Last year a business owner came to me with an all-too-common problem. He said, “I’m profitable. My business is making so much money—why am I broke?” His financial statements looked good to him, and he couldn’t untangle why he kept running dry on cash while business was booming. Worse, he couldn’t figure out how to fix it.
To discover what was going on, I walked that business owner through a cash flow analysis, including all the steps I will outline for you here in these two articles. When we did that, we noticed that for every dollar he made in gross profit, he tied up even more in inventory. That meant that as his company grew, he kept getting poorer and poorer on a cash basis, at one point having to borrow money. That inventory was an asset on his balance sheet, but it was draining his cash.
Having identified that, next we untangled how to improve the velocity of his inventory so that he could change the cruel relationship between inventory and profitability. Today, his business is tremendously changed. He has significantly better cash flow as a result of truly understanding what’s going on.
I hear too many frustrated entrepreneurs say things like: “I’m struggling.” “This is so hard.” And worst of all: “I hate going to work because I’m working my ass off to grow this company, but I can’t seem to make any more money.” You don’t have to feel like this.
If you keep running out of cash in your expanding business, a cash flow analysis can help you discover where your cash weaknesses lie and identify key opportunities for improvement.
From there, you can build improved profitability and more effective goals for growth.
Phase One: Calibrate (Adjust the Numbers to See Beneath Them)
Cash flow analysis gives you a way to understand your business’s cash requirements and how cash changes relative to other factors in your income statement and balance sheet.
That will help you find out how fast you can grow your business, which are the more profitable steps to take, and what strategies you need to get there.
The first step is to remove specific items from your financial statements that can obscure the clues you are looking for. Make the following adjustments, and in the next article, I’ll show you how to read them.
Adjust the Income Statement
1. Remove financing expenses. One of the first things I do is I remove the impact of financing. If you have debt or interest expense or you’re paying an earn-out to a prior shareholder over a period of years, that expense doesn’t reflect how you’re operating the business. Back those non-operating expenses out of the analysis.
2. Take out truly one-time capital investments. You might make capital investments all the time. Maybe you’re always buying equipment, and we do want to include that. But remove anything like a singular fixed asset or an expensive tool that you’re not ever going to buy again, for example, a really sophisticated advanced website. The thing where once it’s built you’re maintaining it at a very small cost, but that $50,000 or $100,000 investment really set the foundation for your business. That’s not operations-based because you’re not going to repeat that in the normal course of business.
3. Remove off-market payments to owners. Some owners pay themselves above market, but if you were to hire someone to do your job, you would pay a market rate. A general manager, for instance, might cost $150,000 while you are paying yourself $300,000. So to see the operating cash flow, adjust your salary to the market rate. To get apples to apples, we should also do this on a tax-effected basis, including all the payroll tax associated with it, distributions and the like.
This step also applies if you’re not paying yourself anything. You want to put market salaries in there to know what the business operations would look like if you had to pay for somebody to do your job.
4. Remove non-operational singular events. Let’s say you had a lot of legal expenses related to a lawsuit last year, or an IP filing costs or regulatory costs—those are one-time, nonrecurring events. You want to remove those costs from your historical financials to figure out how your company goes forward.
Adjust the Balance Sheet
1. Establish your balance sheet assumptions. With all the P&L done, now let’s look at the balance sheet and ask, “How do your accounts receivable move as your revenue grows? What’s the model for your accounts payable balances at the end of every month with increases in your cost of revenue, your cost of goods sold, as well as the operating expenses of the business?” Identify those relationships.
2. Examine changes in inventory. For many companies, inventory will grow in lockstep with revenue. But some companies will find that inventory grows by some multiple of revenue, like in our initial example. If that’s happening, you have to account for needing increasing amounts of inventory on hand as you add distribution outlets (for example). There’s often a function there that you need to understand.
3. Other balance sheet items that drive the use of cash. For some businesses, other factors will become important. One example is prepaids. You want to look at making sure that you drive those assumptions effectively so you know exactly what’s going to happen with cash flow as the business grows.
In Phase One: Calibration, we have gotten the P&L and the balance sheet lined up so you can figure out what’s going on with cash and how cash is being generated by the business. Building a strong cash flow model can help you find the light at the end of the tunnel and drive towards it. You might discover, for instance, that if you push to a certain level of revenue or sales, profitability jumps upward. Since cash begets cash, making that shift starts the snowball building and accumulating.
To better illustrate, I’ve created a mini-model of a cash flow model here that illustrates an example of a high growth and profitable company that’s just struggling to have positive cash flow. There are likely a few levers that would positively impact the company’s cash flow.
In Part 2 of this article, I will explain how to use the statements you created in Phase 1 to uncover the path to improved profitability.