17 Why Cash Matters

Of course, by now you may be saying to yourself, “So what? All this is cumbersome to figure out, and do I really need it?”

For starters, let’s see what our sample company’s cash flow statement reveals (that is, the cash flow statement for the imaginary company whose financials appear in the previous chapter and in appendix A). In terms of operations, it is certainly doing a good job of generating cash. Operating cash flow is considerably higher than net income. Inventory declined, so it’s reasonable to suppose that the company is tightening up its operations. All this makes for a stronger cash position.

We can also see, however, that there is not a lot of new investment going on. Depreciation outweighed new investment, which makes us wonder whether management believes that the company has much of a future. Meanwhile, it is paying its shareholders a healthy dividend, which may suggest that they value it more for its current cash-generating abilities than for its future. (Many growing companies don’t pay large dividends because they retain the earnings to invest in the business. Many, indeed, pay no dividends at all.) Of course, these are all suppositions; to really know the truth, you’d have to know a lot more about the company, what business it’s in, and so on—the big-picture part of financial intelligence. But if you did know all those things, the cash flow statement would be extraordinarily revealing.

That brings us to your own company’s cash flow. As an entrepreneur, you probably look at the check register every week or every month (or maybe every day, if that seat of your pants is getting thin). But here’s why we said before that you need to understand the cash flow statement as well.

THE POWER OF UNDERSTANDING CASH FLOW

First, knowing your company’s cash situation in detail will tell you not just whether the overall cash position is healthy but specifically where the cash is coming from. Is it from operations? That’s a good thing—it means the business is generating cash. Is investing cash flow a sizable negative number? If it isn’t, it may mean you aren’t investing in the business—maybe not as much as your competitors or as much as your company needs for growth. To be sure, you probably know the needs of your business and what is going on in terms of capital expenditures, but watching the trend gives you an indication of where you have been and where you seem to be going. And what about financing cash flow? That category helps you track your indebtedness, and of course it reflects any stock transactions (such as selling shares to an outside investor) you may decide on. Looking at the cash flow statement tells you where your checkbook balance is coming from and which parts of your cash flow may need attention.

Second, you can do things to better your cash position. Consider, for example, a few of the things you can do to improve operating cash flow:

Accounts receivable. Are you selling to customers who pay their bills on time? Do your salespeople, or you, have a close enough relationship with your customers to talk with them about payment terms? Do the people who answer the phone offer customers the kind of service that will encourage them to pay their bills on time? Is the product free of defects? Are the invoices accurate? Do the invoices go out on a timely basis? All these factors help determine how customers feel about your company and indirectly influence how fast they are likely to pay their bills. Disgruntled customers are not known for prompt payments—they like to wait until any dispute is resolved.
Inventory. If you run a manufacturing company, do your engineers request special products all the time? If they do, they may be creating an inventory nightmare. If your operations people like to have lots in stock, just in case, they may be creating a situation in which cash is just sitting on the shelves, when it could be used for something else. Company owners and manufacturing managers can often reduce inventory hugely by studying and applying the principles of lean enterprise. Though lean techniques were pioneered at Toyota, plenty of small companies have learned to apply them effectively.
Expenses. Do you defer expenses when you can? Do you consider the timing of cash flow when making purchases? Obviously, we’re not saying it’s always wise to defer expenses; it’s just wise to understand what the cash impact will be when you do decide to spend money and to take that into account.
Giving credit. Do you give credit to potential customers too easily? Alternatively, do you withhold credit when you should give it? Both decisions affect the company’s cash flow and sales, which is why you and your credit manager or sales reps always have to strike a careful balance.

The list goes on. Maybe your plant manager is always recommending buying more equipment, just in case the orders come in. Perhaps whoever runs your IT system feels that the company always needs the latest upgrades. You have to respond to such requests, and every one will affect cash flow.

Third, entrepreneurs who understand cash flow tend to make better decisions day in and day out than those who focus purely on the income statement. In the following part, for instance, you’ll learn to calculate ratios such as days sales outstanding, which is a key measure of a company’s efficiency in collecting receivables. The faster receivables are collected, the better your company’s cash position.

But our general point here is that cash flow is a key indicator of your company’s financial health, along with profitability and shareholders’ equity. It’s the final link in the triad, and you need all three to assess how you are doing. It’s also the final link in the first level of financial intelligence. You now have a good understanding of all three financial statements, so it’s time to move on to the next level—to put that information to work.

Do you want to try reading and analyzing a cash flow statement? If you do—and we promise it is pretty straightforward—please turn to the cash flow statement exercise in appendix B.