Cash is King

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Cash is King.

Your listening to Money To Wealth with Maxine Kneubuhler on 997 Bridge FM.

We all know “Cash is King” and today this is definitely true. When I say this however, I am not talking about sitting on a pile of cash; rather I am talking about ‘Cash Flow” that is King.

In business and in life we want cash to be moving in and out of a business as efficiently and effectively as possible.

The most widely accepted method of valuing any asset is not based on accounting profits, but on estimating free cash flows and discounting them by the required rate of return. Why free cash flows?

Because cash is fundament to business.

Assets have to be paid for, suppliers need to be reimbursed in the trading terms agreed to build and keep trust, employees and taxes can be a drain on cash resources, and that, we all know is true.

Every business requires cash; if it is not available within the business it must be found. Lenders and owners are the main sources. In my early days in business, and I am sure you all as business owners can relate to this, I often dipped into our personal savings to pay and keep our employees. That value – the return to the shareholder – (yep that is me) is what I was working for. Yet when we use  Lenders and owners both of these come at a price. Lenders require an interest rate (or coupon), shareholders require a rate of return.

Hypothetically a company can survive in perpetuity with no profits provided it is generating cash flows. BUT – a company with accounting profits cannot survive indefinitely if it can’t generate positive cash flows.

On 18 February 2002 Fortune magazine published, Enron’s story – no one knows exactly what happened at Enron, but you could have found a smoking gun by comparing its profits and cash flow; in the quarter that ended June 30, 2001, Enron reported $423 million in earnings and negative $527 million in cash flow.

I will be discussing what are free cash flows, and how this affects shareholder returns live in studio with my guest Simon Penrose President of Brisbane North Chamber of Commerce.

To hear the full interviews head to the 997 Bridge FM Money To Wealth with Maxine Kneubuhler group Facebook page, join in the conversation, my team are live and ready to answer your questions.

 

Answers – Simon Penrose

CASH IS KING

Q

Simon – In the intro I mentioned Hypothetically a company can survive in perpetuity with no profits provided it is generating cash flows. BUT – a company with accounting profits cannot survive indefinitely if it can’t generate positive cash flows.

What are free cash flows?

A

• Free cash flows are the true cash flows generated from operations.
• Free cash flows is not always the best measure to understand a company’s performance in a single year because it can be misrepresented by stalling payments to suppliers, shoving goods down distribution channels and selling off fixed assets.
• But as those manipulations are not sustained for very long, free cash flows is recognised as the best performance measure over the medium term.

Q How is business survival connected to the cash flow cycle?

A.

• Business survival is less about accounting profits and more about cash flow.
• Think of the small business that gets stock in from the supplier: within two months the stock is sold on credit, but the debtors only pay three months later. The accounting profit looks good.
• But, there is a five-month period with no cash inflow.
• Meanwhile employees, rent and utilities have to be paid, and don’t forget the supplier who never gave five months’ credit in the first place.
• The supplier is now questioning whether he wants to supply to this new business again.
• He reckons he will, but he’ll be increasing his price to compensate for the five months’ financing period.
• The small business has its margins squeezed.
• If it borrows from the bank to pay the supplier the margins will be squeezed further with interest costs.
• The only other option is for the owner(s) to contribute more cash and patiently wait for growth and eventually a return.

Q

Then we have the cash management of the business. This is to ensure that not only ENOUGH CASH is available, but also that there is not too much cash. So – sufficient but not excessive amounts of cash. How do we identify the cash requirements of the company during the foreseeable future?

A

• One important task is to identify the cash requirements – this is true.
• This means matching cash inflows and cash outflows as closely as possible.
• The cash flow forecast should tie in closely with the budget, which further emphasises the importance of the budget process.
• If any shortfalls are anticipated, funding sources should be identified in advance.
• You are going to be in a far better negotiating position with any lender if you have time on your side.

Q

The other challenge is to ensure the company does not have EXCESS CASH on hand; cash sitting idle compromises overall return and puts a lot of pressure on the other operating assets.

My team were talking with one of the listeners last week and they were struggling to get their head around this, because they have been conditioned to hold cash. How does it pressurise other areas of the business?

A

• Let’s assume shareholders invest $100,000 in a company and require a 15% return.
• If $40,000 dollars is sitting in cash and $60,000 dollars in operating assets.
• We know that cash will only yield a relatively small return of, say, 5% [if you are extremely lucky these days], or $2,000 per year for ease of this example.
• As the shareholders require $15,000 (15% of $100,000) per year that means the operating assets MUST generate $13,000, or 22% per annum.
• What this illustrates as you said, that large cash balances dilute the overall return, putting a lot of pressure on the other operating assets.

