week 3

hapter 5 Cash Flow Management

Learning Objectives

· To understand the meaning of working capital

· To understand the different types of cash flow

· To understand the cash flow cycle

· To learn strategies for improving cash flow management

Case: De Werks, S.A.

It was Friday afternoon, and the staff were about to leave early for the weekend. Carlos was sitting in the same office as Roberto, CEO and founder of De Werks, S.A. De Werks is a company founded in 2004 and headquartered in northern Italy. The company had become the largest advertising portal for jobs in the country and had expanded its operations to Serbia, Bosnia, and Herzegovina. The numbers posted on the wall of its office looked good. The company had exceeded its sales projection by a large amount, and there was a feeling of well-earned success among its sales team. For the company's staff, it felt almost as if the stress associated with its startup phase was finally over. Now everyone believed the company was heading toward better times.

As Carlos and Roberto were discussing their plans for the weekend, the venture's accountant entered the office with a confused look and a pile of papers in her hands. The topic of her report involved cash, and the essence of her report was decidedly bad news. After 20 minutes of lively conversation, she left the room with a concerned expression on her face. Roberto kept looking at the papers, confused and shocked at the same time. Finally, Carlos and Roberto looked at each other and exclaimed, “We are out of cash.” All of this despite the fact that for the last 2 months, the sales figures were terrific, at least on paper. “We have no cash to pay salaries next week,” Roberto said. “How will we do it?” asked Carlos. The company indeed was doing well in terms of revenues, but clients were not paying on time, and their delays were affecting the company's cash flow. By focusing its efforts on increasing revenues, management had forgotten that cash flow is the blood that runs through a company's veins. When Roberto sent out a companywide e-mail message explaining what was going on and asking for a delay in paying salaries, employees were far from understanding. Employees could not understand why their wages were postponed to an undefined future date when the company seemed to be doing so well.

If “cash is king,” cash flow is the blood that keeps the heart of a king beating. The proper management of cash flow is one of the most critical components of success for entrepreneurial ventures. Without cash, an entrepreneur will not be able to pay suppliers, bills, salaries, or even taxes. In fact, a profitable business on paper can end up in bankruptcy if the cash coming in does not exceed the cash going out of the venture. In this chapter, we will explain the importance of cash flow management and how managers and entrepreneurs can prevent cash flow issues as well as creative ways to collect accounts receivable and delay account payables.  Chart 5.1  presents a schematic representation of the material covered in this chapter.

Chart 5.1 Schematic of  Chapter 5

Working Capital

How does a venture generate income? If the venture manufactures a product, it uses funds to purchase inventory, transform the inventory into products, and then convert those goods through sales into cash or accounts receivable. Each component mentioned is a current asset (i.e., cash, accounts receivable, inventory, or marketable securities) if it can be converted into cash within 1 year through the normal operation of the venture. Conversely, current liabilities (i.e., accounts payable, salaries, utilities) are obligations due during the same relative period of time.

Working capital is the difference between current assets and current liabilities. It defines a venture's solvency as well as its capacity to make large purchases and take advantage of bulk discounts, as well as its ability to attract customers by offering credit terms. The working capital can be either positive or negative. Having a positive working capital balance means that the assets of the venture are more than enough to cover liabilities that are due soon. Having a negative working capital means the venture runs the risk of being unable to pay its upcoming bills with the cash, collectible receivables, or other liquid assets that can be turned into cash within a short period of time. Without these current assets, the firm will be forced to borrow cash or solicit new equity investments.

The difference between working capital and cash flow is that working capital is a balance concept explained by the relationship between current assets and current liabilities, while cash flow measures the venture's ability to generate cash over a certain period of time via its operations, investing, and financing activities. We will now explore certain aspects essential to the proper management of a venture's cash flow management.

Cash Flow from Operations

Cash flow from operations, in its most basic form, is a movement of funds in and out of a venture that originates with the firm's creation of its goods or services. There are also two types of cash flows: positive and negative cash flow.

