cash rules learn and manage the 7 cash flow drivers for your company success

kiplingersbusiness

managementlibrary

bill mcguinnessbill mcguinness

learn & manage

the 7 cash-flow drivers for yourcompanys success

learn & manage


learn & manage


bill mcguinness

KIPLINGER BOOKSWashington, DC

Published byThe Kiplinger Washington Editors, Inc.

1729 H Street, N.W.Washington, DC 20006

Library of Congress Cataloging-in-Publication Data

McGuinness, Bill.Cash rules : learn and manage the 7 cash-flow drivers for your companyssuccess / Bill McGuinness.

p. cm.Includes index.ISBN 0-938721-75-5 (alk. paper)1. Cash flow. 2. Cash management. 3. Accounting. I. Title.

HF5681.C28 M345 2000658.15'244--dc21 00-048134

2000 by the Kiplinger Washington Editors, Inc. All rights reserved. No part ofthis book may be reproduced or transmitted in any form or by any means, electronicor mechanical, including photocopying, recording, or by an information storageand retrieval system, without the written permission of the Publisher, except wherepermitted by law.

This publication is intended to provide guidance in regard to the subject mattercovered. It is sold with the understanding that the author and publisher are notherein engaged in rendering legal, accounting, tax or other professional services.If such services are required, professional assistance should be sought.

First edition. Printed in the United States of America.9 8 7 6 5 4 3 2 1

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AKING SOMETHING I KNOW AND CARE ABOUT, INthis case the cash-flow issues underlying almostevery business question, and then writing a bookabout it proved to be a much bigger task than Iever expected. Without the help and encourage-

ment of several key people right from the outset, I may nothave seen the job through amid the press of so many othertime demands. My heartfelt thanks to those early readers andencouragers: Al Weitlich, my Dad, Ed McGuinness, and mostespecially my lovely wifethanks Kath for all your help andpatience with the book and with me.

A great source of wisdom who helped greatly in giving themanuscript organization and structure was my agent, KarlWeber, who loves books of all kinds and specializes in businessbooks.

Then came the talented editorial team of Arnold Dolanand Hilary Hindsman, who mercilessly worked me and thebook over through several drafts. Last but most important ispublisher David Harrison, who carefully oversaw the wholeproject and always knew when to step in and when to stepback. He became, as I guess publishers always do, the final edi-tor and never let me stop thinking about how you, the reader,could best be helped to understand and use the principles ofCash Rules.

Many thanks, too, to Heather Waugh for her fine eye fordesign of the book and cover and to Rosemary Neff for her out-standing word sense.

T

Acknowledgments

V |

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi

PART ONE: The ABCs of Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Chapter 1: Cash Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Why Cash Flow Is Important Profitability versus Cashflowability Cash Is King What Is Cash Flow? Team Cash Flow

Chapter 2: Cash-Flow Language & Environment . . . . . . . . . . . . . . . . . . . . . . 17Introducing the Cash Drivers: A New Language Cash Flow ina Company Context Building a Cash-Flow Culture

Chapter 3: Basic Accounting:The Grammar of Cash-Driver Language . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33The Accounting Equation The Double-Entry System

Chapter 4: Statements of Cash Flow & Analysis of Ratios . . . . . . . . . . . . 49The Cash-Adjusted Income Statement Long-Term Viability& Cash Flow Other Measures of a Companys Well Being The Ultimate Cash-Flow Risk: Bankruptcy Getting Readyfor a Closer Look at the Cash Drivers

PART TWO: The Seven Cash Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Chapter 5: Sales Growth: The Dominant Driver . . . . . . . . . . . . . . . . . . . . . . 79Growth That Ripples Marketing Mix & the Management

Effect Growth Takes Cash Breakeven Analysis & ContributionMargin Sustainable Sales Growth Big-Gulp Sales Growth &Cash-Flow Implications

Chapter 6: Gross Margin: First of the Fundamentals . . . . . . . . . . . . . . . 103The Two Sides of Margins Gross Margin & Contribution Margin Refining Gross-Margin Calculations Distribution Channels &Gross Margins Gross Margin & Totally Perishable Inventory

Chapter 7: SG&A: The Other Fundamental. . . . . . . . . . . . . . . . . . . . . . . . . . 115Cost Ups & Downs SG&A & Capacity Expense &Expenditure

Chapter 8: Swing Factor #1: Accounts Receivable. . . . . . . . . . . . . . . . . . 121Communicating With Customers A/R & the Marketing Connection Industry Norms Factoring

Chapter 9: Swing Factor #2: Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131Inventory Valuation Types of Inventory Inventory & theProduction Process Just-in-Time (JIT) Inventory Inventory& Purchasing Management Inventory-Related Costs

Chapter 10: Swing Factor #3: Accounts Payable . . . . . . . . . . . . . . . . . . . 145Suppliers & Inventory Discounts Prioritizing &Policing Payables

Chapter 11: Keeping Up:Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . 151Depreciable Life & Economic Shifts & The Capex Driver & Sales Growth Depreciation & Capex Leasing &Capex Capital Budgeting & Capex & Growth

PART THREE: Cash Flow & Business Management . . . . . . . . . . . . . . . . . . 161

Chapter 12: The Mechanics of Cash-Driver Shaping & Projections . . . 163Shaping the Cash Drivers Projecting Future Cash Flows Putting It All Together

Chapter 13: Cash Drivers & Strategic Thinking . . . . . . . . . . . . . . . . . . . . . 185Cash-Driver Harmony Cash Drivers & Competitive Advantage Cash Drivers & Export Potential

Chapter 14: Risk, Return & Valuing Cash Flows . . . . . . . . . . . . . . . . . . . . 195Debt & Equity Values The Markets Move to Using Cash Flowto Evaluate a Business Summarizing the Basic Steps of theMechanics of the Valuation Process

Chapter 15: Whats Next . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

ASH FLOW IS THE RODNEY DANGERFIELD OF BUSI-ness management. It never gets the respect itdeservesthat is, until a business runs into trou-ble paying its bills. Cash is like the air that webreath: Its taken for granted, but desperately

missed when cut off. And like that other precious commodity,water, we tend to overuse it when its plentiful, regretting ourprofligacy only when the flow slows to a trickle.

The study of cash-flow management doesnt get its duethese days for one simple reason: The U.S. economy has beenawfully good for an awfully long time. In most major businesssectors, sales have been growing strongly. Creditboth short-term operating lines and long-term debtis readily available.And best of all, investors have been only too eager to throw ven-ture equity at every half-baked idea that comes down the pike.

When business is booming like this, its no wonder that a lotof managers and stockholders have become rather blas aboutcash flow. Boom times breed sloppy habits, such as overstaffingand overspending on everything from marketing to adminis-trative overhead. And, consistent with the old adage that younever spend someone elses money as carefully as you spendyour own, this overspending is especially flagrant at start-upfirms that are running entirely on outside capital.

To help combat these bad habits, I commend to you thiswonderfully wise and readable new guide to cash-flow man-agement, by business consultant Bill McGuinness. It comesalong at just the right moment in the U.S. business cyclejustin time to refresh the memories of a lot of older executiveswho have lived through both good times and bad times, but

C

Introduction

XI |

who may have forgotten the latter. More significantly, it shouldbe mandatory reading for every young business manager whomay have gotten the impression that cash grows on trees, orbubbles up from the ground, ormore to the pointarrivesevery payday in the bulging satchels of sugar daddies known asventure capitalists.

