Newt Gingrich learns about managing cash flow the hard way

Running a political campaign can be a lot like starting up a business.  Things change quickly, and you really have to keep an eagle eye on the cash flow.

Yesterday’s Washington Post (10/30/2011) had a page 1 article about Newt’s improving fortunes in the presidential race.  (Newt Gingrich: GOP’s consummate survivor is back on his feet)

Alluding to his difficulties in late spring / early summer there is a delicious quote:

He said he hadn’t grasped the full extent of his campaign’s precariousness, which still included more than $1 million in debt in his third-quarter filing, because “I was looking at cash on hand and didn’t realize they weren’t paying the bills.”

 

Ignore your complete financial statements at your own peril!  Also, one more reason to do Cash Flow Projections.

 

 

What is Cash Flow?

According to Wikipedia,

Cash flow is the movement of cash into or out of a business, project, or financial product.

Cash Flow

The trouble is that you run into all sorts of qualifiers and distractions.  There is Net Cash Flow, Free Cash Flow, Discounted Cash Flow, Pre-tax Cash Flow, After-tax Cash Flow, Cash In-Flows, Cash Out-Flows, etc., etc.

I’ll focus today’s article on Net Cash Flow as it applies to a business, and specifically, a small business.  I’ll use the terms Cash Flow and Net Cash Flow interchangeably.  Also, cash is defined to be bank deposits in addition to currency.  Stuff you can spend right away if you need to.

Small Business Cash Flow

Is it the same as profits?  No!  But profits certainly are one component of cash flow.

Is it the same as cash?  No!  It is the movement of cash during a defined time period, not the same as the cash balance at the end of a time period.

Is it a term everyone agrees on?  No!  Otherwise you wouldn’t be asking the question!  I’ll give you the common sense definition:

“Net Cash Flow” = “Cash Inflows” – “Cash Outflows”

But you really have to dig down deeper  if you want to understand it, and control it.  It’s just like your cholesterol levels.  There is good cash flow, and bad cash flow.  You want more of the good, and less of the bad.  So it helps to know which is which.

Why is Cash Flow important?  It is the lifeblood of a small company, and the central focus of value for a profit making entity of any size.  If you run out of cash, you go out of business.  The stakes are huge.  And it is not easy to manage, especially as you grow.  There is a tendency to try to get by on the bare minimum of capital as a way of preserving equity and control for the founder or owner.

Back to the central question: what is cash flow?

I’d have to agree with Wikipedia: Cash flow is the movement of cash into or out of a business. 

If during a month you collect $100 from customers and pay $80 to vendors, you can be said to have “Net Cash Flow” of $20 for the month.  Your “Cash Inflows” were $100 and your “Cash Outflows” were $80.

When people use the term “Cash Flow” they often mean “Net Cash Flow” but sometimes they mean “Cash Inflows”  – so you have to be aware of the context and the person using the term.

Since “Net Cash Flow” is the net amount of cash coming in (or going out) for a time period, you can use it to determine what your cash balance should be:

“Ending Cash Balance” = “Beginning Cash Balance” + “Net Cash Flow”

Remembering your algebra, you can re-arrange the formula and calculate “Net Cash Flow” based on knowing the beginning and ending cash balance:

“Net Cash Flow” = “Ending Cash Balance” – “Beginning Cash Balance”

So another way of defining Cash Flow  is to say that it is the change in cash from one time period to the next.

Components of Cash Flow

The accounting profession and the Securities and Exchange Commisssion (SEC) have rules about how to calculate and present cash flow.  (As you can imagine, “Net Cash Flow” alone does not give you a lot of insight into how a business is doing).

You can look at a 66 page PDF file with the guidelines to follow: Statement of Financial Accounting Standards No. 95 – Satements of Cash Flow.