Positive operating cash flow occurs when the cash entering the venture (e.g., sales, accounts receivable) exceeds the amount of the cash leaving the venture (e.g., cost of goods sold, salaries, accounts payable, etc.).

Negative operating cash flow is the opposite and occurs when the outflow of cash exceeds incoming cash. Negative cash flow should be closely monitored, and solutions must be found to keep the company running. For every dollar of negative operating cash flow, the company must find a dollar of debt or a dollar of equity.

In accounting literature, operational cash flow is often referred to in a shorthanded manner as earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA represents the money available to face the venture's expenses ranging from buying inventory to paying taxes, as calculated in Method 1.

Method 1

Adding noncash expenses (i.e., depreciation and amortization) back to operating profit allows entrepreneurs and investors to generate an approximate picture of the cash flow of the venture. While both depreciation and amortization are considered costs for tax purposes, they are noncash expenses, and thus no money is flowing out of the venture.

To estimate precisely free cash flow (cash flow available in excess of the venture's and equity owners’ immediate needs), we can extend Method 1 by subtracting the net result of the firm's capital expenditures (i.e., the purchase of new capital equipment minus the sale of old capital equipment) and subtracting any dividends to shareholders and adding or subtracting the changes in working capital (see Method 2).

Method 2

As useful as these two estimates of cash flow are, we should remember that cash available is time sensitive. Cash available at any point in time will vary based on when accounts receivable are collected and when expenses are paid. When we project cash flow for valuation purposes, we do not need to adjust for timing because it averages out over the longer time frame of the valuation model. Thus, we can use Model 1 (EBITDA) or Model 2 (Estimated Free Cash Flow) as a proxy in this context. However, when we are interested in forecasting available cash to estimate future short-term or cumulative long-term capital needs, we should make an attempt to adjust for the timing of both accounts receivable collection and expense payments. Only after accounting for the lag in collecting accounts receivable and the lag in paying accounts payable is the system as accurate as possible.

Some entrepreneurs still mistake profits for cash flow. Knowing if a venture made a profit or a loss is not the same as knowing what is happening to its cash. While profit is a result of our accounting practices (revenues minus expenses), invoicing a customer for a product or service creates revenues but not necessarily cash inflow. The money inflow happens only once the money is collected from the customer. There are countless stories of entrepreneurs who reach a high level of sales and consequent revenues but do not have the cash to finance daily activities of the venture, which is exactly what was happening in De Werks. Maintaining optimal and necessary available cash is one of the key jobs of management. To succeed, entrepreneurs must establish control systems capable of monitoring and managing cash receipts and payables in a predictable and useful manner.

For a practical example of the difference between profitability and cash flows, consider the former New York Stock Exchange–traded company Lehman Brothers Holdings, Inc. At the end of 2007, Lehman Brothers Holdings was the fourth-largest investment bank in the United States with more than 25,000 employees worldwide (Humer, 2012). In March 2008, Lehman Brothers announced quarterly profits of $489 million. In September 2008, only 6 months later, the firm was filing for bankruptcy. Despite 4 repeated years of record-breaking profits, the firm ran out of cash to support its operations and to fulfill its obligations to creditors. It had no choice but to file for bankruptcy. This case clearly demonstrates how a blind focus on revenue and profits may lead a venture to fail. Entrepreneurs must understand their cash flow needs. They must be able to predict how much cash the venture will have each month and where the cash will come from, where it will go, and what internal or external factors could affect cash flow. Cash flow forecasts allow entrepreneurs to define their financing needs and create contingency plans. Understanding cash flow projections will also help entrepreneurs make better decisions when opportunities arise. It could be an unexpected opportunity to acquire a competitor, purchase new equipment, or face an unexpected large order from a new customer. If the management team understands various input variables affecting their cash flow, the chances of making a wrong decision are significantly reduced.

Cash Flow Cycle

The cash flow cycle describes the various activities undertaken by a venture to produce cash inflow. It reveals how a venture transforms cash today into cash in the future. The ultimate goal is converting as little cash today into the largest cash payoff possible in the future. The cash flow cycle in  Figure 5.1  gives a simplified overview of the process.

