Drivers of Cash Flow

The truth is in the cash flow

Until the Pips Squeak

Until the Pips Squeak

This is the first article that I wrote on behalf of the Association of Virtual CFOs back in March 2016 and which was subsequently published by Smart Company.

It quantifies the amount of money Woolworths would inject into their cash flow by extending the time taken to pay their suppliers.

For business owners, this article is a great introduction to the importance of managing your working capital.

If you’re a business owner making a profit but feeling like you have no cash then the chances are your cash is being tied up in your working capital.

I hope you enjoy the article, and more importantly, find it useful and illuminating.

Lastly, if you’d like to turn your financial information into a source of competitive advantage, and grow your business with confidence, then please do make contact…I can make a difference.

Until the Pips Squeak.

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KPIs for All SME Businesses

KPIs for All SME Businesses

The play, “A Man for All Seasons” tells the story of Sir Thomas More, the C16th Chancellor of England who refused to endorse Henry VIII’s wish to divorce his wife, Catherine of Aragon. More was a man of great integrity, who whilst pragmatically adapting to changing circumstances, remained true to his beliefs despite enormous pressure being brought to bear upon him.

This article will describe a set of KPIs for SMEs that behave in a similar fashion to Sir Thomas More. These KPIs offer the SME owner a succinct and relevant insight into their business under all conditions, irrespective of Industry, external factors or pressures. Being easily identified and measured they are pragmatic. They are the “Universal KPIs” I referred to in The Emperor’s New Clothes (About KPIs).

Those of you who have read some of my earlier articles may have guessed the identity of my Universal KPIs. I introduced them in The Magnificent Seven and built on that introduction with posts on interpreting financial information (Cracking the Code) and understanding working capital (Seeing the Light (On Working Capital)).

The table below sets out my Universal KPIs and depicts a hypothetical business story (click on the table to expand it):

KPI Table

This table shows Monthly and Year to Date outcomes for my Universal KPIs. The stories told by the table are summarised below, which I hope will help the reader appreciate the clarity of the insight provided by these KPIs.

The Monthly Story

Sales are $45k below budget. However, the above budget Gross Margin of 47% has reduced this cash drain to $9.65k. Operating Expenses (which exclude Interest Expense and Depreciation) are $10k lower than forecast. The net outcome is a small inflow of $350, relative to the budget expectations.

Debtor Days have shrunk to 60 from 62 in the prior month, but the average time taken to collect debtors remains slower than the budget expectation (55 days). Nevertheless, the 2 day reduction in debtor days compared to the prior month has brought $30.7k of cash into the business. Stock Days have shrunk to 95 from 97 in the prior month, but the average time taken to sell stock remains slower than the budget expectation (90 days). Nevertheless, the 2 day reduction in stock days, relative to the prior month, has brought $16.7k of cash into the business. Creditor Days have expanded to 40 days from 37 days in the prior month, and Creditors are now being paid 1 day slower than the budget expectation (39 days). In the current month, the 3 day expansion in Creditor Days has resulted in $25k being retained in the business. Shortening the Cash Conversion Cycle by 7 days during the month has brought $72.4k of cash into the business.

Capital Expenditure in the month was $10k, in line with budget.

In summary: The cash brought into the business from its earnings during the month was in line with budget, albeit the manner in which this was achieved was different from expectation. The actual cash used for capital expenditure purposes met budget. The vast majority of the $72.75k of cash brought into the business during the month is due to a shortening of the Cash Conversion Cycle relative to the prior month.

The Year to Date Story

Sales are $400k below budget. However, the above budget Gross Margin of 45.6% has reduced this cash drain to $146.4k. Operating Expenses are $50k below budget, further reducing the cash drain to $96.4k.

Debtor Days are averaging 60 days, slower than the budget expectation of 55 days, leading to a $16.4k outflow of cash from the business. Stock Days are averaging 95 days, slower than the budget expectation of 90 days. Nevertheless, despite the slower stock turnover there has been a $20.8k inflow of cash in the Year to Date, reflecting the lower business activity and higher gross margins. Creditor Days are averaging 40 days, slower than the 39 days forecast, resulting in $18.8k of cash being retained in the business. Although the Cash Conversion Cycle has expanded by 9 days from 106 days per the forecast to 115 days there has been a net cash inflow of $23.2k, due to a shrinkage in Sales and the higher Gross Margin.

