Conquering Cash FlowTHE COMPLETE GUIDE TO SMALL BUSINESS

CASH FLOW MANAGEMENT

By Rob Stephens, CPA

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Conquering Cash Flow The Complete Guide to Small Business Cash Flow Management By Rob Stephens

CFO Perspective, LLC PO Box 14439 Spokane Valley, WA 99214 509.202.4652 cfoperspective.com

©2020 CFO Perspective, LLC

All rights reserved. No part of this book may be reproduced in any manner without prior permission from CFO Perspective, LLC.

DISCLAIMER

THIS BOOK CANNOT AND DOES NOT CONTAIN LEGAL, TAX, PERSONAL FINANCIAL PLANNING, OR INVESTMENT ADVICE. The legal, tax, personal financial planning, or investment information is provided for general informational and educational purposes only and is not a substitute for professional advice. The use of or reliance on any information contained in this book is solely at your own risk. ACCORDINGLY, BEFORE TAKING ANY ACTIONS BASED ON SUCH INFORMATION, WE ENCOURAGE YOU TO CONSULT WITH THE APPROPRIATE PROFESSIONALS. CFO Perspective, LLC assumes no responsibility for errors or omissions in the contents of the book. We do not provide any legal, tax, personal financial planning, or investment advice.

Cover Design by Nick Schaffert

Table of Contents Chapter 1: The Importance of Cash Flow ................................................ 1

Chapter 2: Profit Is Not Cash Flow........................................................... 4

Chapter 3: The Cash Conversion Cycle .................................................... 7

Chapter 4: The Three Tanks of Cash ....................................................... 12

Chapter 5: Keeping an Eye on Cash Flow .............................................. 14

Chapter 6: Historical Cash Flow Statements ......................................... 19

Chapter 7: Working Capital and Cash Conversion Metrics .................. 22

Chapter 8: Working Capital, EBITDA, and Free Cash Flow .................. 25

Chapter 9: Creating and Using a Cash Flow Projection ........................ 33

Chapter 10: Tips on Monitoring Cash ..................................................... 38

Chapter 11: Sources of Funds ................................................................. 41

Chapter 12: Loans .................................................................................... 44

Chapter 13: Other Types of Debt ........................................................... 49

Chapter 14: Equity ................................................................................... 52

Chapter 15: Everything In Between ....................................................... 55

Chapter 16: Managing Debt and Equity ................................................ 57

Chapter 17: The Art of Managing Cash Flows....................................... 62

Chapter 18: Managing Excess Cash ....................................................... 67

Chapter 19: Cash and Growth ................................................................ 73

Chapter 20: Surviving a Cash Crunch ..................................................... 77

Chapter 21: A Final Word on Cash Flow ................................................ 79

Appendix A: Glossary .............................................................................. 80

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Chapter 1: The Importance of Cash Flow “Never take your eyes off the cash flow because it’s the lifeblood of business.”

- Richard Branson

It’s difficult to overemphasize the importance of cash flow to a small business. Fluctuating cash flows are a huge source of stress for small business owners.

A study by QuickBooks revealed shocking statistics about cash flow issues for small business owners:

• 69% of small business owners have been kept up at night by concerns about cash flow.

• More than half of U.S. businesses have lost $10,000 or more by foregoing a project or sales specifically due to issues created by insufficient cash flow.

• 61% of small businesses regularly struggle with cash flow.

How important is cash flow management to the success of your business? A U.S. Bank study found that 82% of small businesses fail because of poor cash flow management skills or poor understanding of cash flow.

Managing cash flow was one of my primary roles as the CFO of multiple small and medium-sized businesses. I’ve had to learn how to manage cash flow in the good times and the bad. This guide is a collection of tips and techniques to reduce your stress and increase your cash flow.

This guide will help you conquer your cash flow by:

• Helping you get your hands around your current and projected cash flows • Providing methods to increase cash flow and reduce dips in cash flow • Identifying critical sources of cash for your business

The Goal of Cash Flow Management Now that we grasp its importance, let’s look at what we want to accomplish by managing cash. At a high level, managing cash is the art of holding enough cash—but no more than enough. It’s a balance between:

1. Having enough cash to meet needs and capture opportunities 2. Minimizing the reduction of earnings caused by holding cash

You want enough cash for expenses like paying employees and vendors or making loan payments. You also want cash available to reinvest in your company, to grow, or to buy other companies. Owners may have a minimum amount of cash they need to be distributed to them from the company.

At the same time, cash sitting in your bank account doesn’t earn very much. It’s one of your lowest-yielding assets. You need to put it to work in your business to earn higher returns.

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When you don’t have opportunities to invest cash for higher returns in your business, you need to consider paying it out to owners.

What Exactly Is Cash Flow? We can’t talk about cash flow until we first agree on what it is. Cash flow is the amount of money flowing into and out of a business.

That’s all it is. Pretty simple, huh? Yet small business owners are often confused about one major thing regarding cash flow: Cash flow is NOT the same as profit.

Profit is an accounting concept of revenues (a.k.a. income) reduced by expenses. There are all sorts of rules about when you have revenue or when you have an expense. In fact, the last major accounting standard update on revenue was 700 pages long!

Here’s the problem: you can’t pay your bills with profits. Vendors only take real money. Your company’s profit is a good measure of performance, but it’s not the only thing to watch. 54% of all companies filing for bankruptcy experienced record sales in the weeks before they filed.

Let me explain a few terms I will use throughout this guide so you’re clear on what I mean by each.

• Cash: Cash is money you receive from any payment source. It could be via debit card or credit card payments from your customers. In other words, it’s anything that’s deposited into your bank account that makes the balance go up.

• Cash inflows and cash outflows: A cash inflow is cash that you receive, usually from your customers. A cash outflow is money that you paid or transferred to someone else. The main example is when you pay suppliers or other vendors.

• Revenue and expense: These are components of your profit according to accounting rules. These may cause a simultaneous cash inflow or outflow, but not always. For example, you may record revenue from a sale but not collect the cash from the customer until weeks later. I’ll explain this more in a later chapter.

• Net cash flow or net income: Anytime you see the word “net” in the world of finance, it means that one number was subtracted from another to get to a “net” result. For example, net cash flow is calculated as your cash inflows minus your cash outflows. Revenue minus expense equals net income.

Now that you understand a few basic terms, I want to sho you how easy it is to calculate your cash flow: grab a bank statement and subtract your ending account balance from your starting account balance. If it’s a positive number, you had positive cash flow. If it’s a negative number, you had negative cash flow.

You’ve got this! This guide will make you even better at cash flow management.

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You also have access to free resources to help you implement what you learn in this book. They are at the Conquering Cash Flow Resources page at https://cfoperspective.com/ccfr. The site has the following resources:

• Cash flow projection templates • Training videos • Supplemental guide to cash metrics

I’ll explain the largest misunderstanding small businesses have about profits and cash flow in the next chapter.

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Chapter 2: Profit Is Not Cash Flow “One of the earliest lessons I learned in business was that balance sheets and income statements are fiction. Cash flow is reality.” - Chris Chocola

Here’s the first formula in this book: Profits ≠ Cash Flow

It’s simple but very important. Profits do not equal cash flow. In other words, having high profits does not mean you have high cash flow.

A growth strategy to increase profits often leads to a decrease in cash, at least in the short term. This is why high-growth companies are so prone to bankruptcy. I explain growth and cash flow management later in this book.

Cash vs. Accrual Accounting Let me explain cash vs. accrual accounting so you can better understand how accounting profits are different than cash flows.

You may have seen in Quickbooks or whatever accounting program you use that you can run your financial statements using the cash or accrual basis. Accrual basis is an alternative reality that accountants live in to more accurately record profitability. It takes a little getting used to, so I’ll compare cash and accrual basis accounting.

In cash basis accounting, revenues are recorded when you receive cash from the sale, and expenses are recorded when you pay money.

In accrual accounting, revenues are recorded when they are earned. The Financial Accounting Standards Board, or FASB, recently released a 700-page set of rules for when this occurs. I won’t bore you with the details. It’s generally when you’ve done some work or sold a product and the person owes you money.

If they pay you right away, your cash revenue and your accrual revenue are recorded on the same day. However, what if you sell them something in May, but they don’t pay you until July? In accrual accounting, you earned the money in May, so the revenue is recorded in May. The amount they owe you is called an account receivable. The balance on that account receivable is zeroed out when they pay you. In cash accounting, you don’t record the revenue until June, when you receive the cash.

Now for expenses. In accrual accounting, product costs are expensed when you sell the product. Your inventory balance on your balance sheet is the cost of buying and producing items you haven’t sold yet. In cash accounting, you would have expensed those costs when you paid for them. All your other expenses are generally expensed when you owe them.

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Let’s say you bought office supplies in May and paid for them in June. In accrual accounting, you expense them in May, when you owe money to the supplier. In cash accounting, you would expense them in June, when you paid the supplier. In accrual accounting, you would have an account payable for the amount you owe the supply company from the time you recorded the expense until you paid the supply company.

Large expenses are spread over time. Fixed assets are things like equipment and buildings. Their costs are expensed over the months they are expected to be used by you. Spreading out the costs is called depreciating them. Each month’s cost is that month’s depreciation expense.

Good Profit but Bad Cash Flow OK, sorry for the accounting lesson; time to wake up!

Here’s an example of how profits can look OK while cash is on a roller coaster. Let’s say you made 100 T-shirts at a total cost of $800 and sold them for $1,000. Congrats! You just made a $200 profit! In accrual accounting, the revenue, cost, and profit are all recorded at the same time.

Now let’s assume you paid for the cost of goods when you ordered them. Your invoices to customers said their payment was due in 30 days. Your cash flow for your first month during production is negative $800. The following month, you receive the payments from your customers, so your cash flow spikes up to $1,000.

That dip followed by a spike may not be a problem for a small amount, but if you had a shot at a $2 million profit opportunity, could you find $8 million to pay for the cost of goods to capture it?

Key Differences Between Profit and Cash Flow Some key differences between profit and cash flow are:

Profitability Cash Flow

Tells you if you are headed in the right direction (value creation)

Tells you if you have what it takes to get there

Calculated by taking the revenue you generated this month and matching all the expenses that it took to make that revenue

Measures what went into and out of your bank account

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Better gauge of whether your actions will create positive cash flow in the long run

Cash flow management is about timing your cash flows to maximize profit

Process of creating cash Source material for profit

Can be thought about in terms of amounts of value creation

Can be thought about in terms of time (i.e., months of operation)

Can survive large periods of time with negative income

Lack of cash leads to a swift demise

Profit is an accounting concept. It’s a fiction Can take it to the bank or pay your vendors with it

Balancing Cash Flow and Profit I pointed out earlier that it sometimes feels like there’s a tension between profits and cash flow. You must strike a balance between the two.

Investing all your cash in business assets, and even borrowing money to invest in business assets, increases your returns but also increases your risk of running out of cash. In that scenario, you have low cash but high profits and risk. On the other hand, having lots of cash means your risk of bankruptcy is low, but your earnings are likely low, too. Owners may not be happy with the return they are getting from their investment in the company.

Here's how this looks visually:

This is a simplification, and I’m going to show you how to manage this tension. Even better, there are many ways to increase your cash flow so you can invest that cash to increase your profits. Before we do that, I’m going to explain how cash flows in and out of companies.

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Chapter 3: The Cash Conversion Cycle "Success works as a cycle—growth and contraction, balancing and unbalancing—all while you're encountering hurdles that get higher and higher over time.” - Julien Smith

Your business is a constant cycle of cash being invested and then received back, hopefully with a profit. This cycle is called the cash conversion cycle. Knowing how it works allows you to have less cash lost to the cycle. Most importantly, you’ll have cash available when you need it.

The cash conversion cycle of drawing in cash and releasing cash is like drawing in a breath and releasing it. A runner breathes more quickly the faster they go. Top athletes have trained their bodies to get the most power from that oxygen. Cash is the oxygen of your business. You’ll receive a higher return on your cash by speeding up your cash conversion cycle.

I’ll show you how the cycle works and why it causes cash to go down for a while when you reach for growth. Your cash conversion cycle may need to be supplemented with other cash sources that I’ll explain. Understanding the cash conversion cycle allows you to avoid cash crunches and capture opportunities.

I’ll also explain how to calculate your cash conversion cycle. For those of you who aren’t math fans, fear not. I’ve created a cash conversion cycle calculator that you can get at the resources page (https://cfoperspective.com/ccfr) for this book. The resources page also has videos that explain how to use the calculator and how to decrease your cash conversion cycle.

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How the Cycle Works

It starts with the cash you have in the bank. Cash in the bank is secure, but it doesn’t earn you much income. You want to put it to work by selling goods or services.

The next step of the cycle occurs when your employees spend time producing goods or providing services. They aren’t volunteers. At some point, you need to pay them for the work they did. If you are a manufacturer, you also order materials and spend money converting those raw materials into finished goods.

At this point, you owe salaries to your staff and owe vendors for the materials you purchased but haven’t paid out any cash for yet. Accrual accounting tracks what you owe to others and what’s owed to you at any point in time. Under accrual accounting, you would have accounts payable to vendors and salaries payable to your employees.

Your vendors and employees won’t wait forever for their cash. It’s time to pay them. This is a critical point in the cycle. You want to delay this as long as you can. However, don’t get too cute and make your employees or vendors mad. Pay invoices when they are due but don’t pay before that date. We now turn to the part of the cycle where cash flows back to us.

You can’t get your cash until someone owes it to you. They don’t owe you money until you provide some good or service to them. Making the sale and delivering the goods starts the clock ticking for you to finally receive your cash.

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The list of money due to you is called accounts receivable. In accrual accounting, you record revenue and an account receivable when you have completed the work and can collect payment. Collect cash on these receivables as early as possible.

And now we’re back to box #1. The virtuous cycle has ended. You get your money back along with your profit. And the cycle begins again…

Managing the Cycle Now that you understand the basics of the cash conversion cycle, let’s look at how you can maximize your return on investment by better managing the cycle.

The art of managing your cash conversion cycle is to delay the outflow of cash as long as possible while accelerating the inflow of cash. The cash conversion cycle is the length of time from when you pay cash to suppliers or employees until you receive cash on your sales.

The cash conversion cycle can be broken into three periods:

1. Inventory to sale 2. Sale to cash 3. Purchase to payment

This graphic shows the three periods and how they map to the cash flow cycle graphic presented earlier. I’ll explain the metrics for each period later in this book.

1Cash

2 Materials/Services

3Accounts Payable

4Pay A/P

5Sales

6Accounts

Receivable

Cash Conversion Cycle Periods

Three periodsInventory to sale#2 to #5

+ Sale to cash#5 to #1

- Purchase to payment#3 to #4

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Imagine a distributor who buys inventory on January 1 and pays for it on January 15th. They take the product and put it in their warehouse, where it sits until they sell it on April 1st. They collect cash from the buyer 60 days later, on May 31st.

Let’s break that down into the three cash conversion periods:

• Period 1 of inventory to sale is January 1 – April 1 or 90 days • Period 2 of sale to cash is April 1 – May 31 or 60 days • Period 3 of purchase to payment is January 1 – January 15 or 14 days

The total cash collection cycle in this example is 137 days.

They spent their cash on January 15th and didn’t get it back until May 31st. That’s 137 days. They lost that cash for over a third of the year!

Shortening the Cycle The shorter the cash conversion cycle, the more cash you have to capture opportunities, make investments, or pay critical bills.

