Cracking the Code

Posted by on Dec 18, 2013 in Drivers of Cash Flow

The truth is in the cash flow

Cracking the Code

If you read my last post, you will now know the seven drivers of business cash flow (The Magnificent Seven).  In this post we will engage in a little code cracking, to help the SME owner make use of the Magnificent Seven.

What makes the Magnificent Seven so magnificent? In simple terms, they represent the operational areas of a business that an SME owner can directly influence through action they consciously decide to take. In other words, they are the levers that the SME owner can pull or release to help achieve a desired cash flow outcome.

But, before levers get pulled or released, you need to first spend some time tracking the movement of the Magnificent Seven.  It is then necessary to know how to interpret what that movement is telling you. So, let’s establish the rules for decoding the information embedded in The Magnificent Seven. There are six of them and they are:

An action or activity that increases your Earnings is a Source of Cash. 

This means an increase in Sales or Gross Margin, or a decrease in Total Operating Expenses are Sources of Cash.

An action or activity that decreases your Earnings is a Use of Cash.

This means that a decrease in Sales or Gross Margin, or an increase in Total Operating Expenses are Uses of Cash.

An action or activity that increases your Assets is a Use of Cash.

This means that an increase in Debtors, Stock or Net Fixed Assets is a Use of Cash.

An action or activity that reduces your Liabilities is a Use of Cash.

This means that a decrease in Trade Creditors is a Use of Cash.

An action or activity that reduces your Assets is a Source of Cash.

This means that a decrease in Debtors, Stock or Net Fixed Assets is a Source of Cash.

An action or activity that increases your liabilities is a Source of Cash.

This means that an increase in Trade Creditors is a Source of Cash.

It is easy to track this information. Start by extracting the value for each of the Magnificent Seven from your accounting system each month and recording them on a separate spreadsheet, piece of paper etc. There are a couple of tricks to bear in mind when extracting this information:

Firstly, you need to multiply the Sales for each month by the Gross Margin applicable to that month to get the Gross Profit for that month. Make sure you record this figure as well.

Secondly, when extracting the figure for fixed assets make sure it is net of the accumulated depreciation charged against those assets.

Now, having extracted the information it is time to start using it. Here is what you do:

To determine the movement in the Magnificent Seven, subtract last month’s values for Sales, Gross Profit (remember Gross Profit is Sales multiplied by Gross Margin), Total Operating Expenses, Debtors, Stock, Creditors and Net Fixed Assets from this month’s values for the same items.

Reverse the sign of the number you have derived for the movement in Total Operating Expenses, Debtors, Stock and Net Fixed Assets.  So, if the movement in Total Operating Expenses is prima facie a positive number, reverse the sign so that it becomes a negative number; if the movement in Debtors is prima facie a negative number, reverse the sign so that it becomes a positive number etc.

Recheck the now adjusted numbers you have derived for the movement for each of the Magnificent Seven using the six rules set out above.  Positive numbers should represent Sources of Cash and Negative numbers should correspond to Uses of Cash.

Now, add the movement for Gross Profit, Total Operating Expenses, Debtors, Stock, Creditors and Fixed Assets. If the answer is a positive number then that tells you that operationally, the business has generated cash in the month.  If the answer is a negative number then that tells you that operationally, the business has used cash in the month.

You now have a simple method to identify how your business operationally produces and uses cash. This information will alert the SME owner to where lazy cash is being hidden in the business. It is also information that the SME owner can use in a myriad of ways, including identifying and prioritising operational areas for investigation and potential process improvement.