Capital Expenditure on a Year to Date basis is $40k, a saving of $10k on the budget, resulting in that amount of cash being retained in the business.

In summary: The net outcome is that the business has $63.3k less cash than forecast. This outcome has mainly been driven by the lower Sales, which an improved Gross Margin, lower Operating Expenses, lower Capital Expenditure and a modest inflow of working capital funds (as a consequence of the shrinking business activity, not due to a shortening of the Cash Conversion Cycle) has not been sufficient to offset.

All of these factors can be influenced by an SME owner. Indeed, if the Cash Conversion Cycle had met the budget expectation the result would have been a $10k cash inflow into the business in the year to date, relative to expectations.

The Message for an SME Owner

 When I worked in banking, these seven factors were the major drivers of our financial forecasting software (there were a few others: depreciation rates, interest rates, tax rates, dividend rates etc).  They are used because of their close link to the “operational” cash flow of an SME business.

This in part explains why they make great KPIs for an SME. The other significant factor in their suitability as KPIs is that the SME owner can make decisions and take actions that impact on each of theses 7 factors, and hence directly impact the cash flow of their business.

I regard them as Universal because all SME businesses, regardless of Industry, are capable of measuring Sales, Gross Margin, Operating Expenses, Debtor Days, Stock Days (or for professional firms, its equivalent, Work In Progress Days), Creditor Days and Capital Expenditure.

So, if you own a small or medium-sized business and would like to know more about its financial and cash flow health then a good place to start is by tracking these 7 factors on a monthly and year to date basis.

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The Emperor’s New Clothes (About KPIs)

The Emperor’s New Clothes (About KPIs)

I recently read an interesting article on Key Performance Indicators (KPIs) by the economics journalist, Ross Gittens, which prompted me to consider when and how KPIs are best used. I thought I would share my conclusions in this post.

Key Performance Indicators (KPIs) are an established part of the business world, used in many organisations whether operating in the public or the private sector, often to encourage particular employee behaviour and focus, and as an objective means of measuring and ranking performance with consequences for employee remuneration.

They are quantitative or qualitative measures used to review an organisation’s progress against its goals. They may be broken down and set as targets for achievement by departments and individuals. The achievement of these targets is then regularly reviewed.

As such, KPIs immediately meet three of the criteria needed for setting effective goals, in that they are specific, measurable and time bound. Depending on where the benchmark is set, KPIs will also meet the other two criteria for setting effective goals, being that they are also attainable and realistic.

No wonder then that their use in business is extensive.

What about the disadvantages of using KPIs? From the article written by Gittens it is clear that he is not a fan of KPIs. The summary of his misgivings on KPIs is that they can be manipulated. He argues that most jobs are multi-dimensional, and that you cannot construct a KPI covering every dimension – hence the manipulation occurs by cannibalising some dimension of a job (usually quality related) not covered by a KPI. In other words, KPIs are usually capable of only measuring quantity, but not quality.

Hmm, quite the conundrum. On one hand, we have an established business practice that has been widely used for many years. On the other, an argument that says KPIs are simplistic in nature and open to manipulation.

So, are KPIs really useful, or a dangerous fad, a modern-day business-related take on “The Emperor’s New Clothes”?

I think the answer to that question lies in the implicit assumption of the Gittens article, which is that employees are motivated to manipulate imperfect measures of complex real world relationships by the linking of their remuneration to the KPI outcome. But, does this mean KPIs should be abandoned?

What about the SME Owner? Are KPIs useful to them? My conclusion is absolutely Yes, and I think this because:

there is no motivation for the SME Owner to manipulate KPI outcomes, as there is no benefit to them to see the position of their business other than as it actually is; and

after many discussions with SME owners, I know that most use some type of Rule of Thumb measures (at least) to give them a sense of how the business is operating.  

My position is that whilst there may be some flaws to using KPIs at the employee level, they are capable of providing useful and important signals to the SME Owner about the health of their business.

