Financial Statements Basics: Part 4, with Jason Pereira | E086
Cash & Working Capital.
Today is the 4th part of the continuation of a series that Jason is doing on understanding financial statements. Today, Jason is going to focus on cash management and working capital because cash is your lifeblood of a business. He will give you a framework for how to work with the cash because the accounting books and looking at that just don't give you the full picture. He will be explaining all the queries related to cash flows in your business.
Episode Highlights:
01:12: Business exists primarily for one reason, profit. At the end of the day, without profit, there is no business. You have to focus first and foremost on that. Cash is the life flood of generating that profit accounting.
03:16: Profits are priority, not the leftovers. You have to have your expenses controlled such that you hit your target profit because all too often most businesses look at profits. They wonder why it doesn't grow, it doesn't grow because you are now focusing on growing the revenue and shrinking the expenses relative to that.
03:38: Jason explains how does cash management work well for the average person? Your revenue goes into an operating account and from there you pay expenses. That is the normal way you would handle it. Profit first instead says that you should have a number of bank accounts, not just one, and these bank accounts should be earmarked for your obligations. So that the revenue should flow into a general operating account where you will pay operating expenses.
04:09: Jason suggests you should be pulling money into four other accounts that are earmarked for money that is not actually yours. What are those four counts? The first is profit. It is your money down the road. But what they are saying is whether it's once a month or twice a month. Whenever you get paid, you get to move over whatever percentage of profit you're trying to make into that.
04:52: You should have your HST account for GST, depending on private security, because that money is not yours, that's the government, says Jason.
04:59: You have your income tax account, and you transfer a certain percentage of your profit to the income tax account in order to make sure that when the income tax still comes to it's there. And the idea being that especially when we look at these expenses, payroll and income, these are obligations to the government and to your employees. Those are things you need to pay continuously.
05:43: Something is broken with your revenue model, something is broken with your operating with your expenses, but your product, you are going to hit the target profit. You have to make that work. This is a methodology that is also investing called reverse budgeting. You are taking all the savings and investing. In this case the profit off the table. We're also taking it off the fixed expenses.
06:54: If you can operate your business and get smoothly running on a model, you will never make the money you are looking to make. You will focus on increasing the money that you're looking to make, but you will also meet all your obligations that can get you into serious trouble if you don't.
07:31: Jason gives his insights on how much cash needs to be invested in the business in order to make sure you can operate? How do we answer that question? How do we move, modify working capital? Start off with the current assets, consider what's there, Cash is the goal. So short term investments in deposit accounts, financial savings accounts, money market funds, whatever else it is in order to basically help you meet those needs, that's ordered a little bit of interest. That's fine inventory.
08:21: Too much inventory represents an investment now you need that investment in order to make sure that, if you are selling goods, you can sell the goods, people need them, but too much inventory will cripple you.
10:13: Accounts payable is the first one, so money that you have to pay, the longer term you can get to pay it, the better. If you are buying physical goods and you pay right away in cash, probably not the smartest thing. If you put in your credit card, you have 30 days to pay for it. That basically reduces the amount of cash you need at that given moment.
11:08: Your current portion of your long-term debt and interest payable, is the money that is due in the next 12 months. You can work to minimize that by reducing. You can't work to minimize that by potentially refinancing. If you can stretch out the loans that you were taking out, you can basically reduce that which reduces your need for cash, and you need cash investment.
11:39: Taxes payable, make sure you pay them on time, that is for sure. How do you use it? How do you look at the current liabilities in order to minimize working capital? The answer is you increase them. You increase most current liabilities with the exception of also in relation to things that are free or low cost.
13:19: You need to buy inventory, hold inventory and basically sell. Unless you are buying the goods, selling the same day your cash conversion cycle is going to be measured in days. So how would you calculate this, so you have to do some math.
14:29: Inventory sitting around costs your money. The days of sales outstanding are your average accounts receivable again beginning and ending the average of those two divided by your total revenue times 365. That tells you how long it took you to collect your receivables. That is basically the average loan length you're giving someone.
18:44: You have to ask yourself what you can do to reduce your inventory without giving up sales. Your credit terms increase to reduce those and make sure people pay if you have them. If you want people with cash, great. Otherwise, sometimes you know if you're selling through Amazon or online through Shopify, it will often take 30 days to pay you. There are inventory financing companies, whether there are sales conversion companies that will help. They will basically pay you for free the same day you call. Maybe you won't have to wait 30 days. And that reduces your working capital need. It does increase your expenses that reduces your working capital need and payment terms.