It starts as cash that comes from either equity investment (from entrepreneurs themselves or from other sources) or debt (from investors, banks, and other debt sources). As the venture undertakes its activities to produce goods or services, it has to acquire various key resources (ranging from raw materials to a qualified labor force). Resources are then transformed into finished products, which are sold on a cash and/or credit basis. The distinction between payments in cash or in credit is very important. Just because accountants recognize income once an invoice is generated does not mean that the invoice was paid and cash was received. Sales made on credit generate accounts receivable, not cash. Entrepreneurs need to be aware of the difference between accounting for income and accounting for cash flow. Once the cash is effectively received, it is used to pay creditors, taxes, dividends (or other forms of reward to investors), or simply reinvested within the company.

The goal of good cash management is evident: have cash when the venture needs it. While conceptually easy to understand, it is a challenging task even for experienced financial managers. The magic behind cash flow management is timing. On one side, venture owners will want to receive payments from their customers as soon as possible. On the other, they will want to pay their suppliers and vendors as late as they can. The following sections expand on this process and provide more detailed information on how to improve cash flow management.

Accounts Receivable

Whenever we go to a grocery store to buy bread, we get the bread and then go to the cashier to pay for it. It is a simple transaction where money is exchanged for a product. However, in the business world, ventures are usually willing to sell their products on credit. By allowing customers to pay on credit, ventures are able on one side to boost their revenues and on the other open themselves to the possibility of not receiving the cash when the invoice amount becomes due. Two distinct things occur:

Figure 5.1 Cash Flow or Working Capital Cycle of a Company

1. There is an increase in credit sales.

2. This leads to an increase in accounts receivable from customers.

If the customer does not pay the amount he or she owes, a credit loss expense will be registered in the income statement, and the accounts receivable on the balance sheet will be adjusted downward.

The asset accounts receivable represents the cash owed to the venture by customers for goods and/or services that have been sold to them but not yet paid for. As entrepreneurs usually focus most of their efforts on generating sales, they end up giving little attention to customers who have not paid. Progressively, accumulation of accounts receivable from credit customers can ultimately lead to a serious cash shortage. We recommend entrepreneurs pay special attention to accounts receivable and not be afraid to confront their clients when payment is due. If the entrepreneur is not comfortable taking care of the issue, someone else needs to take care of this task. Under no circumstance should an entrepreneur ignore cases of outstanding accounts receivable.

Below is a series of strategies that will help entrepreneurs maximize their chances of receiving their payments on time and minimize losses:

1. Research the Potential Customer. When a venture grants credit to a customer, it is essentially loaning its own money without any guarantee that money will be repaid. Therefore, entrepreneurs should research their customers’ creditworthiness before extending credit. The process can be as simple as making a phone call to the client's bank, or it can involve a more thorough investigation. One option is to have the customer fill out a basic application for credit. Standard forms are available on the Internet and require information such as the names of the principals of the business, the business address, contact information, and so on. If a customer hesitates to give you this information, it usually means he or she has bad credit (Dahl, 2010). You should also ask how long the company has been in business, who its major clients and suppliers are, and what its payment terms are. Calling suppliers is also a good option. In addition, searching online for clues that may indicate a company has or is facing financial issues or is involved in lawsuits is also recommended.

Traditional credit analysis involves three basic elements of assessment: capacity, collateral, and character.

1. Capacity refers to the ability of the venture to pay on a timely basis.

2. Collateral refers to the assets that can be pledged to guarantee payment.

3. Character refers to the basic character traits of the entrepreneur(s).

The extent of research on the credit-seeking customer needs to be adequate to resolve these key issues. Many professional firms specialize in doing credit and background checks on both individuals and firms, or you can use a company like Dun & Bradstreet yourself to check the credit rating and payment history of potential customers (Dahl, 2010).

If after the research the conclusion is that the client is worth the risk, the entrepreneur should discuss and establish the payment schedule with the client. If the customer does not meet your criteria, we recommend you either request 100% payment before or at the time of delivery or an upfront payment that covers the order's costs of goods sold (COGS) with the balance of the invoice due upon delivery.