Some ways to shorten the cycle include:

• Sending invoices as early as possible • Providing incentives for quick payment • Contacting your past-due customers and asking when they expect to pay you • Factoring • Not paying vendors until the due date • Negotiating payment plans with vendors

Let’s go back to our distributor example and make some changes:

• They now don’t pay their vendor until the invoice is due on January 31st. That shortens their cash conversion cycle by 16 days.

• They buy smaller quantities of inventory but order more frequently. They may pay more in shipping or lose quantity discounts, but tying up cash in inventory also has costs. Storage facilities have costs. Ordering in smaller batches may also reduce spoilage and obsolescence of inventory. Our example distributor reduces their inventory, so it only sits in the warehouse for half the time. That reduces their cash conversion cycle by 45 days.

• They invoice immediately upon shipment and clearly state that payment is due in 30 days. They call on customers who are late until those customers are trained to make timely payments. This decreases their cash conversion cycle by 30 days.

Putting this all together, we’ve reduced the cash conversion cycle by 91 days. It’s gone from 137 days to 46 days—a 66% decrease.

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Let’s say their account receivable used to average $1,000,000. Now it’s dropped to $330,000 and has released $660,000 of cash to be invested in the business. If they can earn a 10% return on business growth, they will have increased their profits by $66,000 per year.

Growth and the Cash Cycle The cash conversion cycle also explains how companies that try to grow quickly often find themselves in a cash crunch. In the cash conversion cycle, money goes out for a while before it comes back.

Many owners try to grow their way out of a sales slump. To do this, they often must buy more inventory and increase payroll costs. This increases their costs and further reduces their cash for the length of the cash conversion cycle. Cash will finally start to increase once they start collecting on the increased sales. Many companies, however, get caught in a cash crunch before this happens. I’ll talk about this later in this book. Next, I’ll explain the three tanks of cash.

Period Before After DifferenceInventory to sale 91 46 -45Sale to cash 60 30 -30Purchase to payment -14 -30 -16Total 137 46 -91

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Chapter 4: The Three Tanks of Cash “Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.” - Warren Buffett

The cash conversion cycle explains operating cash inflows and outflows. As we saw in the growth scenario, you need investment and financing cash flows to support and balance your operating cash flows. Let’s look at how all three types of cash flows fit together.

Think of managing your company’s cash as coordinating three tanks of liquid. In fact, a company’s access to cash is often referred to as its “liquidity.”

There are three main sources and uses of cash. Think of each as a tank of cash:

• Investments: The investing tank is the amount of money your current and potential owners have available to invest in the company.

• Operations: The operations tank is your business’s checking account. The amount of cash in the tank rises and falls with the cash conversion cycle.

• Financing: The financing tank is the money you can borrow from banks, friends, and family.

A business starts when the owners transfer their liquid cash to the operations tank. The business spends this cash for operations, reducing the tank.

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Soon, the business produces a return on the cash, which starts to fill the tank back up. Successful businesses have so much cash coming into the tank that they can flow it back to the owners or make bigger investments for growth.

Once lenders are confident that you can keep your operations tank filled, they are willing to allow you to tap into their tank of funds when you need it. Now the owners’ tank isn’t the only spare tank of cash available when you need cash for growth or a big investment.

A cash crunch happens when the operations tank is draining and the owners have already drained everything they had in their investment tank. Lenders get concerned they won’t get their money back from the company, so they shut off their pipeline of cash to the company. I was a bank CFO during the Great Recession and saw companies get into this cash crunch situation.

Ironically, what often caused the cash crunches were good economic times. Owners saw lots of opportunities to make profits in their companies. They drained all their personal cash reserves into the company. At the same time, they borrowed all they could and made big investments.

Everything worked as long as the economy allowed the operations tank to refill with cash quickly. However, the economy repeatedly goes up and then goes down. When it goes down, the operations tank fills much more slowly. With no reserves in the investment tank and no more access to the borrowing tank, the operations tank went down the expense drain.

The next few chapters will explain how to monitor cash so you always know how much cash is in the tanks.

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Chapter 5: Keeping an Eye on Cash Flow “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” - Peter Drucker

The quote above shows that businesses can forget how important it is to monitor cash flow. Monitoring your cash flow is not difficult. However, you must commit to no longer being too buried in the details of the business to check if you have enough cash for the road ahead.

Cash flow mistakes can cause missed opportunities and stress. Worst case scenario, they could be fatal to the company. Below are some classic mistakes made by small businesses:

• Not monitoring cash flow • Watching historical cash flow but not projecting cash flows • Thinking you can spend cash if there is money in the bank • Letting receivables go months past due • Not starting with enough cash • Not keeping a cash cushion • Overspending • Not saving enough cash to pay taxes

Do any of these mistakes sound distressingly familiar? You’re not alone if you’ve struggled with managing your company’s cash. Knowing these errors is half the battle. The tips and techniques in the next few chapters will help you become a master of cash flow management.

You can monitor your cash flows from three perspectives:

• Historical cash flows • Cash metrics • Forward-looking cash flow projections

Let’s dig deeper into each.

Historical Cash Flows Looking at historical cash flow patterns can help you better understand your business. This allows you to make better decisions about how to manage cash in the present. Most business accounting software systems have reports that show your historical cash flows. Sometimes the report is called a “statement of cash flows.”

The accounting and auditing rules define a standard format for a formal statement of cash flows. This format has three main sections:

• Cash flows from operations: Typical large cash flows in this section are cash receipts from customer sales and cash payments to suppliers and other vendors. It also

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includes tax payments. A healthy company has positive cash flow from operations.

• Cash flows from investing: This includes cash flows caused by the purchase or sale of equipment, land, buildings, furniture, or investments.

• Cash flows from financing: Financing cash flows arise from cash receipts from owners investing in the company or cash paid out in dividends. It also includes cash from borrowings and cash payments on those loans.

One of the first things to look at on a statement of cash flows is the total net cash flow of each of those sections. You want your cash flow from operations to be positive to buy equipment or other assets (an investing activity). You may need cash for loan payments (a financing activity). You ultimately want cash to pay the owners (a financing activity). You need to find financing sources of cash if your cash flow from operations is running negative.

Your accounting software may not show cash flows in this format, or it may have reports in other formats. One of the best historical reports is a list of your cash inflows and outflows by month. This will show if you have “seasonal” cash flows, which is also called “seasonality.” Seasonality just means that your cash flows have a consistent pattern of rising and falling. Later, I’ll show you how to smooth out seasonal cash flows by changing the timing of cash flows. Lines of credit, which we’ll cover in the Sources of Funds section, are also an excellent option for businesses with seasonality.

Farmers have months of negative cash flow as they grow their crops. This is followed by a spike of cash inflows at harvest. Nonprofits have a spike in cash inflows at year-end or after a major fundraising event. These businesses learn how to manage their cash flow seasonality.

It’s good to learn if your business has cash flow patterns within a month. For example, you may have higher cash inflows on certain days of the month. You likely have a significant cash outflow on payroll days. One of my main jobs as the CFO of a small company was to make sure we had cash ready for payroll days. You can occasionally bounce a check to a vendor but you should never, ever blow a paycheck. This guide will help you never make that mistake.

Cash Metrics Cash metrics are ratios of your cash flows over time or your cash balances at a point in time. The amount that’s a good ratio for your company is unique to each industry. The most useful analysis to do with these ratios is to compare your ratios to companies like yours or compare your ratios over time to spot trends. Here are some common ratios for small businesses:

Cash Flow Margin Ratio Definition: Cash flow from operations divided by sales

This is a crucial ratio that tells you how much cash you are currently generating for every dollar in sales. A higher ratio is better.

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Current Ratio Definition: Current assets divided by current liabilities

Current assets and liabilities are items on your balance sheet that will usually be received or paid in cash in the next year. If the ratio is greater than one, your balance sheet is expected to produce positive cash flow. If the ratio’s less than one, you will need additional cash to pay your liabilities that come due in a year. A higher ratio means you are less likely to run into cash flow problems. Of course, there are all sorts of cash flows that arise from things not on the balance sheet, so this ratio is good but doesn’t tell the whole story.

Current Liability Coverage Ratio Definition: Net cash from operations divided by current liabilities

Liabilities can be paid by cash on hand (measured by the current ratio) and by cash generated from operations, which this ratio measures. Like the current ratio, higher is better.

Quick Ratio (AKA Acid Test Ratio) Definition: Current assets (minus inventory, prepaid expenses, and supplies) divided by current liabilities

This ratio removes some assets and is a tougher test of your cash flows than the current ratio. Like the current ratio, higher is better from a cash flow perspective.

Burn Rate Definition: Number of days the company can operate using only the cash on hand

This is a crucial ratio for startup companies who have no inflows or not enough to fund their growth. Many high-tech startups closely monitor this metric. This metric tells you roughly how long you can survive until you need to raise more funds (for example, from venture capital or from current owners).

Forward-Looking Cash Flow Projections A cash flow projection is the most important financial report for your business, yet so many businesses miss out on its benefits. Your forecast doesn’t have to be complicated or fancy. It just needs to give you an estimate of when your cash inflows and outflows will occur. Pick a time frame that you think you can reasonably, roughly predict (for example, one month, three months, or one year). One option is to have a more detailed projection for the next 1-3

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months and then a rougher projection for the following 4-12 months. I’ll go into more detail in the next chapter on how to build and use a cash flow projection.

There are numerous benefits of a cash flow projection. They go well beyond the survival of your company or the ability to have the cash available to capture an opportunity when it arises. Here are some of these benefits.

• Early identification of potential low (or negative) cash balances: The more time you have to make adjustments, the more adjustment options you have. A projection lets you know when you need to speed up cash collection or slow down payments to avoid a cash crunch. For example, there may be times when you have enough cash to quickly pay invoices to capture discounts. Other times, you may need to delay payment.

• Your bank, investors, or other stakeholders need it: One of your sources for cash may be investors or banks. They will want assurance that your company has enough cash for operations and to pay them back. The very act of having a cash flow projection shows your business management skills and builds credibility with them.

• Operations coordination: The timing of when to hire staff, make significant purchases, and distribute cash to owners can all be modeled to make sure your strategy is feasible. You may find that you need to adjust the timing or amounts of some of your strategies. Not having a projection might cause you to make decisions or promises that you can’t fulfill.

• Identify cash “leaks”: It’s easy for small things that suck cash out of your business to go unnoticed in daily operations. Reviewing the cash flow projection can show:

o lags between sales and cash receipt for those sales o lags between the purchase of inventory and cash receipt on sales of that

inventory o opportunities to stretch out one set of payments to prioritize another set of

payments.

• Identify the need to get a loan or a capital infusion: The projection may say that operational cash flows will not be enough to fund opportunities for investment and growth. This means you may need additional cash from lenders or owners.

• Avoid tax penalties: It’s not uncommon for bankers to see companies that are making sales but don’t have enough cash to pay the taxes on those sales. Don’t mess with the IRS. Be ready to pay your taxes on time to avoid unnecessary penalties.

• You’re more ready for big cash outflows: Taxes aren’t the only payment you don’t want to miss. Preparing the schedule helps you identify big cash outflows like payroll

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payments for which you may need some time to gather cash.

• Match cash outflows to the seasonality of inflows: Many businesses have a pattern of high cash inflows during certain months of the year and low cash inflows during other parts. At the same time, their expenses may be evenly spread throughout the year. This causes months with positive cash flow and other months with negative cash flow. The projection makes sure you have enough cash built up to cover those lean months.

• Plan out ownership equity distributions: A good cash flow projection for your company allows you to plan your equity distributions. This helps with your personal financial planning.

• Capture Opportunities: Your projection tells you when you will be able to make major investments like equipment purchases. This lets you know when you can start looking for deals on these investments. If you know that good deals often regularly occur during a certain part of the year, you can adjust your cash flows to be ready to capture those deals.

The next three chapters will go into more detail about your historical cash flow statement, metrics, and cash flow projections.

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Chapter 6: Historical Cash Flow Statements “Many small businesses would rather face an angry barbarian horde than tackle their cash flow statement.” -Nicole Fende

The cash flow statement is one of the major financial statements, along with your income statement and balance sheet. The statement of cash flows provides a historical look at where cash came from and went. Below is a summarized format for the cash flow statement.

It starts with net cash from operations, followed by net cash from investing and financing activities. You can learn a lot by looking at your net cash from operations. If it’s negative, it means your company’s core operations didn’t produce positive cash flow. You can be profitable but still be bleeding cash. The negative cash from operations needs to be covered by your beginning cash balance or by net inflows from investing or financing.

The three cash flow categories in this summarized statement format are the same three categories that will be used later for cash flow projections.

What Goes Into Each Cash Flow Category The three tanks of cash I explained in an earlier chapter are the same sections on your statement of cash flows. Here’s more detail on what goes into each of the three sections of the statement of cash flows.

Net cash provided (used) for operations $ xxNet cash provided (used) by investing activities $ xxNet cash provided (used) by financing activities $ xxNet increase (decrease) in cash $ xxCash at the beginning of the period $ xxCash at the end of the period $ xx

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Operational cash inflows are sales. Outflows are most of the expenses on the income statement, also known as the profit and loss statement.

Investing cash flows come from buildings and equipment. Investments like stocks and bonds are also investment cash flows.

Financing cash flows include loans, debt, and equity cash flows.

The statement of cash flows tells you whether your sales produced enough cash to cover your operating expenses or whether you needed other sources of cash. You can learn a company’s sources of funds, whether they are investing enough to replace their fixed assets, and how much cash the owners received.

The income statement shows a company’s profitability, but the cash flow statement gives you further insights into how your company achieved those profits. You can also learn the warning signals that cash flow is becoming a problem, even if your company is showing profits.

What You Might Miss The statement of cash flows provides some basic information, but you may miss some important things you need to know to manage cash. One way to see this is by trending cash flows over time.

Let’s look at a very simple company cleverly named “Sample Company.” Yes, that’s a lame name, but please play along. Here are their financial statements:

They are breaking even with a quarter million in sales and inventory costs. Nothing changed on their balance sheet over the year because they had no profits, their cash didn’t change, and their inventory didn’t change. Their statement of cash flows is very easy. There’s no change in cash from operations because sales equals cost of goods. They also had no investing or financing cash flows.

How tough do you think it would be to manage cash at this company? Do you think it would be like sleep-walking? Would the strategy be as simple as set it and forget it?

Of course not! That’s why I created this example! You’re smart enough to know that I had a point to make.

At YY01 At YY02 Cash from Operations 0Sales 250,000 Cash 100,000 100,000 Cash from Investing 0Cost of Goods (250,000) Inventory 250,000 250,000 Cash from Financing 0Net Income 0 Total Assets 350,000 350,000 Net Change in Cash 0

Equity 350,000 350,000

Balance SheetIncome Statement Statement of Cash Flows

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Here’s the sample company’s cash flows by month.

It’s a roller coaster ride. They start the year with decent cash. If I’m the CEO or CFO of this company, I’m sweating bullets in March. I end the month with $0 in the bank. I’m on the edge of bankruptcy.

But then sales start to increase while costs decrease. Maybe that’s a natural cycle that occurs every year and I know how to perfectly time it. Maybe it’s because I throttled back my production. If it’s because I reduced production, my cash flow limited my future sales and growth. That’s not good. That’s what I want you to avoid.

By summer, I have enough cash to sleep through the night again. By the fall, I’m flush with cash, and I’m dreaming of buying a nicer car. And then the cycle starts all over again.

A repeated cycle of rising and falling cash flow is called seasonality. Most businesses experience this. For industries like agriculture, landscaping, or ski resorts, the cycle is massive. Other companies may just have a bump in sales during the holidays.

