How Is Your Cash Flow?

Cash is the lifeblood of any business. Are you keeping your cash flow healthy?

Russell McGuire
Sep 11 · 5 min read

Throughout the week we’ve been looking at different aspects of the question “how do you make money?”. We’ve looked at revenue models, business models, and operating models, and along the way I’ve dropped hints about the linkages between those activities and cash flow, but today I want to focus specifically on how cash flows through a business.

Below is a diagram of what I call the “cash cycle” — the cash equivalent (in business) for the “water cycle” (in nature):

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Cash Cycle for Business

The business spends cash in three main ways: to buy what’s needed to build the product or service you sell (Cost of Inventory), to pay for all the costs involved in running the business (Operating Expenses), and to make investments to establish capabilities, increase capacity, or improve efficiency in the business (Capital Investments). Hopefully all of these expenses contribute directly or indirectly to profitable sales (Sales Revenue) which replenishes the cash fund to enable the next round of spending.

When a business first starts, and likely at various times in the life of the business, managers may need to raise outside financing. That money comes into the top of the cycle to provide cash for various kinds of spending (especially capital investments). Depending on the form of financing, those providing that cash will likely expect a return on their financing, so at times the business likely provides some of the business’ cash back to those financiers. That might be in the form of principal and interest payments on a loan or in the form of distributions or dividends to equity investors.

There are a few important ways to keep an eye on the health of your cash flow.

Cash Conversion Cycle

Unlike the diagram above, the cash conversion cycle is a number — specifically the number of days it takes for inventory to become cash.

The simple equation for the cash conversion cycle is:
CCC = DIO - DPO + DSO

DIO is Days Inventory Outstanding, which is the number of days on average that it takes to sell your inventory.

DPO is Days Payable Outstanding, which is the average number of days it takes you to pay your suppliers.

DSO is Days Sales Outstanding, which is the average number of days it takes your customers to pay you.

The longer your CCC, the more cash you need and the more of your cash that will be tied up in inventory. You can reduce your CCC by selling product faster (reducing DIO), negotiating with suppliers to pay them later (increasing DPO), or requiring customers to pay you sooner (reducing DSO).

Profitability

Depreciation is probably the area where expenses are accounted for most differently than actual cash costs. For example, your business might purchase a desk for $600 and expect that desk to be used by the business for 10 years. Instead of reflecting a capital expense of $600 in the year the desk is purchased, the income statement might reflect $60 of depreciation in each of the 10 years of its useful life. That approach more accurately reflects whether the business is being managed for long-term profitability, but less accurately reflects the impact of the desk purchase on the cash position of the business.

Given those warnings, when I look at an income statement, the two main things I pay attention to are trends and margins.

Income statements are most helpful when compared to prior periods. What are the trends compared to the last few periods. Given that many businesses have seasonality (certain times of the year that tend to be stronger than others), for monthly or quarterly data it’s also very helpful to look at the trends compared to the same period in each of the last several years? Are the numbers improving or getting worse?

Income statements are generally laid out to provide a number of important margins from top to bottom.

Sales Revenue - Cost of Goods Sold (roughly Cost of Inventory for the sales for the period) = Gross Profit — and Gross Margin as a percent of Sales Revenue.

Gross Profit - Operating Expenses (not including depreciation) = Earnings Before Interest Taxes Depreciation and Amortization (better known as EBITDA) — and EBITDA Margin as a percent of Sales Revenue

EBITDA - Depreciation and Amortization = Operating Income (aka EBIT) — and Operating Margin as a percent of Sales Revenue.

Operating Income - Interest and Taxes = Net Income and Profit Margin as a percent of Sales Revenue.

Here are some important questions I try to answer from a company’s income statements:

  • Are sales increasing?
  • What is the gross margin? Have they set their prices high enough to support the business?
  • What is the trend on EBITDA margins? Are they keeping operating expenses in line with revenues?
  • Are they profitable (Net Income)?

Cash Flow

The cash flow statement has three main sections to report the different kinds of cash flows:

  • The Financing Activities section reports cash flows into the business from investors (e.g. equity investments or loans) and cash flows out of the business to investors (e.g. dividends or loan payments).
  • The Operating Activities section reports all forms of cash flows involved in operating the business (e.g. payments to suppliers, payroll, rent, payments from customers).
  • The Investing Activities section reports cash flows related to investments made by the business (e.g. asset purchase or sale, mergers & acquisitions)

The important questions I try to answer by looking at cash flow statements include:

  • Is the business generating or consuming cash?
  • Is cash flow improving or getting worse?
  • Is the cash flow from Operating Activities positive or negative?
  • If operations are consuming cash (negative cash flow from Operating Activities), what is the monthly burn rate, and given how much cash the business has on hand (from their balance sheet), what is the runway (how long until the business runs out of money)?

As you can see, the question “how do you make money?” is a more complex question than it appears on the surface. Hopefully this week’s articles have given you a good sense for how to manage your business to make sure that you can answer the question with confidence for today and the future.

ClearPurpose

Tales and Tools for Sound Strategies

Russell McGuire

Written by

Strategist, Entrepreneur, Executive, Advisor, Mentor, Inventor, Innovator, Visionary, Author, Writer, Blogger, Husband, Father, Brother, Son, Christian

ClearPurpose

Through ClearPurpose, we share our experience, tools, and methodologies to approach strategy development with discipline and structure, making it easier to achieve clarity, gain consensus, and communicate coherently.

Russell McGuire

Written by

Strategist, Entrepreneur, Executive, Advisor, Mentor, Inventor, Innovator, Visionary, Author, Writer, Blogger, Husband, Father, Brother, Son, Christian

ClearPurpose

Through ClearPurpose, we share our experience, tools, and methodologies to approach strategy development with discipline and structure, making it easier to achieve clarity, gain consensus, and communicate coherently.

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