Financial Statements Basics: Part 2, with Jason Pereira | E084
The Basics of Cash Flow Statements & Working Capital.
Today is the second part of the continuation of a series that Jason is doing on understanding financial statements and some of the data. Today, Jason is going to move on to a couple of other less common reports. He is also going to look for the cash flow statement; this is not required for tax purposes, but every accounting software should be able to produce one of these.
Episode Highlights:
01:25 A cash flow statement gives you an understanding of what happened to your company’s cash and how you got from the starting position at the beginning of the year to the end position at the end of the year.
01:39 There are three different categories or changes within the business that will impact your cash.
02:28 The first area that the cash flow statement looks at is operating cash flow. It is simply a change in your income statement and balance sheet that came from operations.
03:43 If your accounts payable went down, it means you have converted more of your accounts payable to cash. Therefore, you increase your cash and vice versa.
04:04 Jason: Any expenses that count payable are positive to your net cash and any reduction is negative, leading to the change in current liability.
07:11 If you issue any new debt, that new debt increases the cash on hand that you pay off in long-term debt and the reduction results in a lower amount of cash.
09:31 Cash is important because it is the lifeblood of a business. You can be totally profitable with cash being the lifeblood, but you can have negative cash flow.
10:46 Working capital is the total current assets minus the total current liabilities, which is the amount of money you need in the business to have sufficient cash lying around that you cannot pay your bills on time.
13:56 If you had a monthly billing, instead of paying one huge amount throughout the year, you could monthly pay for expenses which reduces the amount of money you need upfront to make that initial investment, reducing your need for working capital.
15:01 You have to be careful with your inventory because if you carry too much, it’s just money waiting to be converted that could be in your pocket, and if you carry too little, you could lose it on sales.
16.49 The current liability, like loan payments, you don’t have much control over things. But, again, this is not an area that you are going to be able to reduce because if you have a loan, and you typically have scheduled payments.
18:28 COVID has taught us that you need to access the cash when everything goes wrong, but there’s a difference between having cash in the bank and accessing the capital.
19.06 If you don’t maintain enough working capital when you sell the business, it will impact your valuation. Working capital is an asset of the business. Too much of it, you can clear that out. Too little of it, you need to invest.
3 Key Points:
Cash flow from investing activities reflects any investments you made in your business, specifically your business’s fixed asset component or balance sheet.
Investment in general matters because that investment can either be used for working capital or other business needs, or personal consumption of the business owners.
If you could increase the duration of your pay and turn your short-term liabilities into long-term liabilities, you would reduce the need for working capital.
Tweetable Quotes:
“The changes to fixed assets are part of investing. The changes to the owners equity and liabilities represent the changes to financing related to cash flow from financing activities.” – Jason
“When you total up all aspects of cash flow, the difference should equal the change in value in your cash balance over the year.” – Jason
“Having a healthy amount of working capital is vital because you need to keep your business afloat, and there are ways you can optimize around this.” - Jason
“If we can reduce your pay, current assets, and inventory, you can reduce the need for working capital.” – Jason
Resources Mentioned:
Full Transcript:
Producer: Welcome to the Financial Planning for Canadian Business Owners podcast. You will hear about industry insights with award-winning financial planner and entrepreneur, Jason Pereira. Through the interviews with different experts, with their stories and advice, you will learn how you can navigate the challenges of being an entrepreneur, plan for success and make the most of your business and life. And now, your host, Jason Pereira.
Jason Pereira: Hello, and welcome to Financial Planning for Canadian Business Owners. As the show said, I'm your host, Jason Pereira. And today is the second part of the continuation of a series I am doing on understanding your financial statements and some of the data that comes off of that. So if you missed the last episode, it was a very basic review of what is involved or what the different accounts in your income statement and balance sheet mean. Now, that is done. And for most people, the income statement and balance sheet is pretty much what they look at, and typically what's more or less basically given to them by their accounts, so that makes sense. But today we're going to move on to a couple other reports, ones that are less common but very important, and this is all have to do with cash flow. So what we're looking for is frankly the cash flow statement.