19:21: Do not be in a rush to pay your bills. The day you get them. Be in a rush to pay them the day before their due and try to negotiate better terms.
3 Key Points:
Jason explains what basic accounting tells you. It tells you that your revenue minus your expenses equal your profit.
Working capital or net working capital is the difference between your current assets and your current liabilities list, it's a measure of the company's quality and operational efficiency as well.
Accounts receivable is the money that's owed to you. The shorter the payment terms on accounts receivable, the faster that money converted to cash, the longer the slower.
Tweetable Quotes:
"You should have your payroll account. Have a separate bank account just for payroll. You make sure you move the amount for payroll over there every month." - Jason
"You don't want a lot of good sitting around. You can make sales, but not so much that you are taking six months to sell it all if it's something small. If it's something big, you may not have a choice, but optimize inventory accounts receivable." – Jason
"Understanding your cash conversion cycle is very important. Understand how those changes over time, because if you can speed up your cash conversion cycle or God willing make it negative if you are that lucky then the working capital shrinks." - 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 Periera. 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 Periera.
Jason Pereira: Hello and welcome. Today is the last day of my series on understanding your financial statements, but we're not really going to focus too much on the financial statements, we're going to focus more on cash management and working capital, and I've been alluding to this the entire time. And why? Because cash is your lifeblood of a business. Without it, you can die. And if you have too much, well, it's a poor use of capital. So what I'm going to do is I'm going to go over a couple things, and the agenda for today is actually, this is a presentation that I gave to the entrepreneur's organization. This is actually a presentation I gave to the entrepreneur's organization on cash flow. It's basically about understanding the nature of your cash flows in your business and changing the way you see it to achieve success. And in particular, I'm going to basically talk about the importance of it.
Jason Pereira: I'm also going to talk about a methodology that has proven very popular for handling your cash flow, and we're going to talk about working capital and cash conversion cycle. So the first cold hard truth about this, like I said, business exists primarily for one reason, profit. You can have other purposes like bettering society and stakeholder engagement, which I totally agree with, but at the end of the day, without profit there is no business. So you have to basically focus first and foremost on that and cash is the lifeblood of generating that profit. Accounting, really when you think about it, is organized for accountants, governments, but not so much for business operations.
Jason Pereira: Now what I mean by that is how many of you as business owners open up your bank account or your accounting software every day, look at it, and then have to do mental aerobics as to when money is coming in versus when money's going out and how you're going to manage that and make sure you meet all your obligations? And any business owner whether they're starting out or advanced has often basically not quite managed to do the math right and ended up being surprised by a tax bill or an HST bill or maybe have to take from a different account to make payroll.
Jason Pereira: Well, there's better ways, and those better ways are not accounting methodologies. They're kind of mental constructs for how you manage cash. And if you're a business owner hearing this and you have this difficulty and you think it's hard to keep on top of your cash, so I want to encourage you to read a book from Mike Michalowicz called Profit First. This is a methodology for handling your cash flow that has often proven successful in helping people actually have profit, but also make sure all their obligations are taken.
Jason Pereira:Now what does it tell you in this book? I'm going to take you through that first. Well, what does basic accounting tell you? It tells you that your revenue minus your expenses equal as your profit. Profit First tries to basically flip this around and says revenue minus your profit equals your expenses, and this is a mental leap to basically say that, "Hey, I'm taking profit off the table early on. Why? Because I need to reign in or control my expenses better to be in line with my revenue in order to support the profit." That's really what they're trying to say is that, "Hey, the profit is a priority, not the leftover."
Jason Pereira: Now of course you have to have your expenses controlled such that you hit your target profit because all too often, most businesses look at profits what's left over at the end of the day, as opposed to targeting it, then they wonder why it doesn't grow. It doesn't grow because you're not focusing on growing the revenue and shrinking the expenses relative to that. So cash management, how does cash management work relation to this? Well for the average person, your revenue goes into an operating account, and then from there you pay expenses. That's the normal way you would handle it.
Jason Pereira: Well, Profit First instead says that you should have a number of bank accounts, not just one. Now these bank accounts should be earmarked for your obligations, certain obligations in particular. So revenue should flow into a general operating account where you will pay operating expenses out of. Correct. But at the same time, and I'm modifying this for Canada, you should be pulling money into four other accounts that are earmarked for money that is not actually yours.