Traditionally, new businesses were content to grow at amoderate rate, and this was perfectly acceptable to their finan-cial backers, whether bank lenders or stockholders. A plan ofmoderate growth gave the new business plenty of time to testits products and services, get to know the market, listen to itscustomers and find the right people to staff the enterprise. Abusiness plan calling for moderate growth would also conservecash, giving comfort to lenders and investors. And it wouldincrease the odds of reaching profitability fairly early, albeit ata modest level. If all went well, the new business would prosperover time, gradually winning market share from other firms inthe same field.

But the business boom of the 1990s turned these tradition-al rules upside down. An assumption took holdmistakenly, Ibelievethat victory will always be won by the company thathits the market first and fastest with a new concept. The newmantra is rapid growth at any cost. Cash is something not tobe managed but to be spent as quickly as necessary to gain thegreatest market share. Another assumption of the NewEconomyalso mistakenis that additional rounds of outsidecapital will always be available to fuel the business, so long asthe firms revenue and market share are growing fast.

As Mr. McGuiness writes in Cash Rules, Growth takes cash,and fast growth takes lots of cash. Old-Economy executiveshave long been aware of the treacherousness of overly rapidgrowth. In their long careers, theyve seen many potentiallysuccessful businesses do themselves in by forcing growth toofast so that product quality or customer service suffered and thecost of over-expansion badly outstripped revenue before morefinancing could be lined up.

Now its the New Economys turn to learn these same time-tested lessons. Business doesnt run on sales growth; it runs oncash, Mr. McGuiness writes. Business doesnt run on even the

XII|

CASH RULES

XIII |

best and most realistic prospects for the future, unless theimmediate future contains enough cash to pay your bills.

Bill McGuinness is a passionate apostle of cash-flow man-agement, and he knows of what he speaks. Hes got a HarvardMBA, but the lessons hell teach you include many that he did-nt learn in business school. He got on-the-job training in ana-lyzing cash flow when he served as a senior banking executivewith Citicorp and Wells Fargo. (Bank lending officers, he notes,had better understand cash flow inside and out if they want tosee their loans repaid.) He learned even more as an entrepre-neur himself, in three different businesses. As a business consul-tant and seminar leader, Bill has taught cash-flow managementto bankers throughout the U.S. and Canada. And he developed,at Lake Superior (Michigan) State University, one of the firstMBA-level courses devoted entirely to cash-flow management.

Here at the Kiplinger publishing organization, we havetried to follow sound practices of cash-flow managementthroughout the 80 years of our existence as a closely held busi-ness. We have been rewarded with decades of steady, if unspec-tacular, growth in revenue and earnings. But more important,along the way we have earned a reputation for corporateintegrity among the people we do business withour lenders,stockholders, suppliers and subscribers. And we sleep well atnighta benefit not to be slighted in these harrowing times ofcutthroat competition. These are the true dividends of soundbusiness management.

On behalf of my colleagues and me, I hope that your busi-ness will benefit from the advice in this book, and I wish youthe best of success in the challenging years ahead.

KNIGHT A. KIPLINGEREditor in ChiefThe Kiplinger Letter, kiplingerforecasts.comand Kiplingers Personal Finance magazineOctober 2000

Introduction

The ABCs of Cash Flow

PART ONE CASH RULES

ASH FLOWS IN AND CASH FLOWS OUT OF EVERY

business. Whatever your job, you contribute toboth flows: You are a resource that costs dollars,and you use or somehow influence the use ofother resources that cost dollars. At the same

time, your actions have a direct or indirect effect on cash com-ing into the business.

But what are the key factors that drive that two-way flow?If you can identify those factors in terms of your companysbasic operations, you will gain a powerful tool for growing yourbusiness and ensuring that the cash flowing in exceeds thecash flowing out.

This book aims to help you do exactly that. It focuses onwhat I call cash drivers, seven things that control virtually allcash flow for virtually every business almost all of the time.They are: sales growth; gross margins; selling, general andadministrative expense (SG&A); accounts receivable;accounts payable; inventory; and capital expenditures(Capex). This book will show you how to understand, mea-sure and analyze your business, as a whole and in its individ-ual parts, in terms of these cash drivers.

You may be the owner or president of the company andtrying to come to grips with trade-offs among market share,pricing and profitability. Or maybe sales management is yourarea, and you need to think through the terms of a new sales-force compensation plan, one that gives adequate attention to

C

Cash Rules

3 |

CHAPTER ONE CASH RULES


a new product line that seems to hold great potential for thecompanys future. Perhaps you areresponsible for office management andhave been asked to hold head-office over-head costs flat as the company expandsgeographically. Every area of the busi-ness, whether product management,sales, purchasing, service or shipping,has issues that can be better managed inlight of the dynamics of the seven cashdrivers. Before we take a closer look atthose cash drivers, though, we need tohave a clear sense of the nature andimportance of cash flow itself. Let me

begin by telling you a story.

Why Cash Flow Is Important

L ast gas for 150 miles. Weve all seen that sign in movies,a television show or a cartoonmaybe even in our owntravels. My family and I encountered it on a longstretch of highway in central Nevada. Even at 85 and 90 milesper hour, that highway seems to run on forever. The signlooked older than the surrounding desert. Surely the nextfilling station couldnt be that far away, could it? Why take achance, I thought while turning in and pulling alongside the$1.99 per gallon self-serve regular pump. A pit stop andsomething cold to drink sounded good to the whole family,even though the gas gauge registered comfortably in the mid-dle of its range.

An hour and a half later, I had reason to compliment myown forethought. Our older Detroit-built sedan flew past a new7-series BMW as though it was standing still. Indeed, it wasstanding still. There it sat, svelte and aggressive, $70,000 worthof Bavarias best iron and engineering ignominiously pulled offto the side of the road. It was, of course, out of gas. The driverhad scrawled that painful admission in black crayon on a fold-ed Nevada map he held high, partially unfurled and fluttering

4|

Every area of thebusiness, whether

product management,sales, purchasing,

service or shipping,has issues that canbe better managed

in light of thedynamics of the

seven cash drivers.

5 |

in the high-speed turbulence of our well-fueled Oldsmobile.Im not the sort of person who tends to gloat, but I must admitthat I had to mask a pleasant sense of self-righteousness as Istopped to help.

Cash as Fuel Our friend stranded in the Nevada desert in his $70,000 auto-mobile violated a survival principle: Dont run out of fuel. Theoverall engineering excellence of the vehicle, the road holdingability of its suspension system, the low coef-ficient of drag that makes it cut so cleanlythrough the hot desert airnone of thatmattered once the needle pointed to empty.The point is that it is the fuel on board, notthe vehicle itself, that is so critical.