This led me to another train of thought, what are the best KPIs for SME Owners to use? Is there a set of “universal” KPIs that are capable of providing useful and important signals for all SME Owners?

I think there is and in my next post, I will share with you my ideas on a set of universal KPIs for the SME Owner. You will discover that these KPIs are easy to measure; capable of being adapted and used by a wide variety of business; represent activities that directly affect the amount of cash that a business produces; are readily influenced by the decisions and actions of the Business Owner; and help identify potential deterioration in the major cash-flow generating operations of the business.

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Seeing the Light (on Working Capital)

Seeing the Light (on Working Capital)

When I was in my teens, a favourite movies was the Blues Brothers. It was shown at the (then) decrepit Cremorne Orpheum cinema in Sydney. We’d watch, dance and sing along to this movie with its absurd plot, revelling in its wonderful sound track.

If you are familiar with the movie, you will know that Jake and Elwood are on a mission from god, to raise the money needed to save the orphanage where they grew up. They don’t know how they are going to source the money until Jake “sees the light” and they decide to put the band back together.

This blog will help SME owners “see the light” on why managing working capital is an easy way to increase cash flow. It picks up on a key message from the research set out in my first blog (It’s Not Rocket Science, 19 November 2013) being that a business with a shorter cash conversion cycle (ie: one that manages its working capital) has better liquidity, requires lower levels of capital and enjoys better returns on investment than a firm that does not manage its working capital. It will give the SME owner the tools needed to begin managing working capital.

First, let’s define a few key terms.

The Cash Conversion Cycle is the number of days between the outlay of cash (to acquire inventory, for example) and the recovery of that cash (the collection of sale proceeds from debtors). It is calculated by adding Debtor Days to Inventory Days and then deducting Creditor Days from this figure.

Debtor Days is a measure of the number of days it takes to collect debtors. It is calculated by dividing Trade Debtors at a point in time by the aggregate of Sales for the 12 months to that point in time and multiplying that result by 365.

Inventory Days is a measure of the number of days a business holds its stock before it is sold. It is calculated by dividing Stock at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

Creditor Days is a measure of the number of days it takes a business to pay its trade creditors. It is calculated by dividing Trade Creditors at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

The Capital of a business is the sum of the equity provided by the owners of a business plus the debt a business has raised from its financiers.

The Working Capital of a business is the amount of Capital invested in the Net Working Assets of the business.

The Net Working Assets of a business are its Inventory plus Trade Debtors less Trade Creditors.

To manage Working Capital an SME owner first needs to measure and track the value of the Net Working Assets and Cash Conversion Cycle.

Net Working Assets represent a Point in Time view of Working Capital. An SME owner who tracks the value of their Net Working Assets on a monthly basis will know the amount of Capital invested as Working Capital and whether that investment is rising (using cash) or falling (generating cash). By breaking the Net Working Assets into its constituent parts, the SME owner can establish the driver(s) for the movement in their Working Capital.

The Cash Conversion Cycle is a Relative view of Working Capital, which provides the SME owner with information about how their Net Working Assets are moving relative to the trading of the business. By tracking the Cash Conversion Cycle over time a business owner will receive information about how efficiently their business is using its available Capital – a falling Cash Conversion Cycle is a sign that capital use is becoming more efficient (ie: you’re stretching a dollar of capital further), a rising Cash Conversion Cycle is a sign that capital use is becoming less efficient (ie: you’re likely to run out of capital sooner).

This information is useful to all SME owners, in all business situations. It is essential for an SME owner with a growing business as nothing uses Capital quicker than growth.

Working Capital management begins when an SME owner uses the information from tracking Net Working Assets and Cash Conversion Cycle to identify and prioritise for review those operational elements of their business that impact on Net Working Assets. For example, the invoicing process, customer credit policy, and debtor collection process have an impact on the value of Debtors and on the Debtor Days ratio – by reviewing these processes it may be possible to reduce the value of debtors / speed up their collection without compromising Sales. Similarly, stock re-order triggers, minimum and maximum holdings, identifying fast and slow-moving stock, and supplier delivery times have an impact on the value of Stock and the Stock Days ratio – by reviewing these processes it may be possible to reduce the investment in stock / reduce its holding period without compromising Sales.