Managing cash means flattening out the roller coaster. Running a business like an amusement park is no fun—unless, of course, your business actually is an amusement park. You first want to know the natural times and amounts that cash rises and falls for your business. That’s what this chapter is about. You’ll learn the key metrics to monitor to make sure your cash doesn’t get so low you get in a cash crunch or so high that you’re missing profits.

Before we can manage, we must monitor. In the two chapters, I’ll show you some metrics to monitor your cash so there are no surprises and you have time to adjust your cash strategy if needed.

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Chapter 7: Working Capital and Cash Conversion Metrics “Money is always eager and ready to work for anyone who is ready to employ it.”

- Idowu Koyenikan

This is the first of two chapters on metrics to monitor your cash. We’ll focus on the cash conversion cycle metrics in this chapter. Remember, you have access to free resources at the Conquering Cash Flow Resources page at https://cfoperspective.com/ccfr. One of those resources is a guide for the metrics in these chapters.

The resources page also includes a tool to calculate your cash conversion metrics. You can also use it to model how much your cash and profit might increase by reducing your cash cycle. This will be very helpful for you with those metrics. I’ll explain more about the tool and show examples later in this chapter.

The cash conversion cycle is like your company breathing in and releasing out cash. It releases cash in the cycle and then draws it back in again at the end of the cycle. Your business will turn a little blue if it’s a long time between breaths of cash. You can speed up the cycle by tracking and improving its three periods.

The cash conversion cycle can be broken into three time periods with a metric to measure each period. They are summarized below:

Period Metric

Inventory to sale Days of inventory outstanding

Sale to cash + Days of sales outstanding

Purchase to payment - Days of payables outstanding

Total Cash Conversion Cycle

The cash conversion cycle is the total number of days from when you pay cash until you receive cash from sales. You can monitor the full cycle time or each of the three periods individually to isolate exactly where your cash conversion cycle is speeding up or slowing down. You want the number of days of the cash conversion cycle to be low. I’ll now define and explain the metric formulas for each of the three periods.

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Days of Inventory Outstanding (DIO) Formula: Average inventory / (cost of goods sold/365)

The days of inventory outstanding is the average number of days it takes to sell inventory.

The last part of the formula (cost of goods sold/365) is your average daily cost of goods, assuming you’re using the cost of goods over a year. I explain how to calculate your average inventory in the metrics PDF.

A lower number is generally better.

Days Sales Outstanding (DSO)

Formula: Average receivables / (net sales/365)

The days sales outstanding is the number of days it takes to collect cash from sales.

The last part of the formula (net sales/365) is your average daily sales amount. Divide your current or average accounts receivable balance by your daily sales to calculate the number of days it takes to collect cash from sales. Net sales are your sales minus any returns or uncollectable sales.

Once again, lower numbers are better.

Days Payable Outstanding (DPO)

Formula: (Average payables + average accrued liabilities) / (cost of goods sold/365)

The days payable outstanding is the number of days from the purchase of materials or labor until you pay cash for them.

The last part of the formula (cost of goods sold/365) is the average daily cost of goods.

Higher is better for this metric, but you don’t want this metric to be so high that you anger your vendors and employees.

Turnover Ratios You can also express those previous formulas as turnover ratios. A turnover ratio measures how many times per year you complete each stage of the cycle. It may be easier for you to understand the number of days in the cycle, rather than a turnover ratio. However, the

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turnover ratios may be used in industry stats you receive or reports you get, so I’ll explain them.

These ratios are another way to measure your cash efficiency. Being efficient with your cash means two things. First, you use as little of your cash as possible to create a return on that cash. Second, the cash you invest is returned to you as quickly as possible. Both types of efficiency increase your cash balances.

For example, your inventory turnover ratio is your cost of goods divided by the average inventory balance during the period of those costs. I list the other formulas in the metrics PDF on the resources page at cfoperspective.com/ccfr.

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Chapter 8: Working Capital, EBITDA, and Free Cash Flow “If you don’t collect any metrics, you are flying blind. If you collect and focus on too many, they may be obstructing your field of view” - Scott Graffius

That last chapter on metrics was so much fun that I created this sequel chapter on metrics. We’ll cover EBITDA and free cash flow, which are broad measures of how much cash your company produces. I’ll also explain the debt service coverage ratio, which is used by bankers when deciding whether to grant a loan to your company, and the cash burn rate.

Working Capital Working capital can be measured two ways.

1. Net working capital is calculated as your current assets minus your current liabilities. 2. The current ratio is your current assets divided by your current liabilities.

They are simple formulas but immediately lead to the question: “What’s a ‘current’ asset and a ‘current’ liability?” Assets are things you own or have rights to. Examples include cash, inventory, and accounts receivable. Liabilities are things you owe, like payments to your vendors or lenders. Assets and liabilities are listed on your balance sheet.

The word “current” means the asset will be converted into cash within a year or the liability will be paid within a year. “Noncurrent” assets and liabilities are all other assets and liabilities. Many accountants create balance sheets grouped into current and noncurrent sections. This type of balance sheet is called a classified balance sheet.

These metrics are a rough estimate of whether you will receive enough cash in the next year to pay what you owe in the next year. That’s why the current ratio is used by lenders to determine whether you are financially healthy enough to receive a loan.

For both formulas, a higher number is better.

The next page has a sample calculation of net working capital and the capital ratio.

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Sample Current Ratio Calculation

Here’s a sample company balance sheet to show the current ratio calculation. This is a classified balance sheet, so current assets have been subtotaled and current liabilities are also subtotaled. Current assets are $600,000. They are divided by current liabilities of $350,000 to arrive at a current ratio of 1.71. Net working capital would be the current assets of $600,000 minus current liabilities of $350,000, which equals $250,000.

Once you know your current ratio, that leads you to the question: Is 1.71 a good or bad ratio?

If I told you that my net working capital was $100,000, it doesn’t tell you much. It would be huge if my liabilities were $10,000. It would be tiny if they were $10 million.

If I tell you my ratio, you instantly know something very important based on whether it’s below or above 1.0. If it’s below one, my current assets are less than my liabilities, which may mean that I don’t have enough cash to cover everything I need to pay in the next year. If it’s greater than one, it’s more likely I’ll have the cash to cover my liabilities.

If your working capital is… It means your…

= 1.0 current assets are equal to your current liabilities.

< 1.0 current assets are less than your current liabilities.

> 1.0 current assets are more than your current liabilities.

AssetsCash 100,000$ Accounts Receivable 200,000 Inventory 300,000

Current Assets 600,000 Equipment 2,000,000 Buildings 5,000,000

Non-Current Assets 7,000,000 Total Assets 7,600,000$ Current Current Current

Assets Liabilities RatioLiabilities $600,000 $350,000 = 1.71

Accounts Payable 300,000$ Line of Credit 50,000

Current Liabilities 350,000 Long-Term Debt 3,500,000

Total Liabilities 3,850,000 Equity 3,750,000 Total Liabilities and Equity 7,600,000$

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The amount the ratio is above one tells you the cushion you have above your current assets equaling your current liabilities. You just take the amount above one, multiply it by 100, and that’s the percent cushion I have.

So, if I tell you that my current ratio is 1.25, you instantly know I have enough current assets to cover my current liabilities plus a 25% cushion.

Is a 25% cushion enough? It may be if I have predictable net cash inflows and access to cash. I would need more of a cushion if I didn’t.

Quick Ratio The quick ratio is also known as the acid test ratio. Frankly, that’s a pretty extreme title for an accounting metric, but it sounds cool.

It’s calculated as current assets (minus inventory, prepaid expenses, and supplies) divided by current liabilities. This ratio removes some illiquid assets and is a tougher test of your cash flows than the current ratio.

Like the current ratio, higher is better from a cash flow perspective. A common recommendation is for this to be equal to one or higher.

On the next page is the sample company balance sheet again with a calculation of their quick ratio. Their total current assets are $600,000, but for the quick ratio, you take out $300,000 of inventory, leaving $300,000. That’s divided by the current liabilities of $350,000 for a quick ratio of .86. As mentioned earlier, a common recommendation is for this to be equal to one or higher.

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EBITDA EBITDA is a metric that’s a simpler version of cash from operations. It reduces earnings by non-cash- and non-operations-related items. It stands for Earnings Before Interest, Taxes Depreciation, and Amortization.

Positive EBITDA means that the core operations of the company are likely producing positive cash flow. This measure does not include changes in working capital balance sheet items like accounts receivable or accounts payable. Cash from operations from the statement of cash flows is a more detailed and accurate measure.

The next page has an example of how to calculate EBITDA.

AssetsCash 100,000$ Accounts Receivable 200,000 Inventory 300,000

Current Assets 600,000 Equipment 2,000,000 Buildings 5,000,000

Non-Current Assets 7,000,000 CurrentTotal Assets 7,600,000$ Assets Current Quick

(w/o Inventory) Liabilities RatioLiabilities $300,000 $350,000 = 0.86

Accounts Payable 300,000$ Line of Credit 50,000

Current Liabilities 350,000 Long-Term Debt 3,500,000

Total Liabilities 3,850,000 Equity 3,750,000 Total Liabilities and Equity 7,600,000$

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Here’s an example of how to calculate EBITDA. This is the income statement for the sample company with the calculation on EBITDA in the lower right.

You start with earnings, which is the $45,000 of net income. Next, add back a series of expenses. I used arrows to show where each part of EBITDA comes from on the income statement. The sum of all those is EBITDA.

Free Cash Flow Free cash flow measures the cash that’s available to debt and equity holders. The formula is related to the EBITDA formula we just looked at, which you can see below:

Free Cash Flow: EBIT X (1-Tax rate) - Change in net working capital + Depreciation and amortization - Capital expenditures

You multiply Earnings Before Interest and Taxes by one minus the tax rate. This gives you the after-tax earnings before excluding interest payments. Unlike EBITDA, you adjust that by the change in net working capital. Next, add back depreciation and amortization. At this point of the equation, you have a better view of the operational cash flows of the company. You then deduct capital expenditures. Capital expenditures are the cash you spend on buying buildings or equipment. I’ll show this visually a little later, which may help you understand this formula.

This measure can be very volatile, depending on the size of capital expenditures.

Sample Company Income Statement

RevenuesSales 500,000$ Less: Returns and Allowance (20,000)

Net Sales 480,000 Cost of Goods Sold 200,000 Gross Profit 280,000

ExpensesSelling and Administrative 200,000 Depreciation 15,000 45,000$ EarningsAmortization 1,000 Before:Interest Expense 4,000 4,000 Interest

Total Expenses 220,000 15,000 TaxesIncome Before Tax 60,000 15,000 DeprecationTax 15,000 1,000 AmortizationIncome Tax 45,000$ 80,000$ EBITDA

EBITDA Calculation

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Free Cash Flow to Equity Free cash flow to equity measures the cash that’s available to the owners and investors in a company. So, unlike free cash flow, this looks at cash after cash flows from debt. Here’s the formula:

Free Cash Flow to Equity: Net profit + Depreciation - Change in net working capital - Capital expenditures + Net new debt

A company that creates free cash is more valuable. This free cash can be distributed to owners, or they can get their cash from selling the company.

The more free cash flow, the more valuable the company. The more valuable the company, the higher the selling price of the company. The higher the selling price of the company, the more cash the investors get when they sell their ownership.

Free cash flow to equity is net profit plus depreciation, minus the change in working capital, minus capital expenditures, plus net new debt. If you were to think in terms of the accounting statement of cash flows, it’s like the change in net cash excluding equity cash flows. Once again, this measure can be very volatile, depending on the size of capital expenditures.

Time for another example from Sample Company. The calculation for Free Cash Flow and Free Cash Flow to Equity is on the right side of the graphic. The first part of the equation calculates EBIT, which is Earnings Before Interest and Taxes. That’s net income plus, or adding back, interest and taxes. That’s multiplied by one minus the rate, which is assumed to be 21% in this example. You then subtract the change in working capital, add back depreciation and amortization, and subtract capital expenditures to get to free cash flow. You add net new debt to Free Cash Flow to calculate Free Cash Flow to Equity.

Sample Company Income Statement

RevenuesSales 500,000$ Less: Returns and Allowance (20,000) 45,000$ Earnings

Net Sales 480,000 Before:Cost of Goods Sold 200,000 4,000 InterestGross Profit 280,000 15,000 Taxes

64,000$ EBITExpenses X .79 Times (1-.21) Assumes 21% Tax Rate

Selling and Administrative 200,000 50,560 Depreciation 15,000 - -3,000 Change in Net Working CapitalAmortization 1,000 + 15,000 DepreciationInterest Expense 4,000 + 1,000 Amortization

Total Expenses 220,000 - 35,000 Capital ExpendituresIncome Before Tax 60,000 34,560 Free Cash FlowTax 15,000 + 52,000 Net New DebtIncome Tax 45,000$ 86,560$ Free Cash Flow to Equity

CalculationFree Cash Flow

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Debt service coverage ratio (“DSCR”) OK, hang tight, because we’re down to our last three metrics.

The debt service coverage ratio is a type of debt-to-income ratio that’s used for business loans. It’s calculated as cash flow by debt payments. The cash flow number used is usually EBITDA.

Lenders will calculate it based on the business’s financials but will also compute the global debt service coverage ratio, which combines the business financials with the owner’s financials. The owner’s financial health can be a strength or liability to the company.

At the banks I worked at, lenders were looking for a ratio of 1.25 or higher. This is consistent with industry norms and Small Business Administration (SBA) loans. A ratio of one means EBITDA equals debt service. The minimum ratio of 1.25 adds a .25 or 25% cushion.

The debt service coverage ratio measures your cash flow and ability to pay. When lenders assess the risk of their loan portfolio, they break losses into two components: the probability of default and the severity of default. This ratio measures the probability of default, which is how likely the borrower will not be able to meet their contractual debt service obligations.

Cash flow margin ratio Once you know your cash flow from operations, you can calculate your cash flow margin ratio. This is your cash flow from operations divided by your sales.

This tells you how much actual net cash you’re earning on your sales. A higher ratio is better, of course.

You can use this ratio to quickly estimate future operating cash flows if you know your sales. Multiply your projected sales by the cash flow margin and—voila!—you have estimated your projected cash flow from operations. I provide a sample of how to do this in the Metrics PDF.

Burn rate The burn rate is the amount of cash you spend over a period of time. It’s usually measured monthly. You can estimate your burn rate by calculating your change in cash during a past period divided by the number of months in that period. You can also use the projected change in cash from your cash projection divided by the number of months in the projection.

This metric tells you roughly how long you can survive until you need to raise more funds (for example, from venture capital or from current owners). This is a crucial metric for startup companies who have no inflows or not enough to fund their growth. I worked in public accounting in Seattle, and startups I audited closely monitored this metric. At startups, this is like a countdown timer that ticks very loudly.

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For example, let’s say your burn rate is $10,000 per month and you have $50,000 of cash. $50,000 divided by $10,000 is five, so you have five months until you need to find more cash or you run out of money.

Whew! That was a lot of ratios! Sorry for all the math. Understanding these ratios helps you know how lenders calculate whether to give you a loan. The metrics provide the pulse rate for the lifeblood of cash in your business. However, the most powerful cash management tool is a cash flow projection. I explain how to use one in the next chapter.

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Chapter 9: Creating and Using a Cash Flow Projection “Failing to plan is planning to fail.” - Anonymous

The resources page for this book (https://cfoperspective.com/ccfr) has a link to a cash flow template. There are two different versions: Excel or fillable PDF. The resources page also has links to a video that explains how to use the template. Below are detailed instructions on how to use the template. You can also use the format below to create your own cash flow projection from scratch.

