The Magnificent Seven

Posted by on Dec 6, 2013 in Drivers of Cash Flow

The truth is in the cash flow

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.