Jason Pereira: This is, again, not required for tax purposes, but every accounting software should be able to produce one of these. So what is a cashflow flow statement? A cash flow statement gives you an understanding for essentially what happened to the cash in your company and how you got from the starting position at the beginning of the year to the end position at the end of the year. And really there are three different categories of operational changes, or changes within the business, that will basically impact your cash. And what this does is it breaks down all the changes that impact your cash into three areas. And here's the crux of it. It explains the change in basically every account on your balance sheet. What do I mean by that? Well, every account on your balance sheet changed between the beginning of the year and the end of the year. Money was spent on those areas.
Jason Pereira: Money was deducted on those areas. Money, sometimes things like depreciation and whatnot were taken off, even though they weren't cash, but this is basically an explanatory document that explains what happened to the cash and not only what happened with the cash account, but also how did it impact everything else. The first area that the cashflow statement looks at is operating cashflow. So this, very straightforward, is simply the changes in your income statement and balance sheet that came by way... Sorry income statement in a second, fixed that part. The changes in your income statement and balance sheet that came by way of operations. So first thing, and the one item that typically accounts for most of the income statement is revenue. So how much revenue did you bring in? So what were your sales?
Jason Pereira: From there, things like cash expenses from sales, so costs of goods sold or services rendered, other expenses and overhead, processing fees, you name it, basically they get subtracted, as well as any tax you actually paid, not accrued, but paid. You can add back other income. So if you add income from interest, for example, on deposits being held, that gets added back. So that is the first part. It's, hey, what happened on the income statement change this in terms of operations. The second piece then goes on to what happened to working capital. So you may recall, working capital was basically your accounts receivable and your accounts payable. And essentially the way this works is the next section would be to add back any changes to accounts payable, because if your accounts payable went down, that basically results in you having basically converted more of your accounts payable to cash. So therefore you increased your cash and vice versa. So if your accounts payable, basically you're going to add it back.
Jason Pereira: And the reason is because if you haven't paid those bills, you still have the cash on hand or your cash balance hasn't been reduced by that expense. So basically any expansion into accounts payable is positive to your net cash, basically any reduction is negative. Also, the change in current liabilities. So any other liabilities you have for the year, if you increase that, that increased the amount of cash that came into the business. If you decreased it, vice versa. So that's the liability side. On the asset side, it's the opposite. So if you had an increase to your accounts receivable, that means that more people owe you money and did not pay you the cash they owe you. So that is reduced and basically then conversely if it's the opposite, it's subtracted.
Jason Pereira: So any increases to accounts receivable, inventory, work in progress, which is basically work being done that is taking raw materials into inventory available for sale, and any other changes to current assets are all negative. So to quickly sum this up. First section of your operating cashflow changes, revenue minus cost of sales, expenses and taxes, add back any other income. So that is, hey, this is what the income statement says happened in terms of the cash position. Then you go to the account's payable section, so you go to the account's payable section, you add back any increases to accounts payable, because, hey, you're using someone else as a debt facility, so that means you haven't paid it, that increases your cash. And then conversely, your current accounts, and conversely, your current assets, you would then basically subtract out any increases to those because those are basically expanding, and that is stuff that should be converted to cash once it's all processed, so it's a reduction.
Jason Pereira: So, that is the operating cash flow. That tells you how much cash your general operations, just doing business, created. So the second section is cashflow from investing activities. So this reflects any investments you've made in your business. Specifically, what it's really looking at in particular is the fixed asset component of your business or your balance sheet. So were there any capital expenditures? Did you acquire any equipment, any property planned equipment? Forget about depreciation, what did you pay for it? Did you acquire any intangible assets? And really what they're looking for is the net change to any of the non-current assets. So anything that is not an asset that can be cashed out inside of 12 months, or is liquid in short order, basically that is your non-current assets, or known as your fixed assets, did they increase? If they increased, it took cash to increase them.