Like the expensive import, no matterhow glamorous the product, no businesscan be successful without its fuelcashtokeep it running. The enterprise that runsout of cash may be the jalopy-like cornergrocery store or the long-establishedFortune 500 company. Either way, if theenterprise runs out of cash, it is stuck. Everyyear, thousands of good-sized, first-ratecompanies go bankrupt, and the core rea-son is almost always the same. Their managers never learnedhow to think and plan in cash-flow terms. Consequently, theyran out of fuel.

But like many analogies, this one, too, eventually breaksdown. Consider the car. It burns fuel to run, then it musteither refuel from an external source or come to a stop. Onthe other hand, a well-run enterprise has a system that canactually generate much of its own fuel. When it is fulfilling aneconomic purpose well, and adapting continuously to itsenvironment, the business can keep on going, like the pinkbunny in the battery ad, mostly on internally generated fuel.Some proportional increase in bank debt or supplier creditmay be part of the fuel-supply system. But these sources of

Cash Rules

When it is fulfillingan economic purposewell, and adaptingcontinuously to itsenvironment, thebusiness can keepon going, like thepink bunny in thebattery ad, mostly oninternally generatedfuel. Companies thatarent so well runare another matter.


6|

capital are available precisely because of the internal cash-generating capacity of the enterprise.

Companies that arent so well-run are another matter. Youmay have a better mousetrap to sell, but if your business can-not generate enough of its own fuel, it will be left by the sideof the road. It will probably be cannibalized for parts or trans-formed into something other than what it was. The businessequivalent of running out of gas is bankruptcy, and the com-pany that is unable to pay bills as they come due is at severerisk of being forced into bankruptcy.

Profitability versus Cashflowability

L ets take this point about the self-generation of cash fur-ther. The main quantitative measure of a businesss suc-cess is not profitabilitythe excess of revenue overexpense. Instead, it is what I call cashflowabilitythe excess ofcash flowing into the business over cash flowing out. It is quitepossible, and even common, for profitable businesses to be cash-flow disasters. Revenue and expense as the determinants ofprofitability are accounting notions that very often play out inways materially separated in time from the actual flows of cashinto and out of a company. Sometimes this time warp results ina cash dislocation that can cause serious financial damage.

The most obvious and perhaps most common way for abusiness to run out of cash is to experience too rapid a rate ofsales growth. The CEO of every company needs to know howmuch sales growth can be handled within given cash con-straints. For a simple example, consider a business that has amaximum sustainable sales growth of 25%. Suppose furtherthat this company has a strong new product concept, that itsproduction methods are world class and that its sales efforts areextremely well targeted. In consequence, sales shoot up by 50%rather than 25%. The problem here is that higher speedmore rapid growthmeans: higher rates of cash consumption; less time to regenerate cash supplies; and greater risk for holders of both debt and equity (bonds and stocks).

7 |

Cash Rules

Consider some likely cash impacts of continuing to growat twice your sustainable rate. Perhaps, through a pattern ofslow payment to support a larger inventory, you have alreadypushed one key supplier to the brink of cut-ting off all but C.O.D. shipments. You havejust missed a payment to the savings andloan holding the mortgage on your newwarehouse because so many sales have notyet been converted to cash but instead aresitting in accounts receivable. With all of theproduction overtime caused by so muchsales growth, you have a massive bimonthlypayroll due the day after tomorrow that youmay not be able to cover. But you are prof-itable! Your income statement says so. It hasbeen audited and it is absolutely right. You are very prof-itable, but in terms of cashflowability, your back is to the wall.

Growth takes cash, and lots of growth takes lots of cash.You will see the why behind this phenomenon in further detailat several points in this book. The sad fact is that the majorityof failing firms are profitable as they enter bankruptcy. No gas,no go. These firms concentrated on burning their fuel effi-ciently rather than on generating adequate fuel quantities. Soinstead of being able to keep on going, they found themselvespulled far off to the side of the road and in danger of fallinginto the bankruptcy ditch. Some may make it back. Manywont. What a shame. For many firms, all the pieces were inplacegood people, good ideas, first-rate products, strongcustomer base, outstanding research and developmentexcept that all those talented people somehow were absent theday the teacher covered cash flow.

Cash Is King

Y ou might think that most of these observations apply tosmaller companies that live close to the edgethe kindsof companies for whom survival is a crucial issue, if notthe main event. While there is some degree of validity to that

Growth takes cash,and lots of growthtakes lots of cash.The sad fact isthat the majorityof failing firms areprofitable as theyenter bankruptcy.No gas, no go.


view, the real question has to do not with company size but withbasic economics. Whatever we do with financial and accountinglegerdemain, cash is still king, Cash Rules! Many large-company

managers are learning this basic reality inthe same down-and-dirty way as the smalland midsize firms. Here is why.

To the surprise of many people, small-company owners and their bankers are notthe only ones who follow cash flow. Thestock market also pays far more attentionto underlying cash-flow realities than itdoes to reported accounting earnings.Little by little, corporate managers havefinally begun to catch on. Many, though,continue to favor earnings over cash flow, a

bias that is truly costly. It is costly to stockholders and sometimesto the management teams themselves as more cash-flowsensi-tive companies take them over and begin the downsizing.

What Is Cash Flow?

Some of the heaviest fog in the business world settlesaround the phrase cash flow. The term is seldom usedwith precision, and its even more rarely discussed in apractical, systematic way. Ive encountered cash flow as thetopic of a specific college or MBA-level course only once, andthen it was just a one-hour elective class.

Cash flow is simply the difference between the cash flowinginto and out of a business over the course of an accountingperiod. Since it is a net figure, cash flow is positive when actualreceipts exceed actual disbursements. The reverse is obviouslytrue; if cash flowing out exceeds cash flowing in, cash flow isnegative. At the most basic level, it really is that simple. Later inthis book well distinguish among operating cash flows, financ-ing cash flows and investing cash flows. But for the moment,the basic definition will serve. One other important issue at thisearly stage of understanding cash flow is a distinction based onthe basic type of accounting system being used.

8|

The stock market paysfar more attention tounderlying cash-flowrealities than it does

to reported accountingearnings. Little by

little, corporatemanagers have finally

begun to catch on.

9 |

Avoiding DistortionsCash versus Accrual There are two basic accounting systems: cash-based and accru-al-based. In a cash-based accounting system, cash flow is quiteeasy to measure. The till and the checkbook tell the storybecause nothing is considered revenue until payment isreceived and nothing is considered an expense until paymentis made. For most businesses, though, a cash-based accountingsystem is far too simplistic to reflect economic realities.

The accrual-based accounting system presents financialresults as though all the transactions hadalready been settled in cash. Cash-basedaccounting contrasts strongly with thatapproach by recording only what actuallydid take place in cash terms. Each methoddistorts what really goes on in the business.The cash-accounting approach misrepre-sents the underlying business and eco-nomic realities of the firm in terms of theflow of value. The accrual method leadspeople unfamiliar with cash flow to believe that the incomestatement reveals cash truth when in reality it reveals only asthough cash truthas though all transactions had been settledin cash. Lets consider some basic accounting principles andspecific examples of how distortions can arise if those princi-ples are violated.

One basic principle in accounting requires the recording ofrevenue when the economic activity that generates it is substan-tially completed. In most cases this happens when the product isshipped or the service rendered. If there is a significant timelag between substantial completion and actual payment, thenwaiting for actual payment before recording the revenue nec-essarily introduces a distortion.