Jason Pereira: What are those four accounts? The first is profit. Now of course, that is your money down the road, but what they're saying is whether it's once a month or twice a month, whenever you get paid, you move over whatever percentage of profit you're trying to make into that. So if your target profit margin is 20%, you move 20% in there every month. Why? Because if left [inaudible 00:04:19], your operating expenses will disappear on lunches or God knows what. And you have your payroll account. You have a separate bank account just for payroll. You make sure you move the amount for payroll over there every month. You have your HST account, or GST, depending on what province you're in, because that money is not yours, that's the governments. And you have your income tax account, and basically you transfer a certain percentage of your profit to the income tax account in order to make sure that when the income tax still comes due, it's there.
Jason Pereira: And the idea being that, especially when you look at these expenses, payroll, HST, and income, these are obligations to the government and to your employees. Those are things you got to basically pay continuously, so keep that money out of the operating account so you don't have to do the mental aerobics. And again, profit is a priority. Pull the profit out as well. And from time to time, you clear that out personally. Everything else is left in the operating account. Your operating expenses better be within that confine. If not something is broken. Something is broken with your revenue model, something is broken with your expenses, but if you're going to hit the target profit, you have to make that work.
Jason Pereira: This is a methodology that is also investing called reverse budgeting. You're taking all the savings and investing, in this case the profit, off the table. We're also taking off the fixed expenses, which are the ones I just mentioned, and everything else has to basically ... You can't spend whatever, just don't spend more than you have there that month. Now if it's not working, this is causing too much stress, you might be taking too much profit. If it is not working and you're taking too much stress and there's no profit, then something else is wrong with the operation of your business.
Jason Pereira: Now how do you do this? Again, I encourage you to pick up the book. I actually encourage you to go to the website. There's some very interesting tools on there to help you figure this out, including this table, where you would basically look at your revenue, your cost of goods sold. What is your real gross revenue? What is your profit? And then basically from there, you break up that gross revenue to profit owners pay, employee pay, taxes, and operating expenses. And you basically put down what amount you want all those things to be, and you figure out the percentage and you figure out there's a gap. If there's a gap, you figure out how to close it. But there's a bunch of exercises on how you do this. But essentially by doing this, if you can actually operate your business and get it smoothly running on a model like this, you will never ... You'll basically make the money you're looking to do, you'll focus on increasing the money that you're looking to make, but you will also meet all your obligations that can get you in a serious trouble if you don't.
Jason Pereira: Now that was my little preaching on how to manage your cash. Second piece, let's go back to one of the primary topics of the day, which is working capital. Working capital, networking capital, is the difference between your current assets and your current liabilities, as I said before. It's a measure of the company's liquidity and operational efficiency as well and its financial health. Basically how much cash needs to be invested in the business in order to basically ... In order to make sure you can operate? So how much do you need? It's going to depend on something else we're going to get to in a second.
Jason Pereira: So how do we modify? So how do we modify working capital? Start off with the current assets, consider what's there. Cash. Cash is the goal. That's good. Cash equivalents, so short term investments in deposit accounts, high interest savings accounts, money market funds, whatever else it is, in order to basically help you meet those needs or to earn a little bit of interest, that's fine. Inventory, we've talked about this in the previous episode. We talked about all these in the previous episode, but inventory. Inventory represents an investment. Now you need that investment in order to make sure that if you're selling goods is that you can sell the goods when people need them, but too much inventory will cripple you.
Jason Pereira: This is where the likes of Walmart have basically become the masters of inventory. Every time you scan something else, something on the way out, their main warehouse knows and they know how long they have to replace, or how many more sales they can make in a store before they have to bring in inventory, and the goal is to make it arrive just before it is needed, because that minimizes your inventory investment. Now you're not Walmart, so that's going to be difficult, but what you really don't want to do is you don't want a lot of goods sitting around. You want enough goods so you can make the sales, but not so much that it could take you six months to sell it all if it's something small. Now if it's something big, you may not have a choice, but optimize your inventory.
Jason Pereira: Accounts receivable. Again, we talked about this previously. So what does that mean? Accounts receivable, it's money that's owed to you. Are your payment terms too generous or not generous enough? The shorter the payment terms on accounts receivable, the faster that money converts to cash. The longer, the slower. Now what's the right number? It depends on your market and what is normal and what you need in order to maximize sales. Then we get into things like prepaid expenses. These are things you pay for in advance. If you can minimize how much you pay for in advance, hopefully without losing any discounts you get, then essentially you can basically minimize the investment in prepaid expenses.