Jason Pereira: If they decreased, it basically resulted in less cash, or more cash being unavailable on hand. The third and final area is the cashflow from financing activities. So the financing activities, now we move over. So what have we done here? We've done the income statement at the beginning. The current assets and the current liabilities, those are all part of operating cashflow. The changes to fixed assets are part of investing. And now the changes to the owner's equity and liabilities represent the changes to financing. How was all of this paid for? So specifically, did you issue any new debt? If you issued any new debt, that new debt increases, of course, the cash on hand. Did you pay off any long term debt? That reduction basically results in a lower amount of cash? Did you sell any new shares?
Jason Pereira: Was there any kind of owner's equity that came into the business? Yes or no. And conversely, did you redeem any shares? And also basically you also have dividends, were any dividends paid? They don't show up on the income statement. They don't show up in the balance sheet, but they basically are definitely a cash expense. So those are the big areas. And of course you have net interest after, this is net interest for investment activities after tax, which goes here as well. So essentially what was involved on the fixed liabilities or the non-current liabilities and what was involved in the owner's equity, that gets summed up here. So to recap. First section, operating cash flow, revenue minus all the costs associated with that revenue, minus the taxes, plus any other income, that's your revenue from operations. You would basically add any increases to current liabilities because that's using someone else's money to finds your operations, and you subtract any increases to your current assets, because that is you financing those operations. That is your net operating cash flow.
Jason Pereira: Second section, the cash flow from investment. And that is, again, changes in the assets sheet. And that is, again, changes in the fixed asset section of your balance sheet. Then investing is the liability and equity side of your balance sheet, what are the changes there? And, of course, dividends issued. When you total up all three numbers from these sections, the difference should equal the equivalent of the change in value in your cash balance over the course of the year. So, that's what this tells you. Why is this important? Why? Because the income statement tells you about stuff that is also not cash like depreciation and amortization, that's in there. Well, that's not a cash expense to you. Also, it doesn't really reflect if there was changes in your payables or collectibles terms, which basically, if you take longer to pay things, you have more cash on hand, vice versa.
Jason Pereira: The other way around, if you take longer to receive things, you have less cash on hand, vice versa, the other way around. So it doesn't really explain what happened with the cash in the business. And why is this important? It's important because cash is the lifeblood of a business. I had said previously in the last episode that cash is like water. You can drown from too much of it. No, not really, it's just not healthy, at least in the case of business, but you can definitely die without enough of it. And cash being the lifeblood, you can be totally profitable, but you can have negative cash flow. Why? Because, simple example, let's imagine a very simple impractical example, let's say I bought things today that I sold tomorrow, and I had to pay my vendors in 30 days, but I didn't collect for six months, I have a negative cash conversion cycle.
Jason Pereira: That is the amount of time it takes me to transform a sale into actual cash in the bank account. So this cash conversion cycle idea, we're going to come back to later on when we talk about ratios. Ratios are going to be another episode and ratios, accounting ratios and calculations, where you take one number divided by another or any number of things, and essentially we calculate some data that if you are not educated on what these ratios actually mean, you don't have context. Well, I'm going to give you context in the next episode, but essentially these ratios are ways to study the trends in your business and the health and extract other information that you didn't actually think was available on there. But we're going to go over that later. So cash is really important. Now, let me go back to beating up on this.
Jason Pereira: In the previous episode, I explained the concept of working capital. Working capital is quite simply put the total current assets minus total current liabilities. What does that really mean? That is the amount of money you need in the business in order to basically have sufficient cash lying around that you are not unable to pay your bills on time. So, that represents an investment. The example I gave you a couple minutes ago, where I pay my vendors in 30 days, whatever it might be, and I basically collect in six months, that's a five month difference. If I have to pay someone up front and I'm not going to collect the money for it in a long time, I need enough money on hand to pay them off, otherwise they're going to cut me off. So that is an example where I need to make a substantial investment in the business in order just to keep it afloat. Conversely, and I've seen these businesses and they're fantastic, and it's rare, but you can have a negative cash conversion business or negative working capital businesses.