If I may be so bold as to summarize, you are supposed to classify cash receipts and payments according to whether they stem from operating, financing, or investing activities.  Rather than making detailed lists of receipts and payments, you can calculate many of the sub-components of cash flow by looking at the balance sheet for two consecutive time periods, and subtracting one from the other.  This is how a financial model generates a complete cash flow statement using the Income Statement and Balance Sheet for several time periods as input.

Operating Cash Flow

Cash Flow from Operating Activities is primarily Operating Profit and changes in Working Capital.  In general, cash flow from operating activities is a GOOD THING, especially from Operating Profits.  Profits are GOOD.  Losses are BAD.

Changes in working capital can go either way.  Less cash tied up in Inventory might be a good thing (and a positive Cash Flow).  Or it could be a company desperate for cash, and unable to pay vendors on time, who are less willing to ship without cash up front.  An increase in Payables, while recorded as a positive cash flow is not necessarily a good thing.  It could be a sign that you are getting behind in your bills.  Or it could be part of a deliberate strategy to free up cash – it which case in increase would be a Good Thing.  How about changes in Accounts Receivable?  A reduction in your Accounts Receivable balance comes in as positive cash flow.  It could be because you are collecting your receviables more aggressively.  Or it could be you just had a lousy Sales month.

How to increase Operating Cash Flow:

Increase Operating Profits (get better gross margins, control expenses better, make more sales)

Decrease your Inventory Balance

Decrease your Accounts Receivable Balance (because customers send you money)

Increase your Accounts Payable Balance (take longer to pay vendors)

Not all of these are necessarily feasible or desirable to do.  As with any financial decision, I recommend you look at a financial model of the enterprise as a whole – to make sure you’re not just playing “whack-a-mole” with cash.

HINT:  Explore the use of Deferred Revenue to finance your business.  An Increase in Deferred Revenue is a Positive Cash Flow.  Deferred Revenue occurs when customers pay you in advance of receiving a product or service.  Annual Software Maintenance falls into this category, as do Subscriptions paid up front, or other similar payment arrangements.

Cash Flow from Financing Activities

Financing Activities refer to debt and equity.  Borrowing money, repaying debt, and paying the interest on the debt are all Financing Activities.  So is selling stock in the company, or paying dividends.

Positive Cash Flow from Financing can be a Good Thing if it is the result of new Long Term Debt, the sale of a minority stake,  or a deliberate increase in short term debt.  If it is credit cards kicking in to absorb lack of cash elsewhere, it might be a Bad Thing.  Conversely, negative Cash Flow from Financing due to a decrease in credit card debt might be a Good Thing – a sign that you are generating cash from other things, and can afford to repay debt.

How to increase Cash Flow from Financing Activities:

Arrange a long term bank loan

Borrow against a credit line

Sell stock in the company

Avoid paying dividends

Cash Flow from Investing Activities

Investing is primarily the act of putting money into long term assets such as Vehicles, Equipment, or Leasehold improvements.  Buying a Fixed Asset generates negative cash flow – but often is a Good Thing.  It is a Bad Thing if you make a large cash outlay and there is not sufficient cash flow from other sources (e.g. a loan) to offset the cash outflow.

How to increase Cash Flow from Investing Activities:

Use operating leases instead of purchasing equipment

Don’t invest in your business (may not be a good long term strategy)

Net Cash Flow

Is the sum of the three components:

Cash Flow from Operating Activities + Cash Flow from Financing Activities + Cash Flow from Investing Activities

If you have done the math correctly, this will be equal to the change in your Cash Balance for the same time period.

More Information on Cash Flow

Check out Philip Campbell’s book, Never Run Out of Cash.  He proposes his own easy to follow Cash Flow Statement that he calls the Peace of Mind Schedule.  He does a great job of explaining cash flow in simple terms, and preaches about the importance of monitoring cash flow and doing cash flow projections.

Check out my SurvivalWare Website for Cash Flow Projection Software.   Anyone can try SurvivalWare Free for 30 days.  Just give us your name and email address, and we’ll send you a link.  No credit cards required.