The first line of the projection is your beginning cash balance. You want to check this balance for each period of the projection to make sure it doesn’t drop below a level you are comfortable with. The sample projection below uses monthly time periods, but you can project cash by weeks, months, quarters, or years.

The projection then totals your operational cash inflows.

• Cash from sales: The main source of cash flow comes from sales. The top line of a cash flow projection is the cash receipt of sales. The cash receipt for a sale could be weeks before or after the sale based on your business. Don’t just use the revenue numbers from your budget or income statement.

• Sales tax collected: For states with a sales tax, there is a line so you can clearly see what you will need to remit to the government. You always want to have this cash ready for payment when it’s due and not dip into it to finance your company.

Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20Beginning Cash Balance $100,000 $105,600 $101,850 $103,150 $97,850 $104,450Net Cash from Sales

Cash from Sales 250,000 280,000 300,000 310,000 290,000 325,000 Cash Paid for Goods 125,000 140,000 150,000 155,000 145,000 162,500

Net Cash from Sales 125,000 140,000 150,000 155,000 145,000 162,500

Other Operational Cash InflowsSales Tax Collected 17,500 19,600 21,000 21,700 20,300 22,750 Other <<Specify Here>> 0 0 0 0 0 0Other <<Specify Here>> 0 0 0 0 0 0

Total Operational Cash Inflows 17,500 19,600 21,000 21,700 20,300 22,750

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The next major section totals operational cash outflows.

• Cash Paid for Goods: Income statements often begin with sales and then deduct the

cost of goods sold to arrive at the gross profit. I grouped the cost of goods with all the other cash outflows. Grouping all the inflows and outflows together is a simpler layout for you to track cash. Once again, put the outflows in the period when you actually pay cash for the goods.

• Salaries: I recommend putting all your salaries on one line. I put it in the first line of operational cash outflows in my cash flow projection. Depending on your industry, you may record salaries in your income statement in two lines (“cost of goods” and “sales, general and administrative”), but you only need one line in a projection. A cash flow projection focuses on when staff is paid, not where to record their salary costs according to the accounting rules.

• Other expenses: The lines after that are your other standard operational expenses like rent, utilities, and marketing. As noted above, put them in the month they are actually paid instead of the month they are expensed according to accounting rules. Do not include any accounting expenses like depreciation or amortization of fixed assets.

The sum of all your operational cash inflows and cash outflows totals your “Net Cash from Operations.” This total is very important. It tells you if your business is producing positive cash flow from your standard operations. You must find supplemental sources of cash for the company if you have negative cash flow from operations. Positive operational cash flow allows you to make large purchases, pay down loans, or distribute cash to the owners. We’ll talk about projecting these next.

Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20Operational Cash Outflows

Salaries 80,000 80,000 80,000 80,000 80,000 80,000 Employee Benefits 16,000 16,000 16,000 16,000 16,000 16,000 Payroll Taxes 25,000 28,000 30,000 31,000 29,000 32,500 Office Supplies 2,500 2,500 2,500 2,500 2,500 2,500 Accounting, Legal, and Consultants 2,000 3,000 10,000 3,000 1,000 1,000 Rent and Leases 5,000 5,000 5,000 5,000 5,000 5,000 Utilities 1,000 1,000 1,000 1,000 1,000 1,000 Insurance 500 500 500 500 500 500 Taxes and Licenses 17,500 19,600 21,000 21,700 20,300 22,750 Travel, Conference, and Education 100 5,000 300 2,500 400 500 Entertainment and Meals 300 750 400 800 500 600 Marketing and Advertising 500 500 1,500 1,500 1,000 500 Monthly Loan Payments - - - - - - Other <<Specify Here>> - - - - - - Other <<Specify Here>> - - - - - - Other <<Specify Here>> - - - - - - Other <<Specify Here>> - - - - - -

Total Operational Cash Outflows 150,400 161,850 168,200 165,500 157,200 162,850

Net Cash From Operations (7,900) (2,250) 2,800 11,200 8,100 22,400

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Financing and Investment Cash Flows Many cash flow projection templates ignore or don’t break out two very important types of cash flows:

• Financing cash flows

• Investment cash flows

You need to understand your operational cash flows before you can start planning your financing and investment cash flows. I recommend first entering the rows for cash from operations sections and any required finance payments in the financing section. You now have critical information to make major financial planning decisions.

Do you have negative operational cash flow or not enough cash for a large investment? This is where you would project how much cash you would need from borrowing money or having the owners invest more equity into the company. The sooner you can identify potential cash issues, the more options you have to adjust your cash flows to minimize these issues.

Do you have a positive net cash flow from operations? Congratulations! You have some exciting options for how to use that cash:

• Invest it back in the business

• Pay down lines of credit or make large principal payments on other loans

• Purchase equipment

• Distribute the cash to owners

Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20

Net Cash From Operations (7,900) (2,250) 2,800 11,200 8,100 22,400

Financing and Investment InflowsDraw on Line of Credit 15,000 - - - - - Other Loan Proceeds - - 250,000 - - - Owner Contributions - - 50,000 - - - Other <<Specify Here>> - - - - - -

Total Financing and Investment Inflows 15,000 - 300,000 - - -

Financing and Investment OutflowsPaydowns on Line of Credit - - - 15,000 - - Other Loan Paydowns 1,500 1,500 1,500 1,500 1,500 1,500 Equipment and Capital Purchases - - 300,000 - - - Distributions to Owners - - - - - 25,000 Other <<Specify Here>> - - - - - -

Total Financing and Investment Outflows 1,500 1,500 301,500 16,500 1,500 26,500

Net Change in Cash 5,600 (3,750) 1,300 (5,300) 6,600 (4,100)

Ending Cash Balance $105,600 $101,850 $103,150 $97,850 $104,450 $100,350

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In the sample projection, the owner contributed $50,000 to the company and the company borrowed $250,000 to purchase $300,000 of equipment. This will allow them to continue or even accelerate growth. The company is producing enough cash in the projection by the sixth month for the owner to distribute $25,000 back to themselves.

The sample projection shows how positive cash flow can be invested back into the company for growth to enhance future returns to the owners. The projection helps identify that possibility so you can capture it. In addition to investing for a future return to owners, cash was also distributed for the personal cash needs of the owner. Cash flow planning for a small business must be done in the context of the personal financial planning of the owners.

The key takeaway is that the power of a projection isn’t tapped if you just enter your best guess of all the items and accept the results. Take the time to think through the possibilities and options. Running multiple scenarios both reduces risk and increases reward. I’ll talk more about this at the end of the chapter.

Visualizing the Cash Flow Projection Graphs help you quickly identify trends, opportunities, and issues. The cash flow projection model I use for coaching clients has a few graphs that I’ll show below. The first two graphs show cash from operations and the ending cash balance.

The sample company in the projection has negative operational cash in January but solid growth in operating cash flow. This could be seasonal cash trends or a much larger trend of growth.

Cash from operations is growing, but the company’s cash balances are flat. The company invested $300,000 in equipment for growth and distributed $25,000 to the owner. These are

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financing and investment cash flows that aren’t included in the operating cash flows of the first graph.

Cash in the bank provides a margin of safety for the company. On the other hand, cash is a very low-yielding asset for your company and can often be invested back into the company for higher future returns. Modeling different combinations of investing or distributing cash allows you to achieve the optimal balance of risk and reward.

Additional Scenarios Provide More Insights Congratulations! If you followed all these steps, you now have a very powerful cash flow projection for your business. The insights you gained from this projection will help you avoid the stress caused by a lack of cash.

Even more exciting, you may have excess cash that you can use to grow your business or distribute to yourself.

Now that you have a baseline projection, you can learn so much more by exploring other scenarios. For example:

• Do you have enough cash to hire staff or buy equipment sooner than you projected in your baseline? Run a scenario to see how much sales and cash flow would increase by investing in staff or equipment sooner.

• What if there was an event that caused cash collections from sales to fall below your projection? Do you have enough cash cushion to weather it? Run a scenario with your best guess of the potential drop in cash. If your cash runs dangerously low, you can adjust other cash flows to plan how you would deal with this situation.

You can save your baseline as a document and then create each of these scenarios and save them with other names. The power of the cash flow projection is in the thought you put into it to contemplate threats and capture opportunities.

You may wonder exactly how to change the timing or amount of cash flows. I’ll show you that in the next chapter.

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Chapter 10: Tips on Monitoring Cash “We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.” - Michael Dell

How often should you monitor cash?

Imagine you drove your car without ever checking the gas gauge. Some of you may do this. You never think about how much gas you have until the gas light comes on. That works as long as there is a gas station nearby whenever the light comes on.

I live in the western United States. Sometimes it’s a long distance between gas stations. On some routes I drive, there are signs that say “next services 50 miles” or “next services 90 miles.” If your light came on 20 miles after that sign and you have 70 miles to go until the next station, you have a problem.

Monitoring Methods Let’s translate this analogy to managing cash. Monitoring metrics is like watching your gas gauge or low gas warning light. Cash flow projections are like using a map app to know how long until the next gas station.

If you have low cash balances and uncertain cash flows, you will need to frequently monitor cash metrics. This is like constantly monitoring your gas gauge. You have little room for error, which in the analogy is running out of gas/cash. Run frequent cash flow projections for short periods of time. Early in my career, I worked for a company that went bankrupt. They ran cash projections once or twice a week that showed weekly cash flows for the next few months. Longer cash flow projections may not be helpful if you have very uncertain cash flows.

If you have high cash balances with frequent and predictable cash flows, then you can monitor your cash more like a person who only thinks about filling up when the gas light comes on. You can monitor cash metrics less frequently. You want some way for a warning to trigger when your cash balances are high or getting low. You still want to run long-term cash flow projections for planning purposes. Even in this scenario, you may decide to manage your cash more aggressively, in which case you need to monitor your metrics and run projections more frequently. I’ll explain what I mean by managing cash aggressively later in the book.

The long stretches of road between gas stations are like companies that have infrequent but adequate cash flows. I used to work at a community bank that made loans to farmers. These farmers had a big inflow of cash at harvest, followed by months of expenses of planting and raising crops. They would submit their annual farm budgets, which were cash projections. The

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bank would monitor the farmers' expenses compared to the budget. Those whose expenses strayed above budget needed to come into the bank so we could see if they needed a larger line of credit and whether they would break even on their crop. Companies with infrequent cash flows need to run longer-term projections and monitor their metrics to make sure they are staying on track with the projection.

Here's a table that sums all this up:

Which Metrics to Monitor? Looking at all the liquidity metrics is comprehensive but overwhelming. At the other extreme, there’s no one perfect ratio that tells everything for everyone. Let’s just consider some of the broader measures of performance.

• Cash from operations is very important, but it’s blind to massive cash flows from financing and investing activities.

• EBIDTA is simpler than cash from operations but misses changes in working capital. • Free cash flow is better than EBITDA in that regard, but still doesn’t include financing

cash flows. • Free cash flow to equity looks at cash flow from an investor’s perspective but doesn’t

focus solely on core cash from operations. You may miss operational cash flow issues by looking only at free cash flow to equity.

Every business needs to pick a few metrics that best fit the audience of the metrics (for example, owners or lenders) and the most important cash flow issues of the company.

I’ll now quickly go through key metrics to point out their strengths and when they may be more useful.

Cash Conversion Cycle and Related Metrics The cash conversion cycle and related metrics are days sales outstanding, days inventory outstanding, days payable outstanding, and related turnover ratios. They are good for improving cash efficiency. One of the first places to look for more cash is within your own

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operations. Use these metrics to improve how quickly you can collect on accounts receivable, managing inventory, or scheduling payments to vendors.

Current Ratio Net working capital, current ratio, and quick ratio are simple ways to roughly assess whether you have enough cash for the next year. Making a cash projection is much better but you can use this for a quick check, especially when you have high and consistent cash inflows.

EBITDA and Free Cash Flow EBITDA and free cash flow are good simple estimates of your cash from operations. They may be easier for you to measure on a frequent basis than your cash from operations from a cash flow statement.

Free Cash Flow to Equity Free cash flow to equity is more useful for planning distributions or cash investments from owners.

Debt Service Coverage Ratio (DSCR) The debt service coverage ratio or DSCR will be used by lenders, so monitor this when you are preparing to get loans or have loans outstanding.

Burn Rate The burn rate is very useful for early-stage companies with few sales but big expenses. It’s also important for fast-growing companies. Finally, companies with net negative cash flow and the possibility of bankruptcy should use this to estimate how long they have until they have to declare bankruptcy.

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Chapter 11: Sources of Funds “It takes money to make money.” - Anonymous

The quote above seems to ring true when a large investment is needed before revenues and cash inflows come from that investment. Examples of these investments are:

• Equipment • Inventory • Buildings • Software

There are four major types of sources of funds:

Net Cash from Operations I covered cash from operations in the chapter on the cash conversion cycle. That section covered how your company produces cash and why it’s important for that cash engine to be efficient. Later in this book, I’ll explain ways to speed up the cycle and to increase your cash.

We then covered ways to measure and monitor cash flow. Most of those metrics measured how well you produce cash from operations. Assessing your past cash flow metrics also gives you a starting point to measure your progress from implementing the strategies we’ll go through later in this book.

Asset Sales You can receive cash in exchange for selling things your business owns. The use of factoring that was mentioned earlier in the guide could be thought of as an asset sale. The sales of any investments, land, buildings, or equipment can bring you cash. Selling excess or obsolete inventory at low prices is another way to generate cash.

Borrowing Loans to the company can come from banks, family, friends, or your own pocket. Loans are an agreement that requires payment back of the amount of the loan (called the “principal” of the loan) and interest. The next chapter will talk about different types of loans. There are also many other types of debt, such as trade finance or merchant advances, which will be covered in the chapter after that.

Equity Ownership Equity is the value of the company. Owners of the company have rights to a share of that equity. For example, if you owned 10% of a company that was sold, then you would be paid 10% of the value of your company. One of the ways to gain equity rights is by providing cash to the company to receive a share of the equity. That’s

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where the terms “shareholders” and “shares of stock” come from. I have a chapter on equity where I’ll discuss things like angel investors and venture capital.

Debt and equity are listed above as if they are two distinct buckets, but the range of funding is actually closer to a spectrum between debt and equity. There is a chapter that looks at these types of funding that fall between pure loans and equity. Examples of these include convertible debt, preferred stock, and some types of crowdfunding.

Friends and Family Before I dive into detailed chapters on borrowing and equity, I want to talk about a funding source that’s very popular with small businesses. When all else fails, you may ask your friends and family for loans. This may be your only choice when banks and other lenders just can’t take the risk of a loan to your business.

When I was in college, my dad was starting his business. I had some funds saved for college, and he had a short-term need for cash. I loaned my cash to him, and he quickly paid it back with interest. He continued to build a very successful business and made loans to other people.

Getting funds from friends and family can get very messy. It may be tempting to do something informally. That lack of clarity can come back to bite you. It’s worth writing out the terms of the agreement.

The first decision is to clarify whether this is a loan or an ownership investment in the company. If it’s a loan, you only owe them interest. If it’s an ownership investment, you just gave them rights to the future income of the company. It may be clear to you that you only intended to take a loan, but they may claim you offered them ownership. Make things clear with an agreement.

The loan agreement also clearly states the consequences if you can’t pay on time. It’s much easier to work this out now rather than when cash gets tight. Your friend or family lender may become scared if you’re struggling to make payments. They may require much bigger penalties than you ever imagined or demand immediate full repayment. Set the terms of the agreement while everyone has a level head.

The biggest concern with friends and family is to think through the impact on the relationship. Consider these questions:

• If you had cash struggles, would this damage the relationship?

• Is the loan worth jeopardizing the relationship?