Process improvement can be measured by tracking subsequent changes to Net Working Assets and Cash Conversion Cycle. Using this approach, continuous improvement and low risk, incremental changes to working capital related process is possible. If done successfully, the SME owner will see a permanent reduction in the use of their Overdraft, or a permanent increase of funds in their Bank account.

The SME owner who has “seen the light” has options in the form of access to greater cash flow: they can use this cash flow to invest in the continued growth of their business, to pay a dividend, or increase the efficiency of their business. If you’re not already actively managing your working capital it is time to jump on the band wagon.

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Cracking the Code

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.

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The Magnificent Seven

The Magnificent Seven

No, this post is not about the epic western, starring Yul Brynner, in which oppressed Mexican villagers hire seven gun-slingers to save them from an evil bandit and his gang. Rather, it is about helping the SME owner understand the Seven Drivers of Cash Flow, knowledge which will help protect your business in good and bad times.

This post marks the commencement of our journey to find answers to the issues identified in my previous blogs (It’s not Rocket Science and Budgeting: A Means to an End).

Let’s begin with a quick recap of the key messages from my previous posts:

To understand your cash flow you need to use all your financial information. You need to pay attention to both your Profit and Loss statement and Balance Sheet.

The objective of preparing a budget is not to predict the future with accuracy. Rather, a budget is a tool that should be regularly reviewed and updated for real world impacts. It is a means to an end, not an end in itself.

 The drivers of cash flow I am about to introduce will help the SME owner address these messages as:

They are found in both the profit and loss statement and the balance sheet, and hence help you use all of your financial information whilst not drowning you in detail; and

Continual monitoring of these drivers will reveal their inter-relatedness. Understanding these links simplifies the budgeting process, and focuses you on the key pieces of financial information that you should regularly review.

So, which pieces of financial information make up The Magnificent Seven?  They are:

Sales: The foundation of your cash flow. As sales change there is usually a corresponding change in debtors, stock, creditors and total operating expenses.

Gross Margin: The Gross Profit of a business (Sales less Cost of Goods Sold) expressed as a percentage of Sales. The higher the Gross Margin, the greater the value added to the business per dollar of sales. For a service business (ie: one that provides a service as opposed to selling goods) the Gross Profit is equivalent to Sales less the direct costs of providing those services (ie: the salaries and commissions you pay your sales staff).

Total Operating Expenses: The costs incurred to run your business.  The gross profit needs to be sufficient to cover your Total Operating Expenses if you are to make a profit. Generally, the higher your gross margin the more quickly your Total Operating Expenses will be covered.

These three drivers are all found in your Profit and Loss Statement.

Debtors: Represent the money owed to you by customers to whom you have made sales with credit terms attached. As your sales change, so too should your debtors.

Stock: Represent goods on hand ready for sale, or to be converted through a manufacturing process into goods for sale. For a service business the equivalent to stock is Work in Progress. Many businesses must buy or manufacture stock before selling it. As sales change, so too does the required investment in stock.

Creditors: Represent the money you owe the suppliers of the goods and services used by your business. As sales change, so too should your creditors.

Capital Expenditure: The money a business spends on plant, equipment, motor vehicles, furniture, fittings etc. As the business grows (ie: as sales increase) then the required investment in this equipment also increases.

These four drivers are all found in your Balance Sheet.

Now, here is the pay-off.  By paying attention to these seven pieces of financial information and tracking them over time you will uncover valuable information about how your business is operating.

Consider this example. If your debtors are increasing at a rate faster than the rate at which your sales are increasing, and if you haven’t changed the terms on which you offer credit, then that is an indicator that there has been an operational deterioration in your debtor collection process. The vigilant owner, understanding the relationship between their sales and debtor levels, uses changes in that relationship as a trigger to find out what is happening before a serious cash flow problem arises.

I will have more to say on how the Magnificent Seven can be linked to operational aspects of a business in a later post.

For now, the key message to SME owners is that The Magnificent Seven is not a movie, but the vital pieces of financial information that will help you understand the cash flow of your business and alert you to changes in its operational health.

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