Jason Pereira: So everything I mentioned here that wasn't cash, accounts receivable, inventory, and prepaid expenses. Now [inaudible 00:08:44] cash bonus because those are cash also, those three, the bigger those numbers are, I want you to think about this, those numbers represent cash that was invested in your business, whereas cash represents cash and it's what you're trying to create. So if anything, you want to try to minimize those without impacting your sales and profitability.
Jason Pereira: Then we have current liabilities. We went through this again. Again, we're going to go through in a little bit more detail. So basically accounts payable is the first one. So money that you have to pay. Well, the longer term you can get to pay it the better, right? So if you are buying physical goods and you pay right away in cash, probably not the smartest thing, right? Or simply, we've all learned this trick, I mean, if you put it on your credit card, you've got 30 days to pay for it. That basically reduces the amount of cash you need at that given moment.
Jason Pereira: Now of course, you need to have enough money to pay that credit card, but you want to ... Essentially, if someone else is going to lend you money at zero interest, you'll want to take advantage of that. Short term debt. So your short term debt, anything that's basically due in the next year. Well again, just if it's necessary, keep it to a minimum. If you need money, if you need debt to basically finance your operations, no problem. Your current portion of your long term debt and interest payable in your long term debt, this is money that is due in the next 12 months. Now you can work to minimize that by reducing ... You can work to minimize that by potentially maybe refinancing. Maybe you stretch out those loans. If you can stretch out the loans that you are taking out, if you can stretch out the current portion and roll that current long term portion, you can basically reduce that, which reduces your need for cash and need of cash investment.
Jason Pereira: Taxes payable. Well, that one you got to make sure you pay that on time, that's for sure. And any dividends payable, that's a little bit different. We'll get to that. But the point here is that how do you look at the current liabilities in order to minimize working capital? The answer is you increase them, right? You increase most current liabilities with the exception of ... Also, in relation to things that are free or low cost, so maybe lines of credit and accounts payable, especially because accounts payable is technically a free loan. The longer term stuff, maybe you recapitalize them, maybe you extend that, and that reduces the amount of cash that you need to generate in order to basically run business. So doing all that will basically reduce your working capital needs.
Jason Pereira: So the key question you have to ask yourself as an entrepreneur is have I looked at everything on both sides of this balance sheet and have I worked to basically minimize it or maximize it, depending on what's best? So that leads us to an important question, how much is enough? Well, that is different for every business, but the way you can better understand ...
Jason Pereira: So let me go back. So that leads to an important question, how long does it take you to actually generate cash? And that is something known as your cash conversion cycle. How fast a sale turns into money in the bank? Even if you're cash and carry, this is not instant. You got to buy inventory, hold inventory, and basically sell, so unless you're buying the good and selling it in the same day, your cash conversion cycle is going to be measured in days.
Jason Pereira: So how do you calculate this? So you have to do some math. The first one is a couple of ratios we covered before. So cash conversion cycle equals your days of inventory outstanding plus your days of sales outstanding minus your days of payable outstanding. So think about this, how long do I hold things in inventory? Which is investment. How long am I waiting for my receivables to be collected? Which is again, offering people a loan, so that is an investment. And how long do I have to pay my bills? Which is you borrowing from someone else. So days of operating inventory outstanding plus the days of sales outstanding minus days of payables outstanding.
Jason Pereira: So let's go through the measure for each of these again. Days of inventory, outstanding average inventory, your starting versus closing inventory in a year divided by your cost of goods sold, divided by 365. Basically that calculation tells you on average how much inventory you had sitting there that would've been sold out of profit. Again, inventory sitting around costs you money. The days of sales outstanding is your average accounts receivable. Again, beginning and end, the average of those two, divided by your total revenue, times 365. That tells you how long it typically took you to collect your receivables. Okay, that's basically the average loan length you're giving someone. Most people these days, it's not a very long cycle, but if you're manufacturing large products and large goods or construction, those numbers can be pretty big now.
Jason Pereira: Then you have days payable outstanding. The average accounts receivable divided by your cost of goods sold times 365. Again, so beginning and end, average of those two numbers, and then cost of goods sold, 365. This is the number of days on average it takes you to pay your bills. This should be as long as possible without getting you in trouble because that reduces your cash conversions. So the reality is that you got to run this math for yourself and you have to understand is there room to improve on each of these? Is there room to get paid faster, to pay later, to basically sell faster, reduce your inventories? Doing that can generate some incredible numbers.