• Would receiving this loan create the expectation that you are obligated to do something similar for the other person for the sake of the relationship? You may end up owing much more than just the money you borrowed.

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Below is a table that lists ways to increase cash from the four sources of cash. The following chapters will go into more detail on these methods to increase cash.

Debt Credit cards Business lines of credit (LOC) Equipment loans Commercial real estate (CRE) Construction loans Personal loans Trade finance Merchant cash advances Purchase order financing Invoice financing Debt securities (bonds) Convertible debt Mezzanine financing

Equity Common equity Angel investors Preferred stock Venture capital Crowdfunding

Sales of Assets Factoring Sale of equipment Sale of buildings Clearance inventory Securitizations

Cash from Operations Ways to Speed Up Cash Inflows Ways to Slow Down Cash Outflows

Send invoices soon after service Don’t pay until due date Email invoices Renegotiate payment terms Deposits and progress payments Leasing instead of buying Incentives/discounts for quick payment Contact past-due customers Collections companies Electronic payments Remote deposit capture Lockbox

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Chapter 12: Loans “It’s easy to get a loan unless you need it.” - Norman Ralph Augustine

Loans to the company can come from banks, family, friends, or your own pocket. Loans are an agreement that requires payment back of the amount of the loan (called the “principal” of the loan) and interest. You may need to pledge collateral (for example, the value of your equipment or real estate) to the lender to reduce the risk to the lender. If you are unable to pay the loan, they will take possession of that collateral and sell it as payment on the loan. Small business owners often must provide a personal guarantee for a bank loan to their business. If your business cannot pay off the loan, the bank can ask for payment out of your personal finances.

In this chapter, I’ll discuss common types of bank loans used by small businesses.

Credit Cards I was in banking long enough to know that credit cards, including personal credit cards, are a popular source of business financing.

They’re an easy source of financing when someone is hungry for money to fund their business dream. When owners sign up for and use multiple credit cards, it can seriously hurt their credit score. If cash gets a little tight and they start missing payments, even bigger damage is inflicted on their credit score. Ironically, this could prevent them from getting other sources of capital that would be more appropriate for their business. Credit cards have very high interest rates and fees, especially when a payment is missed. This is easily the most expensive loan you can get.

Another popular reason owners and employees like to use their personal credit cards for business expenses is so they can earn miles or points. A company’s accounts payable or accounting department has to balance an owner or employee’s desire for credit card rewards with using company cards that give the business more control, reporting, and efficiency.

Business credit cards may be tougher to get than personal credit cards for new businesses. However, business credit cards are a convenient way for companies to make purchases, especially by multiple employees. It may be better to look to them more for their usefulness as a payment method than their appropriateness as a cash flow tool.

Business Lines of Credit Business lines of credit are an excellent business loan choice for short-term cash flow needs.

You usually pay an annual commitment fee based on the commitment amount of the loan. For example, if your commitment amount is $100,000 and you are charged a 1% commitment fee,

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you would owe $1,000 for the ability to use the line, which may be advanced from the line. Your commitment amount is the maximum amount that can be borrowed at any one time.

Interest is paid monthly based on the sum of the previous month’s daily principal times the daily interest rate. The principal amount is the outstanding balance of the loan.

Lines of credit usually have a floating rate, often with the Prime rate as the index. Floating rate means the rate can change on a frequent basis (for example, on a daily or monthly basis). Your rate is usually a rate used in financial markets, like the Prime rate, plus or minus an amount to arrive at your total interest rate.

It may be collateralized by inventory or receivables. Companies that are stronger financially can get unsecured lines because of the strength of their cash flow. Collateral is company or personal assets pledged to the bank in exchange for a loan.

I mentioned earlier that the commitment amount of the loan is the maximum amount you can have in outstanding principal balance at any point in time.

The available balance is the commitment amount minus any outstanding principal balance. When you borrow from the line, it’s called taking an advance or drawing on the line. For example, if you took an advance of $1,000, the principal balance of the line would go up $1,000 and that amount would be credited to your deposit account at the bank.

Operationally, you do this as a transfer from the line to your deposit account via the bank’s online banking system. You make payments on the line by transferring money from your checking account to the line. It’s very easy.

Business lines are revolving lines of credit. You can take multiple advances and make multiple payments. Your commitment amount always stays the same, but the available balance decreases with each advance and rises with each payment. Let’s say your commitment amount is $100,000. That’s also your available balance until you take an advance. If you take an advance of $1,000, your principal balance is $1,000, your available balance is $99,000, and your commitment amount is still $100,000. If you then make a payment of $1,000, then your principal balance is zero and your available balance goes back up to $100,000.

One way lenders ensure that the line is used for short-term needs is by requiring that you periodically “rest the line.” Resting the line means paying the principal balance down to zero. How frequently you must do this and how long the principal balance must stay at zero before you can take advances again is detailed in your loan agreement.

Lines of credit are for short-term working capital needs like inventory, payables, or payroll. I know the head of a small company that received monthly financial statements that always showed decent cash balances. He went to write a check in the middle of a month, but there was no cash. The bulk of his revenues were received near the end of the month. His month-

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end cash balances were fine, but he didn't realize how tight cash was mid-month. He got a line of credit to fix that.

Lines are also used for longer seasonal needs. I mentioned earlier that I worked a community bank that served many farmers. They would draw on their operating lines of credit during the growing season and pay the lines off after harvest.

Lines are renewed annually. The lender will check on the financial health of the borrower during the renewal. The borrower will need to submit updated financial statements or tax returns to the bank.

One clause in loan agreements to look for that’s common in lines of credit is the “due upon demand” clause. This clause allows the lender to “call the loan” at any point.

Calling the loan means the lender can demand that the full outstanding balance needs to be immediately paid in full. This may happen if the borrower’s financial situation is worsening. It might also occur when the lender is weak. It’s used very, very rarely but you want to be aware of it during times of extreme stress in the economy and financial system.

In the movie “It’s a Wonderful Life,” George Bailey is about to leave on his honeymoon when Ernie, the taxi driver, points out that there is a run on the building and loan (a type of financial institution) that Bailey runs. The panic was sparked when a bank the building and loan worked with called their loan. The building and loan gave all the cash they had to the bank and closed their doors in panic. George calms the mob and saves the building and loan until his uncle almost ruins it again. A fun factoid: Bert and Ernie from Sesame Street were named for Bert the cop and Ernie the taxi driver from that movie.

Situations like that were more common during the Great Depression than the Great Recession. What did happen during the Great Recession was that banks reduced the commitment amounts of loans, especially if the borrower never borrowed the maximum commitment amounts. This improved the banks’ regulatory capital ratios.

There’s a joke that a banker is someone willing to lend you their umbrella when it’s sunny but asks for it back when it starts to rain. The Due Upon Demand clause and reduced commitment amounts are the realities behind that joke.

Equipment Loans A term loan is a loan where principal and interest are paid on a schedule based on the term of the loan, as opposed to lines where the principal is drawn and paid back whenever the borrower wants. Equipment loans are term loans with amortization terms of 3–10 years and no balloon term. Equipment loans are usually fixed-rate loans with consistent payments. Payments on term loans are often called P&I payments because they are a mix of principal

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and interest amounts. They are collateralized by the equipment that’s being purchased with the loan funds.

Commercial Real Estate Loans Commercial real estate loans, called CRE loans for short, may have fixed rates or variable rates. They can have different repricing, balloon, and amortization terms.

They are collateralized by commercial real estate. Whereas equipment loans are usually extended when buying equipment, you can get a CRE loan when buying real estate, improving real estate, or when you just want longer-term loans and have equity in your commercial real estate to borrow from.

It’s common for businesses to have more than one loan collateralized by the same property. Another thing that can happen is for two pieces of property to be collateralized by the same loan. This is called cross-collateralization. Selling one of those properties but not the other while not paying off the loan will require the approval of the lender.

You can get all the loan types we’re discussing in this borrowing section from banks and credit unions. You may want to investigate loans from insurance companies if you are borrowing more than a few million dollars for CRE. When I worked in banking, insurance companies had very competitive rates, especially for fixed-rate loans with long terms.

Construction Loans You may take out a construction loan if you are building or improving real estate. Construction loans have a term of one to two years. They are usually floating rate. Monthly draws or advances are made on the loan to pay the builder based on how much construction has been completed since the last payment. At the end of the construction period, the construction loan is converted or refinanced into a commercial real estate loan.

Personal Loans The line between personal finances and business finances is very thin for small businesses. Owners may prefer to use personal loans rather than business loans to get funding for their company. It may be easier for them to qualify for a personal loan than to get a loan for their business. Some options include:

Credit Cards A famous slogan for Visa was, “It’s everywhere you want to be.” Some people believe cards will take their business anywhere they want their company to be, too. They are easy to get. The low teaser rates also look very cheap compared to other rates. I worked at banks where we knew some owners financed their businesses with one card—or a series of cards. My

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caution is that multiple accounts, especially new accounts, can damage your personal credit score, even if you make the required payments. This will make future debt more expensive.

Home Loans A personal loan source for large amounts of funds is a home loan. A first mortgage is when you get a loan secured by your house when you have no other existing debt on your house. First mortgages are often for fixed rates of 10 to 30 years. You can also get variable-rate mortgages that are fixed for 3-10 years and then float annually after that with amortization terms of 15 to 30 years. Home equity loans could be a first mortgage or a second mortgage. For example, if you already have a first mortgage on your house, you take out a second mortgage if there is a big difference between the value of your house and the balance on your existing loan. Home equity loans are fixed-rate loans with terms of 5 to 15 years.

Home Equity Lines of Credit (HELOCs) Home Equity Lines of Credit are known as HELOCs for short. Like fixed-rate home equity loans, HELOCs can be first or second mortgages. They have a draw period of 5 to 10 years, during which they are a revolving line of credit. They then switch to a repayment period of 10 to 20 years.

The loan rate and payment amount are fixed during the repayment period so that the balance at the start of the repayment period is paid evenly to zero by the end. They have a variable rate while they act like a revolving line. Remember that a revolving line is a loan that you can borrow from, pay off, and then borrow from again. You can keep borrowing on them as long as you haven’t hit the maximum you can borrow on the line.

Some business owners may prefer to use a HELOC over a business line of credit because you don’t pay a commitment fee with a HELOC. A HELOC rate may be lower than a business line.

Borrowing funds secured by your home means you may lose your home if you get into financial difficulty. Taking these loans for your business dreams could lead to the nightmare of losing your home. It’s too big of a risk for some owners. For others, it’s the only way to get desperately needed money. And for others, it’s a smarter and cheaper source of financing than business loans.

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Chapter 13: Other Types of Debt “If you would know the value of money try to borrow some.“ - Benjamin Franklin

Loans are just one type of debt to fund your company. Let’s look at some of these other types of debt. Some of these sources are very expensive. If possible, try to use these only periodically or move toward a cash management strategy based on cheaper forms of debt.

On the other hand, these may be your only source of financing. Some companies can’t get bank financing because they’re new, they have a bad credit history, or many other reasons unique to their company or industry.

I’ll then end this chapter with the pros and cons of using debt.

Trade Finance Maybe the most common form of business debt is trade credit. Any time you purchase something and are invoiced, you’ve incurred trade debt. The most substantial form of this is buying inventory on credit. Your supplier, or a financing company they use, provide this to help you sell their product to your customers. You may pay the supplier after a certain number of days or you may not need to pay them until you sell their product.

Merchant Cash Advances Merchant cash advances are loans against future credit card sales receipts. For companies who take credit card payments, you can usually get this from your merchant processor. You repay the loan via a percentage deduction of future sales.

Purchase Order Financing Purchase order financing is when you receive short-term loans based on your purchase orders. These are offered through non-bank financing companies. It’s best for inventory that’s held for a short time.

Invoice Financing and Factoring Two sources of cash that are very similar are invoice financing and factoring. Invoice financing is a loan that’s based on your accounts receivable. Factoring is not a loan; it's an asset sale. It’s the sale of your accounts receivable at a discount to a factoring company.

The factor or finance company will advance you 65–90% of the amount of your invoices. They then collect on those receivables. Once they cover their advance, they will send the amounts they collect minus a fee of 1–4%.

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This may be a good option for companies with a long gap between sales and receipt of cash from those sales. The factor or financing company doesn’t want to have to collect on a bunch of small invoices and many customers. You’ll get better pricing if you have large invoices and customers.

Debt Securities and Securitizations I’ll briefly mention debt securities and securitizations. These are very complex and highly regulated. Even all the groups of structures are beyond the scope of this book.You’ll work with an investment bank for these. They will customize the structure and pricing for you. This is a source of funding for larger businesses. You can issue debt that’s either unsecured or secured by company assets.

Securitization is a sale of assets and not debt issuance. Securitization is the process of pooling assets to sell them to the capital markets as an investment security. Maybe the most well-known are mortgage-backed securities. This is another source of liquidity for larger companies. You would be amazed what you can securitize. I once worked at a company that securitized annuities from lottery winnings and structured settlements.

Pros of Debt I’ll cap off these two chapters on borrowing by listing the pros and cons of debt. First, the pros:

• Unlike raising funds by selling parts of the company, borrowing allows current owners to get funding without diluting their ownership.

• Lenders require a lower return than owners do. This means that the cost of interest and fees is less than the cost of capital of equity.

• Loan payments are very predictable. You usually pay the same principal and interest amount each month.

• Interest payments are tax deductible, unlike dividends paid to owners. This is another way the cost is lower than equity funding.

Cons of Debt And now for some drawbacks to debt:

• Personal guarantees are often required. That means lenders can require payment from your personal assets when the business doesn’t have enough cash to make the loan payments.

• If the company can’t make the loan payment, creditors could also force the company into bankruptcy.

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• The amount you can borrow may be limited to the assets you have available. Equity investors are willing to provide funding for the opportunity to receive future earnings. Lenders want to see current cash flow before they invest.

• Another issue with pledging collateral is the complexity it causes when you want to sell those assets. Getting a buyer and seller to come to an agreement can be tough enough. Lenders with a security interest in an asset sometimes feel like a third party to that transaction. They want to be paid off when you sell assets you pledged. If you are selling below their loan amount, you will need to negotiate a short sale with the lender. In the short sale, you and the lender will need to decide if the lender will discharge the remainder of the debt or whether you will still owe it on an unsecured basis. Sometimes, loans are cross-collateralized. This means that multiple pieces of property secure a loan. Selling any one of those properties, even if it is not the property the funds were used to purchase, requires lender approval. All these collateral issues can slow down your ability to convert assets to cash via a sale of the asset.

• One of the pros I listed for debt is that payments are predictable. That can also be a con. You must make those payments even when your cash flow is low.

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Chapter 14: Equity “Raising venture capital is the easiest thing a startup founder is ever going to do.”

- Marc Andreessen

I’ll be talking about equity issuance in very broad terms. To be honest, equity can be structured almost any way you want. So let’s look at some general ways you can use equity issuance as a source of funding.

Equity is the money owners invest in the company for the rights of ownership. The big decisions owners make when raising equity capital are how much of the company they will give up and at what price. Even a small sale of equity can cause the current owners to give up some control of the company.

There are a few options for equity investors:

• The first is selling only to current owners. The benefit of this is that current owners don’t have to split their ownership with new owners. When new owners reduce their share of ownership, it’s called diluting their ownership. A capital raise from just current owners avoids that.

• Another option is to sell to a smaller group of investors in a private placement. These investors must meet certain income asset thresholds to be eligible to invest in a private placement.

• Two well-known types of investors who can provide funding early in a company’s life are angel investors and venture capitalists. I’ll explain these more soon.