A similar distortion would be introduced on the expenseside if, for example, inventory is expensed only when the sup-plier is paid. That would mean the inventory is never record-ed as an asset. It would also mean that if the inventory is usedin a separate accounting period from the one in which it ispaid for, a related basic accounting principlethe matchingprinciplewould also be violated. This principle requires that

Cash Rules

There are two basicaccounting systems:cash-based andaccrual-based.Each method distortswhat really goes onin the business.

all of the expenses associated with producing revenue in aperiod be recorded in the financial statements of the same time

period. From both an accounting and anIRS point of view, cash-basis accounting ispermissible only in businesses that are sosimple that cash accounting would notdistort results.

In the vast majority of businesses,accrual-based accounting has been adopt-ed as the required method. And this isthe point at which problems of terminol-ogy and understanding about cash flowbegin. Instead of recording everythingbased on the movement or flow of cash,as in cash-basis accounting, accrual-basedaccounting measures the flow of value.But the flow of cash and the flow of valueare quite different in several materialrespects. It is crucial, therefore, to getbehind the details of accrual accounting

to understand what happened in cash terms.

Cash Flow & Credit Bankers usually understand cash flow better than anyone else.The reason is simple. Bankers are unique in that after they sellyou their productmoneythey want you to give it back!Loans are made in cash, and lenders insist on being repaid incash. A good lender, therefore, must understand what it takesfor a businesss cash flow to be adequate to repay debt as sched-uled. The concern is not just repayment, but repayment asscheduledthat is, on time. And there lies the essence of the cash-flow rubtiming. The bank faces more than just its stockhold-ers on this issue of repayment as scheduled. It is also responsibleto powerful state or federal regulators who watch for loans notperforming as scheduled.

It makes sense that understanding cash flow is at the verycore of the bankers business. This has been my personal expe-rience working as a banker and teaching cash-flow dynamics to


10|

Accrual-basedaccounting measuresthe flow of value, not

the flow of cash.But the flow of cash

and the flow of valueare quite different

in several respects.It is crucial to get

behind the details ofaccrual accounting

to understandwhat happened in

cash terms.

11 |

bankers. The goal is always to help them focus more clearly ontheir clients cash-flow potential. I have also been on the otherside of the desk as an entrepreneur experiencing the dark sideof the cash-flow force when sales volume didnt meet goals,expenses exceeded budget and capital requirements ranbeyond plan. I have struggled to coverpayables in a start-up enterprise and coun-seled with clients in similar straits. Believeme when I say, Cash Rules.

You might think that borrowers wouldcare about and understand their cash flowat least as well as their bankers did, butthats rarely the case. Especially in small-and medium-size firms, businesspeopletypically concentrate on satisfying somemarketplace demand. They are generallymuch less adept at support functions suchas accounting or finance. If youre runninga software company or flower shop, or if you are a plumbingcontractor, you probably went into business because you knowand care about computer programming, roses or waterheatersnot finance, important though it is.

There are plenty of specialists in finance and accounting onwhom you might depend. Unfortunately, their experiencesand worldviews are shaped primarily by the use of accountingto track the flow of value, not cashthat is, they are primarilyoriented to the assumptions that underlie accrual accountingsystems. The entire accounting cycle of entries and records, ofjournals and ledgers, of trial balances and financial statements,is focused on keeping track of the bills we send and the bills wereceivenot on the cash that actually pays those bills.

Cash-Based Valuations The funny thing is that whenever it comes time to calculatethe total value of a company, the flow of cash will be muchmore critical than the flow of value that conventional accrual-accounting systems track. Whether your firm is small or large,public or private is not at issue. In every case, the underlying

Cash Rules

Whenever it comestime to calculatethe total value ofa company, the flowof cash will be muchmore critical thanthe flow of valuethat conventionalaccrual-accountingsystems track.


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value of the business will always be subject in some way to avaluation procedure. Someday your business will undergo avaluation process for some purposemaybe for estate orother tax reasons, perhaps for sale or merger purposes, or(though hopefully not) for divorce or bankruptcy reasons.Whether it is the stock market, the courts, your heirs or aprospective purchaser triggering the valuation, the core ofthe valuation process will always be rooted in one centralissue: the capability of your business to generate a flow of cashinto the indefinite future. The greater that flow and the lowerthe risk to the flow, and the higher the growth rate of the flow,the greater will be the flows present valueand the worth ofyour business.

Turnaround specialist David Allen likens cash to blood. Youneed enough to stay alive, as he has told many a strugglingexecutive. Blood may be a bit more dramatic than gasoline, butblood, when looked at functionally, is simply a kind of fuel.When a cash crunch pushes a business hard up against therocks and it is bleeding profusely, its in a life-threatening situ-ation but not necessarily terminal. Far too often, though, bank-ruptcy does mean the death of the business because three out offour business bankruptcies are the Chapter 7 kindthe kindthat means liquidation. Even that wordliquidationcarriesthe root idea of taking something that was not flowing and forc-ing it to flow. We liquidate a business when it is not producingpositive cash flow on its own and has little prospect of doing so.Too often this happens not because of anything fundamental tothe business or its management style. It happens instead due toignorance of cash-flow realities and dynamics.

Team Cash Flow

Imagine a basketball team composed of outstanding playersat every position. For some strange reason, though, theplayers all suffer from the same defecta poor under-standing of the basic rules of the game. The players may begreat at dribbling, passing, shooting and rebounding, but ifthey dont know that they have to inbound the ball within five

13 |

seconds, theyll have a hard time beating even vastly inferioropponents, let alone winning the state championship.

Much of every games success comes from thinking a fewmoves aheadthat is, knowing what to do next. Good deci-sions can be made only in the context of a broad understand-ing of the rules as they affect all the players you might need tocooperate with. In much the same way,knowledge of cash-flow dynamicsshould be a qualification for virtuallyany responsible job in your organiza-tion. This doesnt mean that you needa company full of accountants, but youdo want each key player to see andunderstand the cash-flow issues clearly.Each one should have a definite aware-ness of how his or her personal effec-tiveness and efficiency affect your com-panys cash flow. Accomplishing thisgoal involves some basic education andtraining, as does any new discipline.The purpose of this book is to help youmove in that directiontoward making the cash-flow mindsetan integral part of your businesss operation.

Many small- and medium-size organizations think theycannot afford a trained and experienced chief financial officer.In fact, they cannot afford not to have that kind of expertise.But even among those companies that do have skilled CFOs,there is no guarantee that the cash-flow way of thinking will getintegrated into the organization. The fact is that everybody onyour management team needs to understand how cash-flowdynamics affect his or her department if your business is toprosper in the long term. This book is intended not to turnowners or managers into accountants, but to provide you witha set of essential cash-flow insights and a language for dealingsuccessfully with cash-flow dynamics.