2. Invoice Promptly. Send invoices to customers as soon as the goods or services are shipped or delivered. Do not wait or postpone this important task. Making sure customers receive the invoice quickly will hopefully lead to faster payment.

3. Take Action With Respect to Customers That Have Outstanding Balances on Their Accounts. In the event a customer does not pay within the time frame established, entrepreneurs should not delay taking action. There should be a regular procedure the venture follows to deal with slow-paying customers. The important thing is to take immediate action. If no action is taken, it gives a message to customers that they are allowed to delay their payments past the due date without consequences.

4. Credit Limits. Establish an appropriate credit limit for each customer. If a customer exceeds his or her credit limit, management may request partial or full payment up front in cash or ask for some form of collateral.

5. Offer Discounts. Entrepreneurs may offer customers a discount on the amount of the order if it is paid within a certain time frame.

Collection of Past due Accounts Receivable

Collecting outstanding balances from customers can be an intimidating experience for entrepreneurs. As a result, third-party companies offer “trade credit insurance,” where the insurance company assumes the responsibility for collection.

In severe cases, entrepreneurs may have to hire a lawyer. While this action may be effective in the United States, it may not work as well in other parts of the world. As a result, ventures may have to use collection agencies, as they may be faster than courts in resolving these types of issues. One of the most original collection agencies is the Madrid-based company El Cobrador del Frac (EL COFRAC) ( www.elcobradordelfrac.com ) (Abend, 2009). This enterprise specializes in debt collection by having its employees, dressed in old-fashioned, black frock coats and top hats carrying a suitcase saying in big letters “DEBT COLLECTOR,” follow debtors everywhere they go, including restaurants, stores, and clients’ premises. What happened to a couple who decided to not pay their $83,000 wedding bill to a wedding company indicates the effectiveness of this company (Harman, 2010). EL COFRAC asked the unsatisfied wedding company for the list of people who attended the wedding and started phoning the attendees one at a time. Upon confirmation of their presence at the wedding, EL COFRAC asked them if they had the lobster or the chicken as the main course, following with a request for their address where they could mail the bill. The money eventually was collected, and the collection agency is in high demand, given its outstanding success rate and has expanded its services to the neighboring countries of Portugal and France.

Days Sales Outstanding (DSO) Ratio

The days sales outstanding (DSO) ratio is used to assess the average number of days a venture takes to collect its receivables after they have been invoiced. This ratio provides information about how efficient the venture is at collecting payments from its customers:

In a strictly cash business, the DSO will be zero. However, most ventures do give customers credit terms, which generate accounts receivable. A low DSO ratio means the venture takes a relatively short time to collect accounts receivable. Too low a ratio may indicate that the venture's credit policy is too rigorous, which may be limiting its revenue potential. A high DSO reveals whether the venture's customer base has credit issues and/or the venture has a deficient debt collection system. The average DSO will vary from one industry to another and will vary based on whether the venture has only domestic customers or also sells internationally.

Let us consider the following scenario: a venture that started in January 2012 with $50,000 in accounts receivable (represents unpaid invoices from the last year or even earlier) and had invoiced sales of $900,000 by the end of the year 2012 on 30-day payment terms. This leaves the company with “credit sales” for 2012 of $900,000. Throughout 2012, the venture got payments on invoiced bills of $800,000. Thus, the accounts receivable at the end of 2012 amounted to $50,000 that were initially in the account, plus $900,000 of new invoiced sales, minus $800,000 that were paid during the period. It does not matter if the payments were made for invoices sent out during 2012 or before; all that matters is the final balance of accounts receivable at the end of the period. The accounts receivable at the end of 2012 was $150,000. The DSO for the period considered (365 days) is $150,000/$900,000 × 365 = 60.83.