Jason Pereira: So for example, let me just give you a simple numerical example. If the days of inventory outstanding was 30 and the days of sales outstanding ... So I'm going to hold onto something for 30 days and it's going to take me 90 days to collect, but I'm paying my bills in 15, that is a cash conversion cycle of 105 days. It takes 105 days from the moment that I have the inventory to the time that will start from the moment I purchase the inventory to the time that I basically have gone through the full cycle and turned that into cash. Imagine you have $2 million in sales, that would mean that you have a cash conversion cycle, or the amount of time or the working capital required to fund that is $575,000. How did I come out to that? Well, I need to finance 105 days worth of working capital, 105 divided by 365 times $2 million equals $575,000. That's a lot of money, okay?
Jason Pereira: Now what would happen if you were able to reduce your inventory by 15 days by carrying half as much and hopefully not losing any sales? What if you could reduce your payment terms or your credit terms where people were paying you by 60 instead of 90? And what if you could basically increase your payment terms just by 30? So you do that math and suddenly your cash conversion cycle is down to 45 days versus 105, less than half, right? Because you squeezed what efficiencies you could from place to place.
Jason Pereira: So what does that mean in terms of a working capital investment? That means the working capital investment to the company has now dropped $246,575, so we'll say it's $247 to be fair. So $247 versus $575, that is a networking capital savings of $328,000. Someone with this type of business who made the kind of changes ... I'm assuming they can get away with the payment terms and they can basically still not see reduction in sales, would've been able to pull out an additional over $300,000 out of the business because that money was no longer needed.
Jason Pereira: Believe it or not, I have seen businesses with negative cash conversion cycles where they don't actually need cash in the business. Why? Because they get paid, they may be in a situation where they only have to order from manufacturer once the payment happens, and then they've got 60 to 90 days to pay. So they're collecting up front, they got 60 to 90 days to pay, they don't maintain their inventory, and voila, you have a negative cash conversion cycle. So any kind of direct from manufacturer front definitely works quite well. Those are rare businesses and I am always impressed when I see them and think that is fantastic, so floats are fantastic.
Jason Pereira: So basically you have to ask yourself, what can you do to reduce your inventory without giving up sales? Your credit terms to reduce those and make sure people pay, if you have them. If you don't, if people are cash and carry, great, otherwise sometimes just selling through Amazon or online, online through Shopify. They will often take 30 days to pay you. There are inventory financing companies or there are sales conversion companies that will basically for a fee pay you the same day you sell. So maybe you won't have to wait the 30 days and that reduces your working capital need. Now it does increase your expenses, but it reduces your working capital need. And payment terms, do not be a rush to pay your bills the day you get them, be a rush to pay them the day before they're due, and try to negotiate better terms.
Jason Pereira: So that's really the core of the conversation, right? Is a conversation slowly around cash. I admit the entire Profit First piece was a little bit out of place here, but this is ... I put it in here because in this presentation I gave, I felt it worked incredibly well. It was simply giving you a framework for how to work with cash because the accounting books and looking at that just doesn't give you the full picture. I would also recommend that you look at some of the cash flow planning softwares out there. We can help model out how cash is going to flow to your business so that you understand if there's any cyclicality, potentially how you're going to need to leave some extra cash behind or not. You don't necessarily need those softwares, you can do it with a spreadsheet, but the bottom line is understand your cash flow, it is the single most important thing in your business when it comes to keeping you alive.
Jason Pereira: So I hope you take a look at the book, which is Profit First. Heed my advice on how to optimize your working capital to make sure you're not making over investments in it. You do need an investment, you do need a cushion, but just don't go nuts because that's money that could otherwise be reinvested in the business or be used to fund your lifestyle and savings. And the last piece is understand your cash conversion cycle. Very important. Understand how that changes over time because ... If it does change over time, because if you can basically speed up your cash conversion cycle, or God willing, make it negative, if you're that lucky, then the working capital shrinks.
Jason Pereira: So that was today's episode of Financial Planning for Canadian Business Owners, and this concludes my series on understanding your financial statements and now your cash flow. Hope you enjoyed that. Feel free to share that with any entrepreneurs you know. Frankly, these are lessons that unfortunately you don't learn until you actually have a business, and sometimes you learn the hard way. As always, if you enjoyed this podcast, please review on Apple Podcast, SoundCloud, Stitcher, Spotify, or wherever you get your podcast. 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 jasonperiera.ca. You can even ask Siri, Alexa, or Google Home to subscribe for you.