In business, it is not quite so simple.
While most entrepreneurs focus on revenue and revenue growth, Alan Miltz of Cash Flow Story reminds us, “revenue is vanity, profits provide sanity, but cash is king”.
As a client recently shared with me, regarding hyper-focusing on cash vs being blinded by revenue:
“It’s making a huge difference. We completely revamped our cash position by 1) focusing on our billing timing and 2) we just secured another rate increase with our long-time customer. Why? Because we asked – an important reminder that we covered when reviewing the cash levers we could control.”
The principles that Houston Johnson mentions above is what I want to demonstrate to you below.
Case Study
Take a look at the income statement and balance sheet of a hair products distribution company called Milok Pty, Ltd. How would you rate Milok’s financial performance? Can you calculate how much cash was generated in 2019.
Net Cash Flow is calculated as the change in bank accounts plus the change in debt. While Milok’s cash position did not change, they did pay down $300,000 in debt. This means the business generated $300,000 in cash. This is not bad, however, Milok generated $1,500,000 in net profits. This begs the question, where did the other $1,200,000 in profits go.
Download the full Milok Case Study and worksheets:
The change in Working Capital, which is influenced by manager effectiveness, is computed by adding the changes in Accounts Receivables, plus Inventories (or Work in Process (WIP)) minus Accounts Payables. For Milok, that is $1,000,000 plus $700,000 minus $500,000 which equals $1,200,000.
Wouldn’t it be nice if Milok’s leadership managed the business in a way that converted the $1,200,000 in profits into $1,200,000 in cash in its bank account to invest in people, marketing, and technology?
Cash flow is a Result of Management Effectiveness
The first step is creating visibility. The Power of One tool, developed by Alan Miltz and his partner Joss Milner from Cash Flow Story, allows you to see the impact of small 1% or 1 day changes in the 7 levers company management can influence, if not completely control. These seven levers are price, volume, cost of goods sold (cogs), overheads, accounts receivables, inventories, and accounts payables.
Notice in the image below that these small changes could add another $594,945 in cash flow.
Deeper analysis shows the price to volume sensitivity at Milok. A 1% increase in price provides $190,000 in additional cash flow while a 1% increase in sales volume only adds $43,000.
Consider the impact that discounting has on cash. Your sales team may believe a discount in pricing will generate more sales volume. However, for Milok, every 1% discount in pricing requires almost a 4.5% increase in volume to break even on cash. How can your sales team make effective discounting decisions without understanding this relationship for your company?
Secondly, managers need to understand the importance of effectively managing their people. The accounting term for employee wages used to produce the products or services sold to clients is Direct Labor. Many managers use a metric like labor utilization to measure productivity.
However, connecting the dots between labor utilization and its impact on cost of goods sold is critical, the more efficient labor is the bigger the decrease in COGS. The resulting improvements will be seen in gross margin as well as in increased cash flow.
For Milok, every 1% reduction in COGS is worth $147,000 in annualized cash flow. Understanding this impact creates a powerful reason to be a better manager.
Collect on your Receivables Faster
The third step is converting receivable dollars into receivable days which creates a measure of how long it takes to convert credit sales to cash. When receivable days are greater than the credit terms offered, there is an opportunity to improve cash collection and cash flow. Milok’s receivable days have crept up to 78 days from 69 last year. Getting receivable days back to last year’s standard should be a very realistic goal for this management team. Plus that 9 day reduction will generate a much needed $591,781 in annualized cash flow.
What are your current receivable days? Where should it be and what is the gap? Knowing the cash impact of each day will help you understand the potential impact of your initiatives.
Apply Lean Concepts to Minimize Inventory/WIP Days
The fourth opportunity is to minimize inventory. Many businesses purchase a product and then resell it or they may have work that is in process but has not been billed. Inventory days is an efficiency ratio that measures the average number of days the company holds its inventory before selling it. Milok’s inventory days have increased in the last year from 67 to 78 days. This mismanagement has robbed Milok of more than $450,000 in cash that could be used to invest in the business.
Use Lean Six Sigma, a managerial approach to eliminating waste and defects, to find ways to banish sloppiness and reduce your inventory days.
As an example Astanza Laser, a distributor of tattoo removal equipment, reduced their inventory from 163 days to 59 days over the last year by focusing on better forecasting, better terms with their suppliers, and improved delivery options from their clients. This improvement has freed up more than $500 thousand in additional cash which is now being used to invest in the additional sales people required to fuel their growth.
Dive deeper with these concepts by watching Finance for Middle Managers Webinar Replay
- Move beyond revenue and focus on cash flow as your ultimate measure of success
- Managers should challenge themselves to be more effective at creating cash for reinvestment in the organization
- Understand your organization’s price to volume sensitivity
- Better utilize labor as a strategy for improving gross profits
- Get paid sooner to unlock cash to scale
- Apply Lean Six Sigma concepts to inventory and work in process
Okay, now what?
Have some thoughts or feedback about these concepts? Send me an email, I’d love to hear them!