• Finally, a very visible way companies raise equity is in their initial public offering. Now the ownership is traded to the broad public, which brings a host of regulatory issues.

There’s one other way that I didn’t list above, but I’ll discuss it in the next chapter; that’s crowdfunding.

Something to consider with new owners is that they can provide not only cash but also technical knowledge. This is especially true of angel investors and venture capital, which I’ll cover briefly below.

Another option you have is to issue different types of equity that have different rights. A popular structure for this is to have one class of stock with voting rights and another without voting rights. This allows the current owners to sell equity without diluting their control. I worked at a family-owned bank where the Class A shares with voting rights were held by the family and a small group of investors. The Class B shares without voting rights were traded in what’s called the pink sheets over-the-counter market.

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Some types of equity have a higher priority than common stock in liquidation. An example of this is preferred stock, which I’ll talk about in the next chapter. Another variation on this is that some may demand first rights to cash in a sale. This is common with angel investors and venture capital, so let’s talk a little more about those sources.

Angel Investors Angel investors are often wealthy individuals but could be a group of investors. They usually invest at an earlier stage than venture capital. Since they invest earlier and at a higher risk, they expect a higher return than venture capital. This means they will want a larger share of the company.

Venture Capital (VC) Venture capital often comes from professional managers who source funds from institutional investors. These sources include funds allocated to VC by investment managers.

A big part of the job of the VC managers is providing guidance. This can also be true with angel investors. When considering VC, think of both the funds and the guidance you gain from them.

Pros of Equity Like we did for debt, let's go through the pros and cons of equity. In general, the pros of debt are the cons of equity and vice versa, but there are also other considerations.

• Unlike with debt, equity investors are rarely required to make a personal guarantee. However, owners' personal assets are subject to credit claims with certain business structures, like sole proprietorships. It’s so easy now to get an LLC that it’s madness for someone to expose their personal assets like that.

• You don’t have to pledge collateral. Like I mentioned in the debt section, investors are willing to fund you beyond the value of your current collateral.

• You are not required to make regular payments like with loans. If your cash flow is low, you can suspend dividends or other distributions to owners. If creditors aren’t paid on schedule, they can force you into involuntary bankruptcy. Equity holders can’t do the same when you discontinue their dividends.

Cons of Equity And now the downsides of equity:

• Dividends aren’t tax deductible like interest payments on debt. • Equity is usually the most expensive form of capital for a company because the

investors take on more risk than any other type of investor.

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• Issuing debt doesn’t dilute your ownership, but issuing equity can dilute the current owners' share of their ownership in a company. That decrease can be massive. When companies are close to failing, they may issue new equity that makes all existing shareholders minority shareholders, sometimes a tiny minority. This happened to shareholders of some banks during the Great Recession.

• Ownership dilution dilutes not only the current owners’ economic share of a company but also their control. You see this often where a founder of a company slowly loses control of that company as they raise successive rounds of funding. Even if a company doesn’t issue new stock, control may shift as new investors gain a concentration or plurality of current shares.

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Chapter 15: Everything In Between “Before you even start building your crowdfunding page, start building a crowd first.”

- Roy Morejon

We’ve looked at debt and equity as two distinct buckets. The range of funding is actually closer to a spectrum between debt and equity. Now we’ll look at types of funding that fall between pure loans and equity.

Convertible Debt Convertible debt is a hybrid of debt and equity. It starts as debt and then it can convert to equity. That conversion is often decided by the security-holder. I called it a hybrid, but it’s not debt and equity at the same time. It has the rights of debt while in the debt stage. After conversion, it loses the debt rights and gains the rights of equity.

Mezzanine Financing Mezzanine financing is debt, usually with equity warrants. The mezzanine floor in a building is defined as “a low story between two others, typically between the ground and first floors.” That metaphor is applied to this form of funding because in a company liquidation, it has liquidation rights to cash above equity but is below the senior debt we discussed in an earlier chapter. I mentioned that mezzanine financing comes with stock warrants. Warrants are the option to purchase stock at a specific price during a certain window of time.

Preferred Stock Preferred stock is a class of equity. It’s senior to equity if the company is liquidated but is junior to debt. Further, preferred dividends must be paid before common dividends can be paid. Common equity has no stated dividend. Preferred stock has a stated dividend that’s usually stated as a percent of the par value. The par value is a value given to the stock by the company when the stock is issued.

Preferred stock is like debt in that it makes periodic payments based on a stated formula. However, preferred stock is equity, so the periodic payment is a dividend, not an interest coupon. The issuing company can suspend preferred dividend payments. Preferred stockholders cannot force the company into involuntary bankruptcy for this.

Dividends can be cumulative or noncumulative. If a company issues non-cumulative preferred stock, it can skip preferred dividend payments and does not need to pay the skipped preferred dividends before it can pay future common dividends. If a company issues cumulative preferred stock, all missed preferred dividends must be paid before the company can pay common dividends.

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The most famous example of preferred stock was the TARP program during the Great Recession. The government invested in cumulative preferred dividends issued by participating banks.

Crowdfunding Crowdfunding is based on lots of people investing small amounts in a company. One popular type of sale that’s often called crowdfunding is pledge or donation crowdfunding. For example, people may pledge to buy a product in exchange for special perks from the company. It’s a way for a company to presell for perks.

However, crowdfund investing is also a way for small companies to raise investment capital. The JOBS Act of 2012 defined Emerging Growth Companies (or EGCs) and updated securities rules to allow them to crowdfund. An EGC, as defined by the act, is a company with less than $1 billion in sales that has not issued common equity securities under a registration statement prior to Dec 8, 2011. The $1 billion sales number is indexed for inflation, so it’s a little north of that now.

Title I of the act reduced the regulatory burden of these companies to raise funds.

Title II allows them to make general solicitations for securities. This means they can use advertisements and non-financial professionals to promote their securities.

Title III is known as the Crowdfund Act. It lays out how the securities can be sold and who can invest in them.

In short, all this allows a large number of people with small incomes to make small investments in small companies.

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Chapter 16: Managing Debt and Equity “The most important word in the world of money is cash flow. The second most important word is leverage.” - Robert Kiyosaki

I was the CFO of two different banks during the great recession. I saw some borrowers make massive cash flow mistakes leading up to it. In this chapter, I’ll explain the huge mistake they made with leverage. Then, I’ll list the pros and cons of raising a large amount of funding at once versus a series of funding over time.

Leverage Financial leverage, which is the use of borrowed money, magnifies returns. Business and investment gurus tout how you can make big profits with little money of your own. They show how using other people’s money can make you rich.

It’s true that using other people’s money, known by the acronym OPM, can increase your returns. But OPM can also be like the drug opium. Its highs come with crashing lows. Borrowing large amounts of money increases the risk that your business may run out of cash or have big losses in a downturn. I’ll explain how this works and how to reduce your risk.

Here’s an example of leverage that I’ll explain below:

In this example, the company has $1 million in assets. They have a few miscellaneous liabilities like accounts payable but no business loans. Their debt to equity ratio is a very low .11. Their

No Leverage Leveraged DifferenceAssets 1,000,000$ 3,000,000$ 2,000,000$

Liabilities 100,000$ 100,000$ -$ Loans - 2,000,000 2,000,000 Owners Equity 900,000 900,000 - Total Liab + OE 1,000,000$ 3,000,000$ 2,000,000$

Debt to Equity Ratio 0.11 2.33 2.22

Profit Before Interest 100,000$ 300,000$ 200,000$ Interest @ 7% - (140,000) (140,000) Net Income 100,000$ 160,000$ 60,000$

Return on Assets 10% 5% -5%Return on Equity 11.1% 17.8% 7%

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profit is $100,000 so they have a return on assets, or ROA, of 10% and a return on equity, or ROE, of 11.1%. Return on assets is your income divided by assets. Return on equity is your income divided by your equity balance. They are ratios that measure your profitability.

The owners then decide to get bank loans to invest in company assets to magnify their return on equity. This is the second column. They borrow $2 million, so total assets are now $3 million. For simplicity, let’s assume they still earn 10% on their assets before interest costs. Their profit before interest expense is $300,000. Assume the loan has a 7% interest rate. They would pay $140,000 of interest expense, so their net income is $160,000.

Their return on assets decreased from 10% to 5% because they now have to pay interest on the cash they got to fund the additional assets. However, their return on equity has jumped from 11.1% to 17.8%. For this example, let’s assume net income is also cash from operations. They increase the cash they can invest in the company or distribute to themselves by $60,000.

In other words, leverage increased their ROE and cash flow available to owners by 60%. The owners are making a lot more money. What could go wrong…?

Leverage Goes Wrong

Leverage doesn’t increase ROE; it magnifies it. Many business owners hear about how leverage and using other people’s money can make them rich. That assumes a decent unleveraged ROA. A low or negative ROA can cause massive negative ROE and cash outflows. The dark side of leverage is shown in the example above.

No Leverage Leveraged DifferenceAssets 1,000,000$ 3,000,000$ 2,000,000$

Liabilities 100,000$ 100,000$ -$ Loans - 2,000,000 2,000,000 Owners Equity 900,000 900,000 - Total Liab + OE 1,000,000$ 3,000,000$ 2,000,000$

Debt to Equity Ratio 0.11 2.33 2.22

Profit Before Interest (10,000)$ (30,000)$ (20,000)$ Interest @ 7% - (140,000) (140,000) Net Income (10,000)$ (170,000)$ (160,000)$

Return on Assets -1% -6% -5%Return on Equity -1.1% -18.9% -18%

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Our sample company is now earning a small loss. The first column shows their results with no leverage. They have a ROA of -1% and ROE of -1%. Their net loss is $10,000, which is probably fairly manageable with $1 million in assets and $900,000 in equity.

Now look at the leveraged column. They have three times as many assets, so their loss before interest is three times larger. A $30,000 loss may not hurt them too badly, but they also owe $140,000 in interest. Their ROA after leverage is -6% and their ROE is -19%.

To summarize, a small negative ROA and ROE with no leverage has been magnified into a massive negative ROE through leverage. Their ROE with leverage is 17 times lower than without leverage.

The biggest problem isn’t earnings; it’s cash flow. Companies fail from lack of cash flow, not lack of earnings. Most owners plow the full $2 million of borrowed money into non-liquid assets like real estate or equipment. Non-liquid assets are assets that cannot be easily sold or otherwise turned into cash. They may have even used some of their cash when they had only $1 million in assets as their down payment or equity portion of those illiquid assets. They may have nowhere near the cash left to service a $170,000 loss.

As a banker, I saw this happen with many business owners during the great recession. Real estate investors and owners who made big expansions before the downturn were caught with little cash and big payments.

Balancing Profit and Risk To put this all together, you must balance both profit and risk when deciding how much to borrow and how to use the cash from that borrowing. Borrowing funds to increase your investment and grow your company can cause the return to owners to greatly increase. On the other hand, the return to owners is decimated if the investments start earning low or negative returns.

Profits Risk

The correct amount of borrowing is a balance of profit and risk

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More important than the earnings is cash flow. When you have a decent income from your company's investments, it’s not hard to cover your loan payments. You will need to have a good reserve of cash available for your loan payments when earnings falter.

I encourage you to keep a larger reserve of cash as your borrowing increases. The increased borrowing increases both your profits and your risk. Over the long term, the reserve cash will allow you to keep most of the profits and reduce your risk. Using leverage and keeping reserves means you will receive higher returns during the good times while covering your loan payments and losses during the rough times.

One-Time or Series Funding? Now let’s look at another capital question. One of the big questions when starting a business is whether to raise funds for the company via a large one-time funding or to do a series of fundings. Funding could come from debt or equity. We’ll first look at one-time funding.

Pros of One-Time Funding • One of the pros of one-time funding is that it avoids the risk that capital won’t be

available in the future. So, I just got done saying high amounts of debt increase risk, and now I’m saying higher amounts of debt or equity reduce risk. Which is it? It comes down to maintaining enough liquid assets to service the capital. In the leverage example, the company invested its capital in illiquid assets like real estate. They couldn’t convert it to cash fast enough to make their loan payments. If they did liquidate the real estate quickly, they would incur a massive loss. They would have to set the selling price low to sell quickly. Keep a cushion of capital in liquid accounts like cash or short term investments until you need it for operations.

• The second pro is that you don’t need to spend additional resources on more rounds of funding. In other words, one big capital raise is more efficient when looking at the ratio of the capital you raise and the costs to raise it.

Cons of One-Time Funding • Your forecast may be wrong, so you need more or less than you thought. Unless you

are truly prophetic, you will be wrong. You will need more or less. If you need a lot more, then you’ll have to do another round of funding, which is what the big first capital raise was supposed to avoid.

• However, if you actually need less capital than you raised, then you may be wasting the investors’ money. The return the company gets by keeping the capital in cash or short-term investments is very low. You could distribute back to owners, but then you risk having to do another capital raise if your company suddenly starts growing quickly.

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• A final con for startups is that early capital raises are usually very dilutive or expensive. If an owner does a big raise to reduce risk, they will have to sell off more of their company if they are raising equity than if they are patient and do equity raises later.

Pros of Series Funding • A pro of series funding is that it tends to keep the company more disciplined. Related

to this is that it minimizes wasted money. The company doesn’t have a lot of cash lying around, so the company tends to be more careful about how it spends the cash.

• Another pro is that capital costs are only for current expenses. You don’t have large amounts of expensive capital parked in cash and earning low returns. What you do have is fully invested in higher-yield operations.

• As time goes on, the company gains in value. Equity capital raises don’t dilute the current owner as much. In other words, they don’t have to sell as large of a percent of the company to get the funding they need.

Cons of Series Funding • One con is that there is no certainty in life. Today, the markets may be good for

raising capital, but tomorrow, something may happen that causes people not to want to invest in risky companies. I live in Spokane, where there was a company that was growing quickly in the short-term rental market. They were getting ready to raise another round of funding when COVID hit. Their funders backed out, and the company shut down. Tomorrow may bring better markets or tomorrow may mean frozen markets. You never know.

• A second con is that raising additional funding costs more money.

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Chapter 17: The Art of Managing Cash Flows “If I had to run a company on three measures, those measures would be customer satisfaction, employee satisfaction, and cash flow.”

- Jack Welch

The art of managing cash flows is speeding up cash inflows and slowing down cash outflows. It’s almost always beneficial to do both to increase your cash balances. You can use that cash to pay down loans or invest the cash to earn profits (and even more cash…).

I worked for a large public accounting firm and was part of the audit team for a company that wasn’t the best at managing cash. The manager at our firm showed them how they could improve their cash position substantially by using some of the techniques I explain below. They could have been making hundreds of thousands of dollars more just by managing their cash better.

Ways to Speed Up Cash Inflows Don’t Procrastinate: Ask for the Payment The first tip in this section may seem the most obvious: ask for the money as soon as possible. Some owners are so busy working in the business that billing their customers slides to a lower priority.

The money due to you won’t arrive until you ask for it. You can bill before the time of service or at the time of service to accelerate cash inflows. If you bill after the service, make sure to do it as soon as possible. The longer you delay, the harder it is to collect payment.

Incentives for Quick Payment on Receivables Sometimes, your customers just need a little incentive to pay you more quickly. It’s very common for companies to state the following payment terms in their invoices:

• Due upon receipt – This communicates a sense of urgency, which makes the customer more likely to pay your invoice immediately. Putting a due date in the future allows customers to delay until that date. They may have been completely fine to pay it immediately.

• Net 10 – If you consider “Due upon receipt” as too unreasonable, then pick a later due date. The number of days is totally up to you. The word “net” followed by the number of days (10, 15, 30, etc.) communicates your expectation of when payment is

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due. Your customer shouldn’t be surprised when you call on payments that haven’t been received by then.