If you are in sales, you affect company operationsandthus cash flowdifferently than if you are a purchasing agent,a production engineer or a service department manager. If youare a computer programmer, your sphere of influence includes

Cash Rules

Knowledge of cash-flowdynamics should bea qualification forvirtually any responsiblejob in your organization.This doesnt mean thatyou need a companyfull of accountants,but you do want eachkey player to see andunderstand the cash-flow issues clearly.


things that the accounts-receivable clerks job does not. As youwork through Cash Rules, perhaps as part of a taskforce in con-cert with others in the company, look for the elements, connec-tions, influences and potentials in your job that may positivelyaffect cash flow either directly or indirectly through the sevencash drivers. The main purpose of this book is to help you inte-grate cash-flow thinking into both the everyday and the strate-gic decision-making processes of your company.

Plan of the Book

L ets look now at an overview of the book to see how it canhelp you develop that most basic of business survival andsuccess skills, cashflowability.PART ONE: THE ABCS OF CASH FLOW. Following this introductorychapter, we discuss the language and concepts behind cash-flowthinking, including a preliminary sketch of each of the cash dri-vers and how it is measured. Chapter 3 explains a few of thebasic accounting concepts and mechanics you will need toapply the cash drivers to your business. Finally, Chapter 4focuses on the structuring of cash-flow statements and theirrelationship to balance sheets and the income statement. Thechapter includes a discussion of the relationship between cashflow and more traditional ratios analysis in terms of profitabili-ty, efficiency, liquidity and leverage.

PART TWO: THE SEVEN CASH DRIVERS. The drivers appear indescending order of importance to your business. Sales growthis the lead-off driver, both because of its typically greater signif-icance and because of some specialized topics affecting salesgrowth that warrant special attention before moving on to con-sideration of gross margin.

Gross margin, the subject of Chapter 6, is what remainsafter deducting the cost of production, cost of product acquisi-tion or cost of sales from total revenue. It has both a cost sideand a price side, and both will be discussed in depth from acash-flow viewpoint.

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Chapter 7 looks at ways of controlling operating expense,that is, selling, general and administrative, or SG&A. The focusis on both expense and expenditure, which are consideredfrom two key perspectives, cost control and capacity planning.Chapters 8, 9 and 10 look in turn at accounts receivable fromcustomers, the inventory we hold for either sale or furtherwork, and, last among so-called working-capital items,accounts payable to our suppliers. We explore both the short-and long-term implications for cash flow in how these threeissues are managed. In Chapter 11, long-term investmentsmade for purposes of enhancing productivity under the head-ing of capital expenditures are examined from a financing,timing and strategic perspective, with emphasis throughout onthe cash-flow dimensions.

PART THREE: CASH FLOW AND BUSINESS MANAGEMENT. This sectionconsists of four forward-looking chapters that use the sevencash drivers as the basis for describing, testing and fine-tun-ing plans for growing your business. Chapter 12 follows upwith a nuts-and-bolts case study demonstrating the logicalapplication and calculation of the cash drivers. It does this forboth a sample companys recent history and a projection of itsnear-term future. The projected values of the cash driversare used to teach a method for building the forecasted peri-ods cash-flow statements. Chapter 13 goes beyond the cash-driver assumptions and the mechanics of projecting by takinga more strategic perspective. The point of this chapter is tothink about the business using the cash drivers as a strategi-cally consistent set of measurable business goals centered incash-flow dynamics.

Chapter 14 moves to the important link between cash flowand company value. This view begins with a look at the risk lev-els borne by both your lenders and your stockholders.Regardless of whether these are major institutions or just thefriends, relatives and co-workers who gather at the annual pic-nic, the specific risks to be considered under valuation arealways those associated with market-value erosion. Operationalrisks, of course, are implicitly covered in the discussions of cashdrivers. Company valuation is then discussed in the context of

Cash Rules

a cash-low calculation methodology, with particular attention tothe risk of loss. Such risk may be to holders of either debt orequity. The methodology of valuation presented is consistentlycash-flow centered, as are the related risks of loss, volatility andinadequate growth. Chapter 15 provides a brief summary ofkey concepts along with some suggestions for beginning to inte-grate the cash-drivers mindset into your business life. Now letsbegin with an overview of cash flow.


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ASH IS THE ULTIMATE MEASURE IN BUSINESS.Acquisitions, expansions, buyouts and bank-ruptcies all revolve around and depend on mea-sures and flows of cash. Too little cash can kill abusiness; too much can invite unwanted

takeovers. Every significant decision in a business has definitecash impacts and implications, but ironically, there is no gen-erally accepted way to communicate clearly, consistently andsimply about this important topic on anything but a detailedaccounting basis. Lets begin to remedy that problem by talk-ing a bit more about what cash is and where it comes from.

By cash we mean more than the currency in our walletsand tills. More significant by far are immediately accessibledeposit accounts, money-market funds and the instruments,primarily checks, that draw on those accounts as cash. There isalso a category of investments that can become cash almostinstantly, such as Treasury bills and certificates of deposit.Added together, these make up the actual cash figure on the bal-ance sheet of an enterprise.

Economists talk about money supply quite a bit and define itin a number of ways that have parallels with different parts ofa business firms actual cash. Just as an economy has a moneysupply, so does a company. For whole economies as well as forindividual firms, there is a relationship between the money

C

Cash-Flow Language& Environment

17 |

CHAPTER TWO CASH RULES


supply and the velocity, or turnover rate, of that money sup-ply. For a whole economy, the value of everything that gets pro-duced has to be equal to the available money supply times itsvelocity. The velocity of money in the whole economy is fairlyconstant and changes very slowly over time in response to avariety of influences. In contrast with the quite slow changes in

moneys velocity, the money supply itselfcan change more quickly. Even so, onlyrelatively small percentage changesoccur in the money supply over thecourse of a typical year. When we mea-sure what happens to money supplyspontaneously through the loan-expan-sion or -contraction capacity of the bank-ing system in order to accommodate ris-ing or falling levels of business activity,the change may be a bit higher. Eventhen, however, money-supply changesare usually measured only in the range offractions of a percent per month.

In the individual business, thingsmove much more quickly. Money sup-ply and velocity within a company areboth extremely sensitive to marketinfluences and management decisions.As a result, they can change enormous-

ly in the very short term. Generally speaking, the money sup-ply and its velocity will have more variability for a smallercompany and less variability for a larger one. General Motorsbalance-sheet figure for cash and cash equivalents, the com-panys own money supply, will vary far less over the course ofa year than will that of the Smith Construction Co. The rea-son is the law of large numbers. One consequence is that therisk of the money supplys dipping to the danger point ismuch greater for small enterprises than for large ones. Theother element of risk that is related to size is access to capital.Because risk is greater in a small enterprise, its much harderto get outsiders to plug a gap in the money supply. The goodnews though, is that the basic categories of available money

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Money supply andvelocity within a

company are bothextremely sensitive to

market influences andmanagement decision

making. As a result,they can change

enormously in thevery short term.

Generally speaking,the money supply and

its velocity will havemore variability for a

smaller companythan for a larger one.

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resupply are the same for all. Lets consider the possibilities.Under certain conditions and within certain limits, more

cash can be generated by converting a variety of other assets tocash, by borrowing, or by taking in cash from investors. Thereare, however, a whole series of risks, costs, delays and limits toeach of these strategies. For example, raising equity funds whenthe company is strapped to begin withmay prove unduly costly if too muchequity has to be given up in return.