Jason Pereira: What do I mean by that? If you conversely take six months to pay a vendor and on the opposite side of that you basically make all your sales for cash right away, so I sell something, I get charged today, it's not going to be delivered for three months, technically I don't need any working capital. The buyer provided that. So working capital represents an investment. So why does that matter? It matters because that investment can either be used for working capital or other needs of the business or personal consumption of the business owners. So what I mean by that is paying it as dividends or income. So having a healthy amount of working capital is vital because you need it to keep you afloat, but there's ways you can optimize around this. So consider the following, let's look at each item of the working capital calculation.
Jason Pereira: Cash is what we're trying to maximize here, so we can take more of it out or reinvest more of in our business. First thing we have is accounts receivable. What are your payment terms? Are you cash and carry? If you sell something and collect the money on the spot, then your payment terms are immediate, no problem. But if you're a business that basically sells to vendors and then doesn't collect for 30, 60, 90 days, what are those terms? The longer out your cash collection cycle, the more money that you are technically lending your buyer, so you're basically the credit card for them. They are buying something today that they're not going to pay for a long period of time, 30, 60, 90 days. And basically in that time, you're charging them nothing.
Jason Pereira: So this is why oftentimes companies, especially manufacturing will offer discounts if it's paid within 30 days, because you being the credit card in this case, you got to finance that somehow, and your financing that through either your own money or through debt. So there's a cost to it. So the question becomes how short can you make that cycle? Are you in an industry where you're offering 90 day terms? Well, are your competitors offering 90 day terms? Can you get away with 45? Can you get away with 60? Every reduction in accounts receivable collection times or collection terms basically reduces the need for working capital in your business. That's the first one. Second one, prepaid expenses, things that you pay in advance for. Now, in some cases you can't get away from this. What do I mean by that? Sometimes like software licenses, you have to pay for them manually, so you're not going to get away from that.
Jason Pereira: But there are plenty of other services, or maybe you are on a annual contract. Well, if you had a monthly billing, then basically instead of paying one lump sum throughout the year, and then slowly eating away that nest egg monthly to basically pay for expenses, if you match and make your contributions monthly, that basically reduces the amount of money you need up front to make that initial investment, which in turn reduces your prepaid expenses, which reduces your need for working capital yet again. And then inventory, if you are in a business that maintains inventory, then essentially you have to, of course, manage your inventory well. And this is where retail lives and dies, it's in how well they manage their inventory. Why? Because inventory costs money. And it's sitting there on your shelf, it's costing you either in terms of lack of return on your equity or in terms of the interest rate on your debt.
Jason Pereira: So the question becomes how do you manage inventory? If you're like Walmart, who are the masters of this, you basically know exactly when the last moment is that you have to ship something else in order to maintain no inventory. Ideally you want just in time delivery, you want the last item flying off the shelf while the reshelving delivery basically arrives. Now, it is impossible for small business owners pretty much. But the reality is that you got to be careful with your inventory. If you carry too much, it's just money waiting to be converted that frankly could be in your pocket instead. If you carry too little, you could lose it on sales. There's all kinds of different theories you can read or different valuable resources online about how to properly manage inventory. This is highly specific to your industry.
Jason Pereira: So bottom line is here though, the less inventory you carry, the less working capital investment you need, but it has to be sufficient as to not hurt your sales. So, that is the accounts receivable side. So the idea being is that if we can reduce your AR, your accounts receivable, basically your current assets and your inventory, you can basically reduce the amount of need for working capital. Now let's consider the current liability side, the other side of the equation. So what is on this side of the equation? So on this side of the equation you have, of course, your current liability, so that include things like your accounts payable. So now basically, like I said, with your accounts receivable, where you were the credit card towards your vendors, well, the vendors you buy from, they're a credit card to you as well.