• 2% 10, Net 30 – This provides a discount to the customer for making a quick payment. In this example, the customer can reduce their payment to you by 2% for paying within 10 days. Otherwise, they should make their payment within 30 days. Is offering this discount worth the cost to you? You have to assess your borrowing costs and the lost opportunities due to tight cash flow.

• Past-due charges – If there is no penalty for paying late, some customers are happy to hold on as long as they can to the interest-free loan you are giving them. State a late fee that will be assessed if payment isn’t received by the due date.

Deposits and Progress Payments You can often request deposits or progress payments on large projects or custom orders. For example, you may request a 50% deposit at the time of a custom order. I worked for a company that produced concerts. The industry standard for major performers was a 50% deposit 30 days before the show, and the rest paid the night of the show. Projects that take a long time are good choices for progress payments. Construction jobs are an example of large projects paid on a progress basis.

Contact Your Past-Due Customers Your customers will take paying you as seriously as you take collecting payments. Allowing payments to trail well after the due date trains the customers that they can pay you late. Monitor your past due report at least weekly to identify customers that need a call or email to nudge them to make a payment.

A tip is to ask them to respond to you with a commitment of when they will make their payment. They may not be able to make it immediately, but they must state when they can make the payment. All future conversations are then just holding them to their word.

I’m not saying to be unprofessional or disrespectful. At a credit union I worked for, the collections department manager reported to me. He told me that he trained his staff to always treat the borrowers respectfully. His practical definition for this was that the borrower would have a civil conversation with the collector if they ever ran into each other at a supermarket.

You can be empathetic without being enabling. You can be direct without being disrespectful.

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Consider a Collections Company Collecting on payments scares some owners and, frankly, can suck the life out of you. A collections agency can do this for you, but they will keep a percentage of what they collect as a fee. The collections companies I’ve used in the past kept 30-40% of the payments. They will charge a higher fee for older receivables and receivables that are harder to collect. You usually don’t turn your receivables over to a collections company until they hit a certain number of days past due (e.g., 90 days). Remember that they work for you. Their collection methods will reflect on your business. Make sure you understand their collection methods and shop around for a company that matches how you want these customers to be treated.

Cash Management Services Banks have ways to help you collect your money faster to automate cash flow management.

• Remote deposit capture – You can scan your deposits from your desk rather than having them sit until your next trip to the bank. When I was the CFO of a health clinic system, I would notice that our cash was sometimes low at payroll time. The clinics would have multiple days’ deposits of checks sitting in their desk drawers, waiting for someone to take them to the bank. I would call to remind them to take the deposit to the bank because the funds to cover everyone’s paychecks were sitting in their desks.

• Lockbox – Having the bank make the deposit for you means the cash is credited to you even faster. Checks are mailed directly to a PO box where the bank picks them up and deposits them. They then send a file with the remittance info to you that can be posted to your accounting system.

• ACH, debit card, and credit card payments – Allowing customers to pay online or over the phone with an ACH payment, debit card, or credit card means not waiting for a check to arrive. An ACH (Automated Clearing House) payment is an electronic way to deduct funds directly from the customer’s checking account.

Factoring Factoring may be a cash flow management option for you if you want fast cash from your receivables. Let’s say you have $100,000 in outstanding invoices. The factoring company pays you 70-95% of that immediately and collects on those accounts. They will send you any cash they receive on those invoices above the amount they already paid to you. That cash is subject to a factoring fee that they will deduct from the cash they give you.

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Ways to Slow Down the Outflow of Cash Maybe the quickest way to summarize this next section is to take everything I said in the above section on how to speed up your receivables and to do the opposite when paying your bills. Let’s dive into a few more details.

Pay Your Bills as Late as Possible You can’t afford to take discounts when cash flow is a constraint. If your vendor’s invoice states “2% 10, Net 30” you’re going to schedule it for payment in 30 days. If you are currently flush with cash, take the discount.

Check the invoice or your contract with the vendor for when late payment fees start to be charged. Make the payment before the due date. Pay just before they assess a late fee. More sophisticated vendors may report your late payments to a business credit reporting bureau, so you want to be very cautious about paying your bills on time.

One of the lessons I learned early in my career as an accountant is not to pay the late fee on an invoice. Some vendors will write this off if you make your payment. Others don’t. You’ll soon learn who will charge it to you and who won’t.

Leasing Instead of Buying You can avoid the large amounts of cash needed for large purchases through leasing. You’ll want to work with your accountant or calculate for yourself whether leasing makes more sense than getting a bank loan.

Negotiate a Payment Plan If it looks like you won’t be able to make your full payment before the due date, you can call the vendor to work out a payment plan. The worst thing you can do when you aren’t following payment terms is not to communicate. Being honest with your vendors allows both of you to work together toward the best solution for everyone. Not communicating increases the odds that your vendor will see no choice but to take strong collections actions.

Make Hard Decisions I was the Board Chair of a regional nonprofit company that had a source of funding that was suddenly cut back. We had to lay off a third of that program’s staff. It’s not an easy decision to reduce compensation or lay people off, but sometimes, tough times call for tough decisions. There are a couple of ways to reduce the need to cut fixed expenses during hard times:

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• Build a company with scalable cash flows. A company that can survive anything is a company that can scale down its cash outflows when cash inflows drop. They usually do this by maximizing variable expenses rather than being locked into fixed expenses. Variable expenses rise and fall with sales or production volumes.

• Keep overhead low and efficiency high, even during good economic times. During good times, it’s easy to focus on growth and become lax on keeping expenses low. Those expenses slowly create cash leaks in the company that then must be fixed when cash is tight. They are always detracting from your profits, so continuously challenge them.

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Chapter 18: Managing Excess Cash “Just as a fisherman must watch the ebb and flow of the tides, an investor and businessperson must be keenly aware of the subtle shifts in cash flow.”

- Robert Kiyosaki

If you implement the strategies in this book, your cash balances may be increasing. Now you have a good dilemma: what to do with the excess cash. Leaving it in your checking account isn’t the best use for the cash. Let’s talk about some ways to put that cash to work for a higher yield.

Here are some options you have for that cash:

1. Pay down your existing debt. If you have a line of credit with an existing balance, this should usually be your first choice.

2. Transfer it to savings options at your bank or invest it in bonds, stocks, and other marketable securities.

3. Invest in operations. This includes buying fixed assets, giving bonuses to employees, or pre-purchasing inventory and supplies. You may use it to grow your company.

4. If you have no business opportunities for the cash, you can distribute it to owners.

We’ll go through each of these options in more detail. Before that, there’s one thing you should do before deciding what to do with your excess cash. You may be able to guess by now what I’m going to say. The first step is… run a cash flow projection.

Running a projection gives you a longer-term perspective of your cash needs. Use it to model the different options for using your excess cash. It helps you think through the cash options and their effects on your company.

Now let’s look in more detail at the four options for excess cash.

Paying Down Debt If you have outstanding revolving debt, paying it down is often your best option for excess cash. Revolving debt is debt that you can pay down and then make advances from later. Examples include credit cards and lines of credit. They usually have higher interest costs than your other short-term investment options.

Another option is to pay down your term debt. Term debt has scheduled payments for the paydown of the loan amount. For example, you may have loans for your equipment or real estate. This can be a good use of excess cash if the loans have high interest rates and you won’t need the cash in the future.

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My caution to you is don’t pay down term loans if you might be able to use the cash in the future. You don’t want to pay down the loan and then need to get a new loan again in the near future. One risk is that your finances may not be strong enough in the future to get a new loan.

You can manually pay down your lines of credit or you can set up automatic sweeps. Sweeps are nightly transfers from one bank account to another. You can set a minimum balance you want to be kept in your checking account. The rest is swept or transferred to another account. The excess balance in checking can be automatically swept to pay down your line of credit. You just set it and forget it to save money.

Another tip is to always monitor whether refinancing debt will save you money. You might get a lower rate if market rates are lower. Another reason you could get a lower interest rate is if your financial position has improved, so you’re less risky to the bank. Run the numbers even if your loan has a prepayment penalty. The interest savings may be more than the cost of the penalty.

Savings and Investment Cash sitting in your checking account is probably earning you nothing. Moving those funds to savings accounts or investments will increase your return on that cash, usually with very low risk. In today’s low-interest-rate environment, you won’t earn a lot, but it’s better than nothing.

My first tip is to consider another type of checking account. Analyzed accounts give you an earnings credit on your balances, which is like an interest rate that can only be used to offset your bank fees. Analyzed accounts are most beneficial if you have large balances with high banking fees.

Another option is to transfer money into a money market account or CD. A money market account is a savings account that usually has higher rates than regular savings accounts, especially for higher balances. Sometimes financial institutions have special savings accounts with high rates, so don’t forget to check all their savings accounts.

Certificates of deposit, or CDs for short, offer higher rates in exchange for you agreeing to keep your money invested in the CD for a fixed term. The term can be anywhere from three months to five years. You pay a penalty if you withdraw your money before the end of the term, which is called the maturity date. The penalty usually ranges from one month to one year of interest depending on the term of the CD, with longer-term CDs having higher penalties.

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Check out both banks and credit unions when looking at savings, money market, and CD rates. Credit unions often have higher rates than banks. It’s much easier to qualify today for the membership rules of credit unions, the deposits are insured like banks, and many credit unions provide business banking services. Another option is to check out online banks and credit unions.

You can also invest in the broader capital markets like mutual funds, ETFs, brokered CDS, and bonds. Mutual funds and ETFs are just pools of stocks, bonds, and other capital market investments. Their price, and your return, match the price changes and interest of the investments they hold.

Brokered CDs are similar to bank CDs, but you buy them through your investment advisor or brokerage firm. Unlike CDs you invest in directly from your bank or credit union, brokered CDs do not allow early withdrawal. You have to sell them like a bond. If rates have gone up since you bought the brokered CD, you will sell it at a loss. If rates have gone down, you can sell it at a gain.

Bonds are the debt of companies and government agencies that pay you interest. Check the risk that the issuer of the bond won’t be able to make the payment. High yields on a bond may signal high risk. Also, don’t buy bonds with terms longer than when you expect to need the money.

You can invest in stocks, but they are not appropriate for short-term investments. Generally, don’t invest in stocks for funds you need in five years or less. Finally, don’t invest in mutual funds or ETFs that hold investments that would be inappropriate for you. This is just some general education, and you should work with an investment advisor to decide what’s right for you.

You have a couple of broad options on where to go to make these investments. If you are comfortable and knowledgeable about these investments, you can make the purchases yourself through an online broker. If you want more advice and someone to make the trades for you, talk with an investment advisor.

Invest in Operations Using excess cash to purchase fixed assets like new equipment can be a smart investment, especially if your old equipment is outdated or worn out. You can also move to a new building or update your existing facilities. Maybe it’s time to buy your building instead of leasing it. Look into buying property now in good locations that you might want to build on in the future.

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Pre-purchasing inventory or supplies can sometimes get you a discount on them. This comes with storage costs, though, so don’t spend more on storage and obsolescence than you save in the discounts. Related to this is taking the discount on your invoices. Identify the vendors that offer discounts, like the “2% net 30” example I talked about in the accounts receivable section of this book.

A popular phrase is that your employees are your most valuable asset. If so, use that cash to invest in that asset. Be strategic on how you invest here. Raising everyone’s wages means increased costs and cash flow needs forever. It’s tough to cut wages in the future when you can’t keep that promise. If you are uncertain about future cash flows, pay a bonus instead. Another option is to make an extra donation to their retirement accounts.

Distributions to Owners Your first task with extra cash is to run a cash flow projection to estimate future cash needs. The problem is that your guesses about the future aren’t correct. To compensate for that unknown, you have to hold onto extra cash or be very confident that you can get the cash again if you need it. It’s more difficult for larger companies to do new rounds of capital raises. They have to be more cautious when distributing earnings to owners.

The line between the owners’ finances and the company’s finances is much more permeable in small companies. Cash moves frequently and easily from the company to the owners and vice versa. Small companies may have more flexibility to distribute to owners if the owners are liquid and stable enough to provide cash if the company needs it again.

Like the previous discussion about pay raises vs. bonuses, you may consider a special dividend rather than raising your dividend rate. Don’t create expectations of future cash distributions when your operations are just beginning to create cash or there is significant uncertainty about future cash flows.

A third option is for stock buybacks. Larger companies do this when they see the opportunity to reduce the dividend they pay on their outstanding shares. The dividend on the shares they repurchased goes right back to them. It can also allow them to maintain their stock price or benefit from increases in their stock price. Companies may use it to reduce the number of shareholders.

A reverse split allows companies to buy out smaller shareholders. Small companies may directly buy out a partner.

Some of these stock buybacks can improve the financial ratios of the company. Going back to our leverage example, you can increase leverage by increasing debt, but you can also decrease outstanding equity.

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Managing Cash Example Let’s apply what we’ve learned about managing cash flow to a sample company we looked at early in the book. This was their monthly cash roller coaster.

Here’s a list of a few ways they could smooth out their cash flows.

Low-Cash Months High-Cash Months • Line of credit • Owner cash infusion • CD/bond sale/maturity • Discounts for pre-orders • Increase trade credit terms

• Pay down lines of credit • Distribute to owners • Invest in CDs/bonds • Take discounts from suppliers • Purchase equipment

This is just a recap of things I’ve discussed earlier. Some of these just move cash flows from one period to the other. Some are used when the company has excess cash to invest. Some increase cash balances throughout the year. There are many other ways I discussed earlier that the company could increase its cash balances throughout the year.

They can make two very simple cash flow changes to help smooth out their cash: They borrow $20,000 in March when their cash is low and pay it off in May or June. Even better, they could have excess cash automatically swept to pay down the line as quickly as possible. Their cash never drops below $20,000, so the owner can sleep better. In July, when their cash is building, they invest in a 7-month CD. They can always withdraw the CD early for a small penalty if they need the cash late in the year.

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The blue line was their original cash flow. The green line is the cash flow after those two simple changes. These two changes would probably have little impact on net income. The earnings on the CD would pay for the interest costs of the line of credit.

I listed many ways the company could increase cash, increase profits, and smooth out its cash flow. All these small changes can lead to big improvements in cash flow.

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Chapter 19: Cash and Growth “So this is the goal: To make money by increasing net profit, while simultaneously increasing return on investment, and simultaneously increasing cash flow.”

- Eliyahu M. Goldratt

It’s ironic that many companies get into cash trouble when they are quickly growing and reaching for higher profits. I’ll explain why this happens. I’ll show you how to calculate your sustainable growth rate and give an example. That formula will bring back concepts from earlier chapters to show how to increase cash to increase your ability to grow.

Cash and the Growth Cycle

We’re reunited with our friend, the cash conversion cycle. It starts with step one of having cash to step four of paying cash and then returns back to step one with getting our cash back with a profit. Companies have a delay between the costs of production and collection on sales. Higher sales require more cash to cover the increased production costs until sales revenues are collected. Companies that don’t prepare for this literally die from lack of cash while reaching for the growth that could lead to increased profits.

Preparing for Growth Here are three steps to prepare for growth:

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1. I bet you can guess the first step: whenever making a big cash decision, you need a projection. You need to know how much cash the growth will take and when you will need that cash. That leads to the next two steps.

2. Get a line of credit, or make sure there’s room on your current line. Using this line may be part of your strategy. You may just have it in place if your cash needs exceed the cash you raised for the growth.

