 3 or more groups in terms of:

• Inventory value (usage rate x individual value),
• Order lead time, and
• Consequences of shortages

Here the logic is that a small quantity of inventory might represent a large portion of inventoryvalue.

• Group A → consists of all high value inventories. Stock is kept to a minimum and all items are strictly monitored and tightly controlled. Precise ordering is important.
• Group B → items are of medium value and require a medium level of monitoring and control.
• Group C → inventory comprise basic, inexpensive items. These items are ordered in large quantities to ensure continuity of supply, while monitoring and control is not that important.

Receivables/ debtor control

Controlling receivables (money owed by our customers) is the key to cash flow management in any business. First establish a policy which, amongst other things, covers:

• Who you grant credit to.
• How you assess the granting of credit.
• What your collection policy is.

Then,

• Request down and milestone payments.
• Invoice daily instead of weekly or monthly.
• Offer cash discounts to encourage early settlement.
• Closely monitor accounts taking swift action on overdue accounts.
• Payables/ creditor management

Extend payables (money owed to suppliers) by:

• Paying in terms of your payment terms → if terms are 30 days, don’t pay on 15 days.
• Delaying payment without losing supplier goodwill or trade discounts.
• Negotiating better terms with your suppliers.
• Communicating and establishing relationships with your suppliers.

When choosing a supplier → negotiate and base your decision on both the purchase price and the payment terms.

Cash discounts are usually attractive and if possible, it is worth taking advantage of them.

1)  Improving processes and efficiencies

Improving processes and efficiencies reduces costs, assets, re-work, waste, scrap and delays/ waiting, thereby improving cash flow.

2)  Sales

As mentioned earlier in the article, an increase in sales does not necessarily improve cash flow. This is because, as sales increase a business needs more capital and ties up more cash primarily in inventory and receivables, but often also fixed assets.

However, without sales you don’t have a business, and you definitely won’t have a profitable business, since you will not have any revenues to cover your fixed and variable costs.

So what to do:

• Prepare a forecast of your expected sales and expenses → take into account cyclical trends. Remember that sales are a combination of selling price and the number of units sold.
• From the forecast, project your actual cash flow requirements and ensure that you have sufficient capital (cash) from shareholders and loans to meet your requirements.
• Target sustainable growth levels.
• Check your pricing and margins → how do your prices compare with your competitors and have your prices kept pace with your increasing costs?
• Implement regular price adjustments → especially if you are an importer and your input costs vary with the exchange rate.
• Ensure that you know:

• The cost of manufacturing or purchasing a product.
• The gross profit of each product
• How many of each product is being sold.
• How much effort (time) is required to sell a product.
• Your top customers by sales and profits.

While each of these elements has been discussed individually, they are all intertwined and woven together so reducing or increasing one element will often impact on the other elements and have a ripple effect throughout the company.

Do you treat all customers the same or do you treat them differently? Do you know which clients generate substantial sales and more importantly, which customers generate substantial profits and cash flow?

In order to determine the relative importance of your customers, rank each customer in terms of the following criteria:

1. Sales
2. Profitability
3. Payment history.

1. SALES

How much and how regularly does the customer spend money with you? Is sales revenue stable, increasing or declining? What is the sales revenue per month over 12 months or more? to calcu- late sales revenue, first identify the products sold and then the number of units of a prod- uct sold x selling price per unit. Then deduct any discounts granted.

2. PROFITABILITY

Look at profitability by product purchased and then adjust or reduce for discounts, delivery and returns. When we talk about client profitability we are refer- ring to gross profit. Gross profit is equal to sales less the cost of buying or manufacturing stock. The calculation of the cost of sales for a wholesale or retail business is very different to that of a manufacturing business.

WHOLESALE OR RETAIL BUSINESS

In the case of a wholesale or retail business, the actual cost of a product is the purchase price less any discounts received plus all costs incurred in getting the product to your warehouse or store (transport, insurance, import duty, equipment hired or purchased to unload, the cost of labour used to unload stock etc).