Asset conversion is always a possibil-ity for generating cash, and there aretwo basic ways to accomplish it. The firstis to sell off assets that are not essentialto the businesss operation. The secondinvolves better management and tighterforecasting of the so-called asset-conver-sion cyclethe sequence during whicha sale converts a portion of inventory toa customer receivable, and then eventu-ally to cash as the customer pays. Thisasset-conversion cycle is fairly regular. Aregular cycle, however, doesnt necessar-ily mean an even one. Lumps andbulges occur due to uneven ordering dates, variations ininvoice size, seasonal factors and other reasons that leave theshape of the asset-conversion cycle far from a perfect circle. Itoften looks more like a prehistoric engineers attempt at build-ing a wheel by tying a bunch of rocks together. There are lotsof irregularities.

The consequences of mismanaging or misestimating thesecycles can be dangerous. This is true even for solid businesses,because running out of cash and not having enough time toreplenish the money supply leave the firm unable to pay debtsas they come due. Obviously, that exposes the company topotential legal action by creditors. It is also dangerous because,even in the absence of legal action, the risk to payroll integrityand supplier confidence may easily cause irreparable damageto the overall quality of the operation. You must, therefore, putthe highest priority on paying debts as they come due.

Cash-Flow Language & Environment

Under certainconditions and withincertain limits, morecash can be generatedby converting a varietyof other assets to cash,by borrowing, or bytaking in cash frominvestors. There are,however, a whole seriesof risks, costs, delaysand limits to each ofthese strategies.


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With very few exceptions, debts have to be paid in cash asdefined above. Salaries have to be paid in cash. Virtually every-thing has to be paid for in cash. You may get two weeks, or 30

days, or other terms on which paymentis due, of course, but when its due, itsdue in cash. When your enterprise has abill to pay, nobody really wants yourdelivery truck, or the products sitting inyour warehouse, or all the wondrousthings your designers, architects or pro-grammers could do for them. Nor doesanyone want to be paid with a stack ofreceivables due, even from your verybest customers.

Everyone you owe wants cash. If youcant provide cash when its due, orsomehow reassure your creditors thatits coming very soon, they will most like-

ly force you into bankruptcy. But wait a minute, you say, yourea very profitable business with wonderful prospects, a newproduct line and a world-class customer base. You have a lockon the market and are growing 40% a year. The answer willsimply be: Sorry, payment needs to be made in cash. Businessdoesnt run on profit; it runs on cash. Business doesnt run onsales growth; it runs on cash. Your business doesnt run on eventhe best and most realistic prospects for the future unless theimmediate future contains enough cash to pay your bills. Cashis the fuel on which the enterprise runs, and we need a lan-guage to help us talk simply and consistently about it.

Introducing the Cash Drivers: A New Language

Imagine an environment in which key employees in all kindsof jobs learn to use a simple, cash-focused vocabulary as theprimary way of framing business issues and taking part inbusiness discussions. Imagine the improvement in clarity of

Business doesnt runon profit; it runs on

cash. Business doesntrun on sales growth; itruns on cash. Business

doesnt run on eventhe best and most

realistic prospects forthe future unless the

immediate futurecontains enough cash

to pay your bills.

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communications. Imagine the sharpened focus on measurablegoals. Imagine the improvement in cash flow and, ultimately,company value. The benefits cross all boundaries. Large firmsand small ones, without regard tolocation, division or product specialty,would benefit. Imagine the possibili-ties in your company, on your job, ifthe effects of not only the big decisionsbut also the relatively ordinary oneswere routinely processed through acash-flow mindset and discussed incommon terms. This language con-sists of the dynamic vocabulary of theseven cash drivers (that Ill detail inChapters 5 through 11) operatingwithin a basic accounting grammarthat I will cover in Chapters 3 and 4. With the background ofour basic cash-flow discussions thus far, lets turn to an overviewof the cash drivers.

CASH DRIVER #1: SALES GROWTH. The most basic cash driver is thesales-growth ratetypically measured as the percentagechange in sale volume from the previous period. Sales growth isone of the first things that lenders, managers and professionalfinancial analysts look at when evaluating business perfor-mance. The reason is straightforward: Sales volume tends todrive practically everything else. Other things being equal, sig-nificant changes in sales volume will have major ripple effectsthrough the companys balance sheet, income statement and,especially, its cash-flow statement.

CASH DRIVER #2: GROSS MARGIN. Gross margin is what remainsfrom sales after you have covered your direct product or ser-vice costs. Gross margin is measured and expressed as a per-cent of sales to help demonstrate more clearly how many centsout of each sales dollar are available to pay for everything elsein the business. All operating, financing and tax costs as well asany return to owners of the business will come out of the grossmargin.

Imagine the possibilitiesin your company, on yourjob, if the effects of notonly the big decisions,but also the relatively ordinary ones wereroutinely processedthrough a cash-flowmind-set and discussedin common terms.


CASH DRIVER #3: SELLING, GENERAL & ADMINISTRATIVE EXPENSE(SG&A). This is commonly thought of as your overhead in man-ufacturing and merchandising businesses. In a service business,where there is often no gross margin per se, SG&A alsoincludes those costs associated with providing the service that isyour reason for being. SG&A is generally best expressed as apercent of sales to reveal directly how many cents out of eachsales dollar are taken by normal operating expenses.

CASH DRIVERS #4, 5 AND 6: ACCOUNTS RECEIVABLE, ACCOUNTSPAYABLE, AND INVENTORY. Rather than thinking about each ofthese items as a percentage of sales, as with the preceding dri-vers, we normally find it most helpful to think about thesetrading accounts in relation to time. The term is days worthso many days worth of annual sales tied up in accountsreceivable from your customers, so many days worth ofannual cost of goods sold expenses tied up in your inventoryinvestment, so many days worth of annual cost of goods soldfinanced by your suppliers through accounts payable. Thesedays measures also have the benefit of simultaneously tellinghow long it typically takes for three important things to hap-pen: How long it takes to collect on a sale (accounts-receivabledays), how long the average item sits in inventory before sale(inventory days) and how long we typically have benefit of asuppliers product or service before actually paying for it(accounts-payable days).

CASH DRIVER #7: CAPITAL EXPENDITURES. What does it take in theway of new investment in the infrastructure of your business tokeep it healthy and growing? Thats the capital expenditures(Capex) issue. It is usually helpful to measure this cash driverboth in absolute termsthat is, in dollarsand also in relativeterms linking it to sales growth. The best relative measure Ihave found is capital-expenditure dollars expressed as a per-cent of the dollar growth in sales during the same period. Ittakes more in the way of fixed assets to support higher levels ofsales, and so we want to express that reality in a relational way.

If somehow we could know the relative levels of the sevencash drivers for any good sample of companies, say the

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23 |

Fortune 500, for the coming year, we could predict with amaz-ing accuracy their likely levels of cash flow. Although there arelots of other factors besides these seven, these are the drivers, andthey are the drivers because imbeddedwithin them are the core issues and rela-tionships of the enterprise. As we focuson each of the drivers in their individualchapters, we will look specifically at whatthose issues are.