3. Start raising funds, also called capital, before growing. You’ll need to focus on operations when you’re in the middle of a growth phase. Now is the time to make sure you can get the funding needed for growth. Before you start growing, you want the cash in hand, not promises. Many companies have failed from promised funding that never materialized. Waiting to start growth after funding allows you to delay growth until you have the funds to survive the growth.

The Sustainable Growth Rate Next, let’s look at the sustainable growth rate formula. I’ll go through the formula, but what I really want you to focus on are the concepts behind the formula.

The sustainable sales growth formula calculates the amount you can grow without needing external equity capital.

The formula for it is: (net income/beginning equity) x (1–dividends as a percent of net income)

The formula I just gave is good for you if you want to grab numbers from the balance sheet and income statement to calculate your sustainable sales growth rate.

Let me simplify the formula a little to start walking us to the concepts. The first half of the formula was your net income divided by your beginning equity. This is your return on equity. The second half of the original formula was: 1 – your dividends as a percent of your income. This is called your earnings retention rate. So, a simplified version of the formula is your return on equity times your earnings retention rate. Let’s dig into that a little more with an example.

Sustainable Growth Example Let’s use an example company with $4 million of net income that distributed $1 million (for example, via dividends) to the owners.

Their dividend rate is the $1 million of dividends divided by $4 million of net income, which equals 25%.

If they had $4 million in earnings and distributed $1 million out to owners, then that leaves $3 million of earnings that was retained in the company.

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If you divide the $3 million of earnings retention amount by the $4 million of earnings, then the earnings retention rate is 75%. Remember, the earnings retention rate is: 1 – the dividend rate. The 75% earnings retention rate is the same as: 1 – the 25% dividend rate.

OK, enough fun with math. Let’s explore this visually. Think of your earnings as a pie where part of the pie gets distributed to owners as dividends, and the rest stays with the company.

In our example, 25% of the earnings was distributed, so that left 75% of the earnings in the company.

We can now calculate the sustainable growth rate for our sample company. As a recap, they have $4 million in income. They plan to dividend out $1 million, which is 25% of their income. We’ll assume they have $16 million in equity.

Their ROE is calculated as $4 million divided by $16 million, which is 25%. Their earnings retention rate is 75%.

The sustainable growth formula is ROE times the earnings retention rate. For them, that’s 25% times 75%, which equals 18.75% growth.

Implications for Growth If your head is spinning from the formulas, fear not. The importance of the formula is that it shows what you need to do to sustainably grow your company. That’s powerful.

Once again, the simple formula for the sustainable sales growth rate is your Return on Equity (ROE) times the earnings retention rate.

A paraphrase of that formula is: it’s what you earned times what you kept in the company. Now, let’s dig into those two parts.

Earnings Retention Rate

Dividend Rate

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What you earned is your return on equity. Your return on equity is your return on assets times your leverage. I won’t go through the formulas on this. Just trust me. Return on assets is your earnings divided by your assets. It measures your profitability and efficiency on your use of assets. It’s about your profit margin but it also is about the cash conversion cycle and all those related turnover ratios of how many times you can sell that inventory.

We also talked about leverage earlier. Leverage means financing your company with higher amounts of debt. The ROA times leverage formula says you can magnify your return on equity simply by increasing your leverage. We saw an example of that. We also saw the risk involved. A high ROA was magnified into a high ROE. If you have a loss (e.g., your ROA goes negative), then you have a massive negative ROE and may not have enough cash.

The second half of the formula paraphrase tells us that how much cash you keep in the company—that you don’t distribute to owners—greatly impacts your growth rate. When you pull money out of your company, you stunt its growth.

So the big numbers in the formula are your:

• ROA • Leverage • Dividend rate (distributions to owners)

There won’t be much disagreement from most companys’ owners that a higher ROA is better.

The two big business strategy decisions owners must make about growth is how much leverage they’re comfortable with and how much to distribute to owners. An owner with a high tolerance for risk will want more leverage than an owner who places a higher value on the safety and sustainability of the company. These two owners will have to negotiate a compromise.

An owner who needs a large amount of cash from the company to fund their lifestyle will clash with an owner who wants to focus the company on growth to build long-term value. Even a sole proprietor has to clarify their risk tolerances and personal financial needs to determine a sustainable growth rate for their company.

Of course, you always have an option to grow beyond the sustainable growth rate: raise more equity. But that involves selling off part of the company. It means less share of future earnings and at least a partial loss of control. For some owners, that’s not a price they’re willing to pay. For them, they are limited to the sustainable growth rate.

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Chapter 20: Surviving a Cash Crunch “There is really only one way to address cash flow crunches, and it’s planning so you can prevent them in advance.” - Elaine Pofeldt

Even if you use every tip in this book, you may still face a cash crunch where you don’t have enough cash to run your business in a normal way. This is a time for emergency cash management. If your business model has a fatal flaw, no amount of cash management techniques can save you. However, if this is just a short-term problem, the tips below can help you survive the crisis.

Buy All the Time You Can Time is precious when cash is low. You want to foresee the cash crunch as soon as possible. Then, use the tips in this guide to stretch out the time you need to use cash for as long as you can. It may mean incurring penalties or late fees on some payments to make other critical payments. Challenge every cash outflow to see if there is any way to delay payment.

Closely Monitor Your Cash Your low cash balances are a major source of stress. You may be tempted to ignore watching your cash to reduce this pain. That’s a major mistake that only makes the problem worse. During normal times, you can run cash flow projections as infrequently as once a quarter. If you are tight on cash, you may need to update your projection every week and calculate your cash flows for each week for the next month or three months.

Renegotiate Payment Terms You won’t be negotiating from a position of strength, but you may be able to negotiate for payments to be smaller or later. Be completely honest and show how reducing payments now may allow you to survive a short-term cash flow problem and increase the chances for full payment in the future.

Keep Communicating with Your Lenders When I worked at banks, one of the biggest mistakes made by borrowers who missed payments was not communicating. If you’ve missed payments, it’s clear to you and the lender that there is a problem. The lender wants to work with you to find a solution to get paid. That’s usually by working with you rather than working against you. Stopping communication leaves them no option but to assume the worst and begin legal collection and foreclosure procedures.

When All Else Fails (A Little Bit About Bankruptcy) Contemplating bankruptcy is a serious step that you should not do without first consulting a bankruptcy attorney. The legal structure of your company has a major impact on what assets are subject to creditors (people that you owe money) in bankruptcy. For example, the

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personal assets of sole proprietors and partners can be tapped to satisfy bankruptcy claims. Other structures, like corporations and limited liability companies (LLCs), can limit claims to only the assets of the company. This helps protect the personal assets of the owners.

If you are declaring personal bankruptcy, there are two main options:

• Chapter 7: Discharge of your debts • Chapter 13: Restructuring or partial payment of debts

Businesses also have two main options:

• Chapter 7: Liquidation of the business • Chapter 11: Reorganization of the business. Creditors vote on the plan.

I’m just listing a few key points about this. There are many details for which you need to consult an attorney. The main thing I want you to take away from this is that bankruptcy does not always mean the liquidation and end of your business. If you have a plan to reorganize your debts to the satisfaction of creditors, then the company may survive. Some owners wait until their company has dug a hole so deep that a Chapter 7 liquidation is the only option. Sometimes, it’s worth talking to a bankruptcy attorney earlier in your cash crisis to see if Chapter 11 is a possibility.

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Chapter 21: A Final Word on Cash Flow “In a truly great company profits and cash flow become like blood and water to a healthy body. They are absolutely essential for life but they are not the very point of life” - James C. Collins

This guide has shown you how to better manage your cash to increase your cash flow, increase your profits, and reduce your stress. You know your options and can face your finances with confidence. You have the tools to conquer cash flow.

When you are flush with cash, it’s easy to become lax or quit doing some of these good cash flow management practices. Keeping them in place will make sure you don’t lose any opportunities. It also may keep improving your cash flow to the point that you have new opportunities.

God bless, and I wish you and your company well.

Be sure to check out the CFO Perspective website at cfoperspective.com for free tools and insights for your business.

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Appendix A: Glossary Term Definition 2% 10, Net 30 2% discount on invoice if paid in 10 days, otherwise the

invoice amount is due in 30 days Accounts payable Amounts due but not paid to vendors. Accounts Receivable

Amounts due to you from customers for sales you made to them.

Accounts Receivable Aging Report

The accounts receivable report breaks the cash owed from your customers into buckets based on how many days past due they are.

Accrual basis accounting

In accrual basis accounting, revenues are recorded when earned and expenses are recorded when owed. In other words, items are recorded when a transaction takes place, not when cash exchanges. This creates receivables, payables, and other non-cash balance sheet items.

Advance Transferring money from your line of credit into your deposit account. More broadly, it’s whenever you borrow from a line of credit to receive cash or pay for an item.

Amortization The accounting practice of spreading a large amount, usually the cost of something, across many time periods. This is similar to depreciation, but amortization is used for intangible items.

Amortization Term The length of time it would take to pay the loan to zero at your loan payment amount.

Assets Things you own or have rights to. Examples include cash, inventory, and accounts receivable.

Available Balance Calculated as the commitment amount less any outstanding principal balance

Balloon Term The balloon term is when all remaining principal is due. Baseline scenario A starting projection scenario, often a most likely scenario,

that other scenarios are compared to. Call the loan Calling the loan means the lender can demand that the full

outstanding balance needs to be immediately paid in full. Capital Funding Capital expenditures

Large expenditures for items with long lives (e.g. buildings, equipment, or land). These are also called fixed assets.

Capital infusion Receipt of money from owners Cash basis accounting

In cash basis accounting, revenues are recorded when you receive cash from the sale and expenses are recorded when you pay money.

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Term Definition Cash conversion cycle

Time from cash payment for goods and services until receipt of cash from sales

Cash crunch Period of very low cash amounts Cash equivalents Short-term, highly liquid investments that are readily

convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value due to interest rates.

Cash flow The movement of cash in or out of the company’s cash accounts.

Collateral Company or personal assets pledged to the bank in exchange for a loan. If the borrower is unable to pay the loan, the lender can sell the collateral as payment on the loan.

Commitment Amount

The maximum amount that can be borrowed at any one time

Commitment Fee Fee for access to a line of credit. Cost of goods sold The cost of items (i.e. inventory) purchased or built for sale. Current assets and current liabilities

Assets that will be converted into cash within a year or liabilities that will be paid within a year

Current ratio Calculated as current assets divided by current liabilities Debt funding Funding obtained by borrowing funds that will need to be

repaid to the lenders/investors. Debt securities Borrowings that can be traded in securities markets.

Examples include bonds. Debt Service Coverage Ratio

Calculated as income divide by debt payments. The income number used is EBITDA, which is earnings before interest, taxes, depreciation, and amortization.

Depreciation The accounting practice of spreading a large amount, usually the cost of something, across many time periods. This is similar to amortization, but amortization is used for intangible items. Depreciation is usually done for large capital purchases (e.g. buildings or equipment)

Dilute ownership Reduce a current owner’s percentage share of company ownership.

Dividends Distributions paid regularly (e.g. quarterly) by a company to its owners.

Earnings retention rate

Percent of income that’s not distributed to owners

EBITDA Earnings before interest, taxes, depreciation, and amortization.

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Term Definition Equity Equity can mean a couple things. It can refer to the

accounting value of assets less liabilities (i.e. “owner’s equity”). It can also refer to the current value of something you own less any loans against that item.

Equity funding Equity is the money owners invest into the company for the rights of ownership.

Factoring Selling accounts receivable or purchase order commitments. The company gets immediate cash from the factor in exchange for a fee to the factor

FASB Acronym for the “Financial Accounting Standard Board” that makes U.S. financial accounting rules.

Fixed assets Items with long useful lives (e.g. buildings and equipment). Fixed rate A loan whose rates does not change during the term of the

loan. Floating rate A loan whose rate can change on a frequent basis (for

example, on a daily or monthly basis) Global In loan underwriting, this means the analysis or ratio

includes numbers from the business and any related owners or companies.

Gross The full amount of something before deducting related items.

Illiquid Not easily converted to cash. Income statement a.k.a. Profit and Loss Statement or “P&L” Index A rate that’s widely used in financial markets that the loan’s

interest rate is based off of. Involuntary bankruptcy

Creditors sometimes have the legal right to force a company to go through bankruptcy proceedings, rather than the owner or business choosing to do so.

Leverage Using borrowed money to magnify return on equity Liabilities Liabilities are things you owe, like payments to your

vendors or lenders Liquidity How easily assets can be converted into cash. Marketable securities

Investments easily traded on financial markets (i.e. bonds and stocks)

Merchant processor Companies that provide debit and credit card processing services

Merchant processor Company that provides services that allow businesses to accept credit card or electronic payments.

Mezzanine Financing

Mezzanine financing is a hybrid of debt and equity. Examples include preferred stock and convertible debt.

Net The difference between two numbers

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Term Definition Off-balance sheet liquidity

Cash from sources not listed on the balance sheet

On-balance sheet liquidity

Cash from assets on the balance sheet

OPM Acronym for “Other People’s Money.” The idea is to borrow other people’s money to increase assets and returns on equity.

P&I payments Loan payments that include both principal and interest amounts.

Payables Same as “Accounts Payable” above. Personal guarantees When a person pledges to pay business debts out of their

personal assets if the business isn’t making it’s loan payments.

Prepaid expenses A prepaid expense is recorded in accrual accounting when you pay cash for something before it should be recorded as an expense. For example, you pay your rent before the month that the rent is for.

Principal Amount of the loan. Sometime called the “balance” or “outstanding balance”

Purchase order A document sent from a buyer to a seller requesting to purchase goods or services. The form is also used by the buyer’s employees to process the authorization for the purchase.

Receivables Same as “Accounts Receivable” above. Repricing Term The repricing term is how frequently your loan rate

changes. Return on Assets (ROA)

Calculated as net income divided by assets

Return on Equity (ROE)

Calculated as net income divided by equity.

Revolving Line of Credit

A line of credit in which you can take multiple advances and make multiple payments.

Seasonal A pattern or occurrence that happens at the same time each year.

Seasonality A repeated cycle of rising and falling cash flow. Secured debt Debt in which collateral is pledged. Sensitivity testing The process of changing inputs or assumptions of a model

to measure the effects on the outcome or results of the model.

Sensitivity testing Entering different assumptions in a model to test how much they change the outcomes of the model.

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Term Definition Stock buyback When a company purchases its own stock. Stress testing Modeling scenarios of poor economic conditions Stress testing In financial modeling, when you model an adverse situation

and then identify ways to mitigate the negative impacts of the stress on company finances.

Sweeps Automatic transfers from one bank account to another Unsecured debt Debt in which no collateral is pledged. Variable rate A loans whose rates can change during the term of the

loan. Vendor Company or person that you buy things from. Working Capital Ratio

Same as the current ratio. See “Current Ratio”

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About Rob Stephens and CFO Perspective

Rob Stephens is the Founder of CFO Perspective. CFO Perspective provides financial consulting and education to small business owners so they can achieve their goals. He helps small business owners identify what they most value and then build strategies and processes to increase that by providing value to customers and employees.

Rob has a 20-year career that includes serving as CFO for two banks and a health clinic system. Additionally, he was also Director of Operations at a $4 billion bank and SVP of Finance of a $2 billion credit union, where he was also Program Manager of an investment advisory group with $170 million in assets under management.

Rob also teaches entrepreneurial finance and behavioral finance classes to MBA students at Gonzaga University.

Rob holds a Masters of Science in Personal Financial Planning and a Graduate Certificate in Financial Therapy from Kansas State University. He received a B.A. in Business Administration from the University of Washington and is a CPA.

For more information and free resources:

cfoperspective.com 509.202.4652