MANUFACTURING BUSINESS

In the case of a manufacturing business, the calculation of the cost of sales is much more complex as one has to take into account direct material, direct labour and other manufacturing overheads. »

• Direct material forms part of the final manufactured product, eg. Wood used in a table, and the quantity used varies with production volumes (you use twice as much wood for two tables as you would for one).
• Direct labour is the labour physically applied to manufacturing the product.
• Manufacturing overheads include all manufacturing costs except direct material and labour.
  • Indirect material does not form part of the final manufactured product eg cleaning materials or materials whose cost is so small that it’s not worth calculating eg cotton for sewing a suit.
  • Indirect labour cannot be directly linked to the final product eg the factory supervisor or people who maintain and service the machinery
  • Factory rental
  • Rates and taxes
  • Water
  • Electricity
  • Insurance of the factory and stock
  • Leasing of machinery and equipment
  • Depreciation of machinery and equipment.

3. PAYMENT HISTORY

How do the credit payment terms compare to other customers? Look at the frequency and ease with which you are paid for your products and services. If you are paid late and have to follow up fre- quently, this adds to your costs and should be used to adjust the customer profitabil- ity. the key question here is: are the credit terms reasonable for that customer and are you paid on time in terms of the agreed cred- it terms? You have already identified your key customers who generate the majority of your sales and profits. How many of these are your late or bad payers?

From your categorisation you now have customers that roughly fall into the following categories:

• Premium
• Intermediate
• Marginal.

Is there over-reliance on any of your premium customers? Would the livelihood of your business be threatened if one of these customers closed down or moved their business elsewhere? If the answer is “Yes,” then you firstly need to ensure that these customers are exceptionally well looked after and secondly that you actively identify and target potential new premium customers so that your reliance on your cur- rent key customers is reduced.

Now assess those customers in the intermediate and marginal categories with a view to deter- mining their potential future rev- enue and profit potential for your business. Do they buy exclusively from you or occasionally from you? are their businesses well managed?

How many of the intermediate and especially marginal customers have substantial future  revenue potential?

You should now have the following clients:

1. Premium – in terms of existing revenue spend
2. Intermediate – with good opportunity for future revenue and profit growth
3. Intermediate – with little opportunity of future sales and profit growth
4. Marginal – with good opportunity for future growth
5. Marginal – with little opportunity for future growth.

In categories 1, 2 and 4 you need to ensure that the relation- ship and service levels are main- tained or improved still further. You should develop the relation- ship at multiple levels with the customer.

In category 3 the relationship and service levels should be maintained or possibly reduced.

In category 5 you need to exit or improve profitability. Since sales volumes cannot be in- creased, then the way to increase profitability is to:

1. Increase prices and/or reduce discounts
2. Reassess the credit terms
3. Strictly enforce payment terms
4. Do not accept returns
5. Establish a minimum value for goods to be delivered or charge for delivery
6. Reduce the number of client calls made or limit customer contact to phone calls.

Companies often believe that they require a substantial range of products to compete, but more often than not they are better off with a smaller product range which will allow for increased business and sales focus and ultimately profitability.

In determining what products to sell, there are a number of questions to consider:

• What is the cost of manufacturing or purchasing a product?
• What is the gross profit of each product?
• How many of each product is being sold?
• How much effort (time) is required to sell a product?
• How should sales staff be incentivised?

WHAT IS THE COST OF MANUFACTURING OR PURCHASING A PRODUCT?

The calculation of the cost of manufacturing or purchasing a product (the cost of sales) for a wholesale or retail business is very different to that of a manufacturing business.

In the case of a wholesale or retail business, the actual cost of a product is the purchase price less any discounts received plus all costs incurred in getting the product to your warehouse or store (transport, insurance, import duty, equipment hired or purchased to unload, the cost of labour used to unload stock etc).

In the case of a manufacturing business, the calculation of the cost of sales is much more complex as one has to take into account direct material, direct labour and other manufacturing overheads. The calculation of the cost of sales will be covered in more detail in a future article.

WHY IS THE MANUFACTURING OR PURCHASING COST IMPORTANT?

The cost of manufacturing or purchasing a product is key because once a products cost is known, then you can establish a selling price. Over or under pricing can also be avoided.

WHAT IS THE GROSS PROFIT OF EACH PRODUCT?

The gross profit of a product is essentially the selling price less the manufacturing or purchasing cost (cost of sales) of the product.

WHY IS GROSS PROFIT PER PRODUCT IMPORTANT?