The cash drivers apply not just tolarge companies but to all organizations,especially businesses, of virtually anysize. In the small enterprise with ahandful of employees and sales of up toa few million dollars, the draw that theowners take may reasonably be considered an eighth cash dri-ver. That account can vary significantly and, in a sense, rep-resents a special subcategory of SG&A expense. We wont bedealing with this element specifically, but keep it in mind ifyour situation makes it appropriate.

Some specialized industries may also have their own keymeasures that can effectively be used as cash driversforexample, percentage of seats sold (load factor) for an airline,or percentage of homes penetrated on a line for a cable-TVoperator. For most of us most of the time, however, the basicseven cash drivers are the appropriate tools. Lets take a minicase study to illustrate some of the areas in which cash-driverlanguage can make business smoother and simpler.

Cash Flow in a Company Context

Imagine that last year you started a company with $5 millionyou won in the lottery. You have a great product idea:organic memory membranes for use in electronic games.You have hired a few outstanding engineers to implement yourbrainstorm, and, little by little, you have added other special-ists as needed.

Your companys first nine months were spent on design


In the small enterprisewith perhaps just a handful of employeesand sales of up to afew million dollars, thedraw that the ownerstake may reasonablybe considered aneighth cash driver.

and development of production equipment, while you andyour sales staff negotiated a deal with CyberFun, the worldsleading maker of computer games. CyberFun plans to use your

memory membranes in its newest lineof hand-held toys, to be launched intime for next Christmas. Three monthsago, you began shipping your product,in small batches at first, then in pro-gressively larger shipments as yourmanufacturing yield and product qual-ity improved. There were a few set-backs, of course, and some of the earlybatches failed to meet the procurementcontract specs, but last months ship-ment was near-perfect. You can expecta big check from CyberFun by the first

of next month. Youll finish Year One with a solid $10 millionin sales. Its a huge success story! Or is it?

The problem is that every cent of your $10 million in salesis tied up in a single account receivable from CyberFun.Meanwhile, youve spent all your original $5million (your lot-tery winnings, remember?) plus $2 million more that you bor-rowed from your neighborhood banker, Debby at FirstInterGalactic BanCorp. The first loan repayment is due tomor-row, and youll have barely enough cash left to meet Fridayspayroll. But your balance sheet and income statement look great! Whathappened?

Your balance sheet and income statement reflect a flow of$10 million in product value to CyberFun. The balance sheetshows a $10 million flow of value to you in the form of anaccount receivable from a first-class, blue-chip company. Theincome statement calls that $10 million sales, though not apenny has actually changed hands, and shows actual expensesof only $5 million and a $2 million after-tax profit. Yet despiteall of that accounting profit, you are out of cash because of thebig investments made for carrying receivables and inventory,plus building a state-of-the-art manufacturing facility.

Accrual accounting systems, you will recall, track the flowof value, and they do that very well. But except in the simplest


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The seven cash driverscan help you think

about what drives cashand focus your attention

on the critical issues.They provide an

essential paradigmnot only for business

survival, but forstrategy and success.

25 |

cash businesses, there are inevitably significant differencesbetween the cash flow and the value flow. The seven cash dri-vers can help you think about what drives cash and focus yourattention on the critical issues. They provide an essential par-adigm not only for business survival but also for strategy andsuccess. Understanding that paradigm will enable you to con-tribute more fully to the success of your organization, regard-less of your job. Each of the cash drivers is crucial. If youunderstand what they mean and how to manage them, youwill have taken a big step toward ensuring the long-termhealth of your company. Lets look at a heavily disguised, yetreal, company where cash-flow thinking was added on ratherthan built-in.

The Jones Dynamite Co. is a medium-size wholesaler of explosives in theSoutheast. In the early 90s, there was considerable sales growth becauseof a successful strategy of renting specialized explosives-related equipmentbundled together with the explosives themselves. At the same time, how-ever, a lack of tight controls permitted Joness overhead expenses to driftupward somewhat faster than sales, thus increasing SG&A expense as apercentage of sales.

But thats not all. While it was concentrating on expanding marketshare, the company did not pay enough attention to customer credit andcollection issues. This allowed dollars that were tied up in accounts receiv-able to increase even faster than sales grew. From 1991 to 1994, Joneswent from holding an average of approximately 35 days worth of sales inaccounts receivable to nearly 50 days. Thus Jones not only had to financethe additional investment in accounts receivable that inevitably comes withrapid sales growth; it also had to finance the excess accounts receivableassociated with not paying close enough attention to collection and creditpractices. This combination of circumstances used quite a bit of cash overand above what was needed to develop the specialized-equipment rentalside of the companys business and to hold larger explosives inventory.

Because of the magnitude of these cumulative cash drains, Jones could


Recovering But Still Not a Team

A CASE STUDY


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easily have become another of the many basically sound companies thatfail at the rate of more than one every hour, with no time-out for weekendsor holidays. If Jones had failed and filed for bankruptcy, it would not bebecause the company ran out of energy, good marketing ideas or a broadcustomer base.

Surprising as it may seem, chances are that most business bankrupt-cies could be headed off without radical surgery if enough cash was avail-

able to keep going just a few months longerjustenough time to solve the new-product bugs, or toabsorb the loss of a major client, or to sublet half ofthat big warehouse, or any number of other problem-solution combinations.

The good news is that with the help of their bankerand lawyer, the two brothers who own Jones under-stood that the organization had gotten too big and toocomplex for their longtime bookkeeper. She hadalmost no formal training and had come to the com-pany right out of high school as its first full-time office

worker. That was ten years after the two owners father had founded thecompany on a shoestring following the Korean War. Jones had long agopassed the stage where it should have hired a controller. Many CPAs agreethat when a company passes a half-million dollars in sales, a hundred cus-tomers and dozens of suppliers, as Jones did in the mid 80s, it should hirea chief accounting officer. And especially in view of the ambitious growthrate in sales that Jones targeted, professional cash-flow planning was amanagement necessity.

Jones may sound like an extreme example, but it followed an amazinglycommon pattern. Ignorance of cash-flow dynamics kills more companiesthan fraud, fire, competition, technological obsolescence or anything else.There are few circumstances that cant be handled and recovered from ifkey executives and managers have internalized a cash-flow mindset andintegrated it into their management style. At Jones, an experienced andprofessionally trained controller was finally brought in with excellent sup-port from the bookkeeper. Some major improvements were made andsome financial discipline was imposed. Much of this discipline was a nat-ural byproduct of the controllers focus on the development and imple-mentation of accounting systems and controls. Another dimension of thejob that quite naturally helped was a new emphasis on financial reportingwith a view toward identifying implications for the future.

Ignorance of cash-flow dynamics kills

more companiesthan fraud, fire,

competition,technological

obsolescence oranything else.

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Building a Cash-Flow Culture

Jones has now recovered fully from its near-disastrous cash-flow bind, and yet a major difficulty remains. As is the casewith so many organizations, the new financial discipline isessentially being imposed by the controller from a point of viewthat is conceptually external to the essence of Joness business.The controller just isnt a constructionguy, much less an explosives guy. Thepeople in the company who really knowthe products, the customers and the spe-cific business environment still dontunderstand or think about cash flow.They just react to the controller as a sortof cash-flow cop. Even the owners jokepublicly about the new financial disciplineas though it represents an uncomfortablestraitjacket binding the company, ratherthan something integral and organic totheir overall decision-making processes.What is missing at Jones is a cash-flow awareness from withininstead of a discipline imposed from above. What is needed isa self-discipline that comes from having the cash-flow way ofthinking and cash-driver language instilled into every key play-er on the team.