Q

What would happen if the company was only to earn $12,000 and the shareholders still require a 15% return?

A

• To continue with this example, and the company was to only earn $12,000, the shareholders still require a 15% return, so the value of the company should fall by 20% to $80,000 that is $12,000/15%).

Q

What should be the target cash balance?

A

• Ideally as a rule of thumb the cash target should be between 0.5% and 2% of revenue.
• This of cause depends on the industry concerned.
• Anything in excess of this amount may be compromising the company’s overall return.
• The target cash balance should be managed as effectively as possible so that when there is spare cash it should be earning the best return.

Q

At a board meeting last week, people at the table mentioned “I am making fist full of cash but there is nothing left in the bank? Equally there were people at this table who were wallowing in cash and living the high life even though there profit and loss statements were gloomy. Let’s clarify the profit and cash story – profit does not equal cash and cash does not equal profit. When I said that – they all looked and said WHATTTTT.  Why is that your Profit and Loss reports say you’re doing well BUT you have no cash anywhere to be seen?

A.

• Here are a few examples why this may be happening:
• You’ve been paying tax:
  • A tricky habit to avoid, but the truth is that as soon as you make any profit, you have to pay tax.
  • Tax payments don’t usually show up in Profit and Loss reports because, cruelly enough, they are not tax-deductible expense).
• You’ve brought new equipment
  • Any gear that costs a certain amount, isn’t immediately tax-deductible and so doesn’t show up as an expense, but gets listed as an asset instead.
• You have teenagers
  • The most merciless financial cash drain on any individual
• You repaid a loan
  • Loan repayments don’t usually show up as expenses, meaning that loan repayments gobble up cash but don’t affect your profit.
• You’re owed heaps
  • If you bill a customer in April, your Profit and Loss reports show this income in April, even though you may not actually receive cash until weeks or months later.
  • If customers owe you more now in total than they did six months or so ago, this difference has sucked up you cash.

1. Q. It may be easy to grasp why a business may not have any cash even though the business is turning a profit. What about the opposite scenario, where a business is rolling in cash but the Profit and Loss reports look unfavourable? In many ways, this situation is even worse, because you can all too easily get lulled into a false sense of security and spend beyond your means. Let’s talk about why cash might be rosy but your profits grim?

A.

• You receive a loan
  • Loans are both a blessing and a curse. As we discussed earlier.
  • When you receive a loan, the sudden influx of cash can burn a hole in the thickest of pockets.
• Your creditors are building up
  • You can actually get by for a quite a while making a loss but staying afloat, simply by running up outstanding accounts. If you start to stretch out suppliers to 60, 90 or even 120 days, you not only generate a fair amount of bad feeling, but wad of cash also.
• You’re running stock down
  • If your stock levels go down, you have more cash available. Simple as that.

Q

One of the paradoxical things about being in business is that if you get too successful too quickly, you can actually send yourself down the gurgler.

 

A.

In order to be in business you need cash, furniture, computers and so on. These new assets take up cash; in order to pay for them, you need first to make a profit and, second, invest this profit back into the business.

• The concept of too-fast growth is often called the limit of sustainable growth.
• As your business grows, your assets have to grow with it.
• You can either finance these assets by reinvesting profits or you can finance them by taking out a loan.
• For example if you can invest enough profit to increase cash, debtors, equipment and so on by 10 per cent a year, your business can comfortable grow as 10 per cent a year.

Let’s summarise

Maxine

Cash is a constant pressure for every new business. Even if the company keeps to its start-up budget, it takes time for trading to reach a high enough level to generate positive cash flows. For new businesses, fast growing companies, and in times of recession, cash is king. In other words profit takes a backseat, while cash flow becomes the critical factor.

An example to summarise all of this may help.

Image that your business turns over $250,000 a year and you have around $50,000 tied up in stock, computer equipment and outstanding customer accounts.

If you made a profit this year of $40,000 and you had personal drawings of $35,000, this result means you have only put $5,000 back into the business.

$5,000 divided by $50,000 equals 10 per cent.

This year’s turnover of $250,000 plus 10 per cent equals $275,000, meaning this amount is the maximum you can grow your business in the next year without having to seek extra finance.

 

A final lesson and a warning: Cash flow problems can cause well-established companies to stumble and even collapse there is a limit on the pace at which a business can comfortable grow. To be very successful, too quickly, runs the risk of putting such a strain on your cash flow that, unless you can secure additional finance, your business may not survive.

 

Maxine:

Jump in on the conversation and To get a copy of todays show notes and answers to these question visit the Money to Wealth Facebook page for 997 Bridge FM.

 

 

END OF SHOW __________________________________________

Next week we will be talking Making Money Work

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