Frequently we hear that “the market determines the selling price” and often this is true, but it is essential that the product costs are such that you earn a gross profit on the product at the current market price. If you cannot earn a gross profit on a product then your options are:

• Differentiate the product so that it can be sold at a premium to the current market price,
• Reduce costs by improving business and manufacturing processes so that sufficient profit can be made on the product.
• Stop selling the product.

In your business would you buy a product for R100 and sell it for R50? No. Yet how many companies sell products for less than cost because they never knew what the product cost in the first place. If your revenues are increasing and your profits are declining then that new product you introduced that is selling like hot cakes is probably being sold for below cost.

You should almost never sell a product at below cost. The exception to this is the loss leader. Loss leaders are frequently used in retail. They are products sold at cost or below cost with the intention of attracting customers into the store to buy more profitable products. Examples include bread and milk. The loss leader is also often packaged together with another product, for example, companies who sell razor blades will provide the handle for free because they make their money selling the blades.

HOW MANY OF EACH PRODUCT IS BEING SOLD?

Sales figures by product are important so that you know what is selling and what is not. However companies often focus exclusively on sales, while ignoring profits. Do so at your peril.

Knowing the gross profit for each product allows for a focused sales effort. A sales effort focused on the most profitable products as opposed to the most expensive products.

HOW MUCH EFFORT (TIME) IS REQUIRED TO SELL A PRODUCT?

Another criteria to look at is the selling effort or time required to sell a product. The driver here is volume and products which require too much effort or time to sell and thus are sold in low volumes should have less effort spent on them or be discontinued. See Table 1 below where initially there is a sales revenue focus. Then look at Table 2 where the focus has shifted to a profit focus. The same amount of time is till spent selling, but the focus has changed from sales revenue to profit.

The exception to the above would be in a business where the sheer volume of product sold is what drives profitability. Here the volume of the lower profit products results in profits exceeding the profits of the higher margin products. A typical example of this is a retailer such as Pick n Pay where the products have low profit margins, but are sold in high volumes.

HOW SHOULD SALES STAFF BE INCENTIVISED?

Sales staff should not be incentivised on sales revenue, but rather on gross profit. This ensures that the most profitable products are sold and not the most expensive. The goals of the company and the sales people are thus aligned. In Table 1 above it is clear that the best product for the company to sell is B which at R 400 (50% of R 800) has the biggest gross profit and margin. However, if someone is incentivised based on sales revenue then they will focus on C which at R 120 (10%} of R 1200) has the smallest gross profit and margin.

Being able to create accurate balance sheets, income statements and cash flow statements could be the difference between business success and failure.

Inadequate financial controls are responsible for 75% of business failures. That is, one or more of the following financial controls may be absent or inadequate:

• cash flow forecasts
• costing systems
• budgetary control
• monitoring of key performance indicators.

Why is this so? One of the reasons is that a large portion of management cannot ‘talk the language of business.’ Businesses exist to make a profit and to maximise returns to shareholders. So is it not essential that management at least understands what the financial statements represent and what the drivers of value are?

Let’s look at the annual financial statements of a company and more specifically how the balance sheet, income statement and cash flow statement are created and intertwined. We will achieve this by building up the financial statements as part of the process of a new business starting up, and the events and requirements which unravel over time. The intention is not to cover every nuance, but rather to establish a framework and the basic principles, thus enabling the user to better grasp the annual financial statements.

Understanding your financials

• A balance sheet shows the assets and liabilities of the business at a particular date, or where the business obtains funding and what it purchases.
• The income statement shows income, expenses and profits for a particular period.
• The cash flow statement shows the amount of cash received and used by the business.

Each of the actions below is numbered and the numbers correspond to the entries in the balance sheet, income statement or cash flow statement. Assuming we are starting a new business, we have put together the business plan and are ready to get started.

