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Reflections on Cash Flow

John W. Altman

For entrepreneurs, the importance of cash flow cannot be overstated. Simply put, no cash, no business. To put it another way, consider the phrases, "Burn Rates, Fume Dates, and Wallpaper," which refer, respectively. to how fast a company is using cash, when it is perilously low on cash, and what stock certificates are worth when it no longer has cash.

With the above as fair warning, it is perhaps a good time to re-examine a few concepts about accounting and finance. The first is that accountants distinguish revenue from expenses, with the difference being a net gain or loss, the latter indicated by parentheses. The second is that entrepreneurial finance concerns itself with "free cash flow," which is the difference between total cash income and the total of all cash outlays required. A more complete definition for "free cash flow" is net income after taxes, plus depreciation, minus required investments in plant, equipment and working capital to successfully run the business.

In fast growing entrepreneurial companies, sales growth is a significant factor affecting cash flow. As sales continue to grow, an entrepreneur usually needs to increase fixed assets (plant and equipment) and working capital. Remember growth in assets comes from three places: retained earnings, increased debt, or the sale of more of your precious stock (equity).

As you begin work on the financial section of your Business Plan, pay particular attention to cash flow. Don't run out of cash! While raising enough money up front will help solve under-capitalization failure, good forecasting (especially sales) and tight expense control (as in initial low salaries!) will conserve your precious cash and extend burn rates significantly.

Other hints to preserve cash include the following:

  • Raise enough start-up capital!
  • Shift Fixed Costs to Variable!
  • Keep inventory and supplies at an absolute minimum!
  • Defray and delay expenses!
  • Lease or borrow instead of buy!
  • Act as if it's your own money -- IT IS!!!

As we have learned, you don't have to own resources to control them. Be creative. Virtual corporations are in vogue because of this insightful definition of entrepreneurship: "A way of managing that involves the creation of an opportunity without regard to the resources currently controlled."

Let's now focus on the best description of the cash flow cycle found in Robert C. Higgins' best-selling Analysis For Financial Management:

"Finance can seem arcane and complex to the uninitiated. There are, however, a comparatively few basic principles that should guide your thinking. One is that a company's finances and its operations are integrally connected. A company's activities, method of operation and competitive strategy all fundamentally shape its financial structure. The reverse is also true. Decisions that appear to be primarily financial in nature can significantly affect company operations. For example, the way a company finances its assets can affect the nature of the investments it is able to undertake in future years.

"The cash flow-production cycle…(involves) a close interplay between company operations and finances. For simplicity, suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets and is now ready to begin operations. To do so, the company uses cash to purchase raw materials and hire laborers; they make the product and store it temporarily in inventory. What began as cash is now physical inventory. When the company sells an item, the physical inventory changes once again into cash. If the sale is for cash, this occurs immediately; otherwise, cash is not realized until some time later when the account receivable is collected.

"This simple movement of cash to inventory, to accounts receivable and back to cash is the firm's operating, or working capital, cycle. Another ongoing activity…is investment. Over a period of time, the company's fixed assets are consumed, or worn out, in the creation of products. It is as if every item passing through the business takes with it a small portion of the value of fixed assets. The accountant recognizes this process by continually reducing the accounting value of fixed assets and increasing the value of merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity, the company must invest part of its newly received cash in new fixed assets. The object of the exercise, of course, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that started the journey.

"We could complicate…(the matter) further by including accounts payable and by expanding on the use of debt and equity to generate cash, but … already demonstrated (are) two basic principles. First, financial statements are an important window on reality. A company's operating policies, production techniques and inventory and credit-control systems fundamentally determine its financial profile. If, for example, a company requires prompter payment on credit sales, its financial statements will reveal a reduced investment in accounts receivable and possibly a change in its revenues and profits. This linkage between a company's operations and its finances is our rationale for studying financial statements. We seek to understand company operations and to predict the financial consequences of changing operations.

"The second principle…is that profits do not equal cash flow. Cash - and the timely conversion of cash into inventories, accounts receivable, and back to cash - is the lifeblood of any company. If this cash flow is severed or significantly interrupted, insolvency can occur. Yet the fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency. To illustrate, suppose a company loses control of its accounts receivable by allowing customers an increasingly long time to pay, or suppose the company consistently makes more merchandise than it sells. Then, even though the company is selling merchandise at a profit in the eyes of an accountant, its sales may not be generating enough cash soon enough to replenish the cash out - flows required for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. Here is another example.

"Suppose the company is managing its inventory and receivables carefully, but that rapid sales growth is forcing an ever-larger investment in these assets. Then, despite the fact that the company is profitable, it may have too little cash to meet its obligations. The company will literally be "growing broke." These brief examples illustrate why a manager must be concerned at least as much with cash flows as with profits."

As you become more confident with the numbers game…you will begin to grasp the importance of cash flow and why it is literally the lifeblood of your new company. Remember: "Nothing happens till somebody sells something and collects the cash or accounts receivable!"

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