This means that on average, it takes this venture approximately 61 days to convert accounts receivable into cash. Customers are paying an average 30 days later than they should since the venture's payment terms are 30 days. The venture is wasting capital that could be reinvested within the company or used to reduce debt or return to shareholders. Collection inefficiencies are often overlooked by entrepreneurs who do not understand how to measure the cost of delayed payments from customers. Below is a formula that quantifies the benefit of faster collection in terms of dollars saved (Fraser, 2000). Faster collection means the venture will rely less on its own credit line or its shareholder equity while waiting for customers to pay their invoices.

To find “Days Saved” in the equation above, simply subtract the venture's improved DSO from its original DSO.

For example, a venture with gross annual invoiced sales of $10 million, borrowing at a rate of 6%, which improves its DSO by 7 days, will save more than $11,000 a year.

Accounts Payable

The best scenario in cash flow management is to collect receivables as fast as possible and pay outstanding bills as late as possible while keeping a good relationship with your customers and suppliers. There often are advantages associated with paying outstanding bills early. If a supplier is willing to provide a discount if the invoice is paid within 10 days instead of the regular 30 days, it might be worth doing this.

As an example, suppose a supplier offers a 2% discount if paid within 10 days (otherwise the payment should be made within 30 days). Here is the formula to use:

In this case, a 2% discount for paying within 10 days (20 days earlier) would represent the following annual interest rate saving:

In this case, it is probably even worthwhile borrowing money to take advantage of the discount offered by the supplier.

The average number of days a venture takes to pay its bills, known as the days payable outstanding (DPO), can be measured with a procedure similar to the accounts receivable.

Some traditional accounting and finance books calculate this ratio differently by replacing the “annual cumulative accounts payable incurred” by annual total cost of goods sold (COGS). We agree with this procedure as long as all costs (both those paid in cash and on account) are included. A small entrepreneur, especially in less developed parts of the world, may incur some COGS that are not invoiced as they are required to be paid in cash. Again, this ratio can be high or low depending on the type of industry and whether a firm is dealing with international suppliers.

For entrepreneurs seeking to improve their accounts payable, there are several recommendations:

1. Negotiate longer payment terms with your suppliers, justified by the volume purchased and/or the trust built over time.

2. Request that your suppliers invoice you only upon your receipt of the product (especially with international suppliers).

3. Set priorities. Pay the bills that incur an obligatory interest charge or that extend a discount first.

4. Invest in a good accounting system to organize bills, payments, and warning alerts.

5. Test suppliers by delaying payments. They may have set a 30-day payment simply as a standard but may not mind if they receive payments within 50 days.

6. Study the local culture and offer payment terms that are in line with the local conditions.

Summary

Working capital is the difference between current assets and current liabilities. Positive working capital implies that the venture can pay upcoming liabilities without increasing debt or adding to shareholder equity, while negative working capital signals upcoming difficulties for the venture.

The main differences between working capital and cash flow were also discussed. Working capital has to do with the way management controls the magnitude of its current assets and current liabilities. Cash flow has to do with the amount of cash the firm has after it collects its revenues and pays its bills. When measuring cash flow, the manager must control for the existence of non-cash items like depreciation, as well as cash outlays that are not part of the firm's cost structure, dividends, capital expenditures, and principal payments of loan balances or amortization of intellectual property.

In this chapter, we described working capital is a financial metric to measure the operating liquidity of a venture; as such, it is most germane to the credit worthiness of the venture and represents an indication regarding the ability of management to control the relationship between current assets and current liabilities. Also in this chapter, we described cash flow as the ability of a venture to generate spendable cash from its operations. Again management's ability is measured; the ability to generate cash flow is a measurement with respect to (1) how well management collects the firm's revenues, (2) how well management controls the firm's expenses payments, and (3) how well management plans out the firm's capital budget and dividend payment policy.

An important point that was emphasized in this chapter is the difference between profits and cash flow. Profits are revenues minus expenses computed under an appropriate accounting convention, while cash inflow only occurs once the cash is collected from the customer and appropriate expenses are deducted and paid.

The cash flow cycle is the process through which the firm transforms initial revenues into cash that can be used in operations. How well management manages the cash flow cycle represents a key metric with respect to management's job performance.