1. The first thing the business will need is money. This is typically obtained from shareholders or owners (equity) and loans (long-term and short-term, generally from banks). These are known as financing activities and result in an inflow of cash into the business.
2. The business now needs to invest in fixed (long-term) assets such as property, motor vehicles, machinery and computers. These are known as investing activities and result in an outflow of cash from the business.
3. Next we need some product to sell so we purchase stock. An increase in stock results in an outflow of cash from the business, while a decrease results in an inflow. Stock, together with debtors and creditors, make up the working capital and are short-term.
4. Assuming the above stock was purchased on credit, we now have creditors or accounts payable, that is, people or businesses to whom we owe money. An increase in creditors results in an outflow of cash from the business, while a decrease results in an inflow.
5. We sell some stock and generate revenue, also known as sales or turnover. Revenue is units sold x selling price.
6. The difference between the selling and the purchase price of units sold is gross profit.
7. As the sales were on credit, we now have debtors or accounts receivable, that is, people or businesses who owe us money. An increase in debtors results in an outflow of cash, while a decrease results in an inflow.
8. The business has various other expenses for administration, selling and marketing, which are deducted from the gross profit. The profit remaining is called earnings before interest, tax, depreciation and amortisation (EBITDA). Simplistically, EBITDA will be used in the cash flow statement as the proxy for the cash flow from operations.
9. When we purchased the various fixed as- sets (point 2) only the balance sheet and cash flow statement were affected.  However, we are allowed to deduct an annual expense called depreciation, which further reduces profitability. Depreciation is calculated by taking the purchase price and dividing it by the number of years of its useful life. For example, depreciation for machinery purchased for R100 with a useful life of five years will be R20 per annum charge. Amortisation would apply in the same way and refers to patents and goodwill. Depreciation and amortisation are both non-cash flow items, that is, they are book entries and do not affect the cash balance, only profitability.
10. Lenders are paid interest on their loans next and we have earnings before interest and tax (EBIT), also known as operating income.
11. Taxes are deducted next resulting in net profit after tax (NPAT), or net income.
12. If the company decides to reward share- holders for their investment and the risks taken, they are paid dividends. There is no obligation to pay dividends. What is left of the profits after dividends are paid is called retained income and is retained in the busi- ness to help fund future growth, replacement or new assets, such as machinery and motor vehicles.

The Pareto principle (also known as the 80-20 rule, the law of the vital few, and the principle of factor scarcity) states that, for many events, roughly 80%of the effects come from 20% of the causes.

We all know of or have heard of the 80 – 20 rule and we glibly bandy it about, yet we seldom apply the principle in our own lives or business. Look at the following and see if you recognise any of them, then correct them:

• 80% of sales/ profits are generated by 20% of products

Why then do we sell the other products? Do we really need them? Maybe we do but have you checked? Do you know the profitability of each product you sell or service you provide? What about the hidden costs of holding stock such as storage, interest paid and stock obsolescence?

• 80% of sales come from 20% of your clients

Do you know who the 20% of clients that generate 80% of sales and profits are? Are those 20% really profitable? If you don’t develop relationships with your key clients maybe a competitor will. Have you asked these key clients what is important to them instead of you assuming (rightly or wrongly) what is important? When last did you visit your clients? The oft heard response is, “but I don’t have the time!” you don’t have to visit all of them just 20%. If you had a hundred clients and visited 2 per week you would see 100 per year and thus visit each key client 5 times a year (20% of 100 clients is 20 key clients. 2 client visits per week x 50 weeks = 100 visits. 100 visits divided by 20 key clients = 5 visits each).

• 80% of complaints come from 20% of clients.

Are these 20% the same 20% that generate 80% of sales/ profit or are they from the 80% that generate 20%of sales/ profit? Do you need them?

• With tasks or actions often something 80% complete today is worth much more than something 100% complete (Is it ever actually 100%??).

Does the extra 20% make a difference? Is the opportunity cost of the extra 20% worthwhile? Probably not, but that does not excuse you from not running the “spell check”. A journey starts with a single step someone once said. Then why don’t you start? Avoid paralysis by analysis and get started when 80% ready, the remaining 20%won’t make a difference or you can make it up or learn it along the way.

• 80% of production problems come from 20% of the operators/ machines.

Why don’t we train them or fix them?

• 80%of your raw materials and products are sourced from 20% of your suppliers.

Have you developed relationships with these suppliers? Have you told them what is important to you? Remember you are there client. Are these relationships strong so that they contribute and add value to your company? Are these suppliers paid punctually? How important are you to your supplier?

• 20% of a company’s stock is critical to its survival.

Do you know which stock makes up the 20%?

• 80% of our time is spent doing things of little value or things we dislike.

Why not employ someone else to do them? Someone who enjoys these activities. We are all different and need different things to blow our hair back. Do what blows your hair back, if you have some.

• 80%of the work is done by 20% of your staff.

Do you really need the rest? What about outsourcing these functions?

80% of the earnings are paid to 20% of the staff. Make sure you are one of them.