Jason Pereira: So are you paying cash upfront for everything? I've spoken to many businesses, who are like, "I just pay cash for everything." Well, if your vendors offering you 30, 60, 90 day terms, you'd be foolish not to take them. Why? Because they're offering you to... If I said, "Here, borrow this money for free. I'm not charging you anything." Simplest example is you can put that in a bank account or in some basic interest, not much these days, but you profit for nothing. Well, if you basically use them as a credit card, you don't have to use your credit card or other loan facilities, and it reduces working capital, yet again. So the tips are, for this, see how far out you can push your payables with your vendors in order to basically stay on side with them. And the longer they extend them to you, the better off you're going to be.
Jason Pereira: The second piece of this is your current liabilities. Now, here are the current liabilities, so things like loan payments. You won't really have a lot control over these things, quite honestly, so frankly that is not an area that you're going to be able to reduce, because if you have a loan, you typically have scheduled payments so it comes down to always negotiating the best possible terms for them. Now, here's where the turnaround is. If there's a lot in the current cycle, well, maybe there's an argument towards renegotiating the terms of that loan, because frankly extending the loan for a longer period of time reduces your working capital need. Yes, it stretches the loan over a longer period of time, absolutely, but the reduction in working capital need also basically frees up cash flow for other business operational things and for basically you taking money out. So, that's the second one.
Jason Pereira: On the current liability side, like I said, the big sections here are frankly your accounts payable and your debts. There's some other things that go in there, like accrued revenue, but nevertheless, that's really the big part of it. And like I said, here is what it comes down to. If you can increase the duration of your payables and turn your short term liabilities into long term liabilities, you reduce the need for working capital. You couple that with the reduction in current assets other than cash, and you can significantly reduce the amount of cash you need in the business, allowing you, like I said, to either invest that money for growth or turn around and basically issue dividends or give yourself a raise temporarily or bonus. Because, again, this is money that could be used elsewhere.
Jason Pereira: One of the biggest places I see this is when I go help clients sell their businesses. A lot of times they want to hold onto a lot of working capital to field comfortable. That's fine, you can, you should hold onto enough cash, and COVID taught us that you need access to cash when everything goes wrong, but there's a difference between having cash in the bank and access to capital. So if you have a line of credit you're not using or have access to it, that reduces your need for working capital because you have a cushion in case of emergency. But I've seen people literally keep three... Well, maybe not three, six months worth of working capital in cash. That is a huge investment. That is a huge investment that frankly, if you go to sell your business, the reality is that someone's going to basically say, "Well, you got to take that money out anyway," so you may as well take it out in the first place.
Jason Pereira: The second piece of it is that if you don't maintain enough working capital, when you sell the business, it's going to be impair your valuation. We talked about this in the business sale episode of my podcast, but working capital is an asset of the business. Too much of it, you can clear that out. Too little of it, you need to make an investment, but understand it. And what we're going to talk about next time when we get into ratio analysis is we're going to talk about what each of these ratios means. And one of the things we're going to talk about on the cash flow ratios is the cash conversion cycle.
Jason Pereira: That is going to inform you as to how long it takes you to turn sales into cash, and that should in turn impact how much you keep in working capital. So that was today's second episode. I threw a lot at you. I suggest you recap this with a model cashless statement in front of you and follow along. Take some notes, listen to it again. But this is a Cole's Notes of helping you understand that. We're going to drive into the analysis part next week, stick around. If you enjoy this podcast, please leave a review on Apple Podcast, SoundCloud, Spotify, Stitcher, or whatever that your podcasting. Until next time, take care.
Producer: This podcast was brought to you by Woodgate Financial, an award winning financial planning firm catering to high net worth individuals, business owners, and their families. To learn more, go to woodgate.com. You can subscribe to this podcast on Apple Podcast, Stitcher, Google Play, and Spotify, or find more episodes at jasonpereira.ca. You can even ask Siri, Alexa or Google Home to subscribe for you.