To some degree, a cultural shift has to take place.Language, which is always basic to any culture, needs to beadjusted to express the new cash-flow realities. To the extentthat information and training about cash flow become part ofthe way people communicate and motivate, then, and onlythen, is the cultural shift truly under way.

As we think about culture shift, consider a real-life examplethe Hudsons Bay Co., the largest department-store chain inCanada. At more than 300 years of age, this former fur-trappingfirm might be expected to know something about the importanceof survival and cash flow. But just surviving this long proves verylittle. At one time, albeit a very long time ago, Hudsons Bay wasarguably the largest and most prosperous firm in the New World.But if we had the records to calculate its true rate of return overthe past three centuries, we would no doubt find that despite the


There are fewcircumstances thatcant be handledand recovered fromif key executivesand managers haveinternalized a cash-flow mindset andintegrated it into theirmanagement style.


Bays size, actual return on investment has been significantly neg-ative on an inflation-adjusted basis.

And recent performance indicates that the companys man-agement still seems to have an inadequate understanding ofcash flow. After spending a bundle to acquire Kmart of Canada,the company had little cash left for the major remodeling itsaging stores required to appeal to todays fashion consumers.These buyers are critically attuned to their total shopping envi-ronment and experience. The Bay must also deal with the cashimplications of keener competition in electronics, appliancesand other product lines taken over by giant, low-margin spe-cialty retailers. The implications affect not only price but alsoinventory risk. Whats a company to do?

One response has been to beef up customer service at theretail-sales level. It may be too little too late, but at least thecompany is trying. One element of the plan is somewhat hit ormiss, but it is moving in the right direction: The company isrewarding good service on the retail-sales floor, as identified bymystery shoppers, with cash bonuses.

Your company may not have the age or the size or theproblems of the Bay, but the simplicity of immediate cash is stilla well-understood concept at the most basic level of employ-ment. Those cash bonuses reinforce a simple truth: Better cus-tomer service generates more cash, and the company is willingto share some of that cash with deserving employees. Lets nowtake a more systematic view of the relationship between cashflow and motivational systems.

Goals and Rewards Bonuses, rewards, commissions and other compensation-planelements have long been tied to traditional targets such as salesvolume and output levels. Once the cultural shift to cash-flowthinking and cash-driver language begins to take hold, the nextstep is to begin setting cash-flow goals at the level of each sig-nificant organizational unit or individual in the companyandthen to fully link the goals to the compensation system. Peopletend to produce what they are measured on and compensatedfor. As the cash-driver mindset begins to capture and redirect

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some of your thinking in the course of reading this book, keepin mind this motivational aspect.

In organizations of all sizes, the cash-flow motivational shiftis on. In 1998, Pepsico introduced a change for senior division-level managers whose long-term compensation had previouslybeen tied to profit. Under the newplan, the compensation linkage is tiedmore directly to three-year cash-flowtargets in their divisions. The purposein Pepsis case isnt a survival issue, as itmight be with smaller companies.Rather, it is the conviction that share-holder value is really much moreclosely related to cash flow than toearnings. Entrepreneurs often under-stand this at a gut level, but they arentalways very good at tracking it and liv-ing by it. Corporate-management peo-ple may not have that entrepreneurialgut instinct about cash flow that comesfrom concern for the companys survival, but they learn reallyquickly when the survival of their bonus is suddenly at stake.

The fact that a large conglomerate like Pepsico has shiftedthe compensation plan of division managers to reflect cashflow may not seem particularly relevant if your firm is a smallone, but here is why it is: The Pepsi division manager has thebest shot at making her numbers when she has learned how toget every key manager up and down the line to think in cash-flow terms. If those managers are effective, they pass thatcash-flow mindset on throughout the organization. At somepoint, this could mean that there is a bonus for the accounts-receivable clerks responsible for following up on past-dueinvoices from bottlers. Getting those accounts receivable downby just one days worth from the division average might beworth 1.5% extra in next months paycheck. Keep it down forthree consecutive months and there could be an additional1.5% quarterly bonus. Thats a cumulative 6% raise for thequartermaybe enough for the first and last months leasepayment on the new car. The cultural transformation made


Once the cultural shiftto cash-flow thinkingand cash-driver languagebegins to take hold, thenext step is to beginsetting cash-flow goalsat the level of eachsignificant organizationalunit or individual in thecompanyand then tofully link the goals to thecompensation system.

possible by combining new language with new incentive andgoal-setting systems can create real value for shareholders atPepsico, and it can do the same for your ownership group.

The shift toward cash-flowbased goals and incentive sys-tems isnt just some faddish management technique. It isbased on a major new understanding of company value that

is permeating corporate Americaa recognition that cash-flow man-agement, throughout the organiza-tion, is linked even more closely toshareholder value than earningsare. The reasons have to do withissues that relate more to capitalallocation and management motiva-tion systems than to mere survival.When those corporate concerns areapplied to smaller firms, they maybe even more relevant because ofthe greater scarcity of capital andthe greater risks inherent in thesmaller business.

Ideally, if your people are given abasic education about the signifi-cance of the cash driversand ifthose cash-driver terms are integrat-

ed into the language of your internal communicationsthingswill begin to change. And as they do, more adaptation to cash-flow thinking becomes possible. Important documents such asjob descriptions and performance reviews can be tied to thecash-driver model. Desired results come to pass as cash beginsto flow more freely and rapidly instead of pooling and eddyingin stagnant pockets, tributaries and backwaters. The final piecein the cultural transformation that your new cash-driver lan-guage creates falls into place when your company begins to cre-ate appropriate reward systems tied to cash-driver goals.

This chapter has introduced you to the basic vocabulary ofcash-driver language, using several case studies to illustratevarious points. The hypothetical CyberFun Co. provided abackdrop for seeing more clearly the difference between accru-


30|

The shift toward cash-flow based goals and

incentive systems isntjust some faddish

management technique.It is based on a new

understanding of companyvalue that is permeating

corporate Americaarecognition that cash-flowmanagement, throughout

the organization, is linkedeven more closely to

shareholder valuethan earnings are.

al realities and cash-flow realities. Jones Dynamite continued todevelop some of those points and added the relational dynam-ic of how better financial management rescued the companywithout really shifting its culture with regard to cash flow. Atthe Hudsons Bay Co. there was a hint of some culture shift,and at Pepsico there was a clear and forceful move into astrongly cash-floworiented management culture.

Before going further in the development of your under-standing of cash flow and how it is basically set by your man-agement of the cash drivers, it is important for you to under-stand the basic context, or grammar, in which cash-driver lan-guage functions. That context is accounting, the sometimesdreaded A word, and in the next two chapters I will try to min-imize the pain as I introduce you to the essentials of account-ing. If you already have a good grasp of basic accounting the-ory, you can skip these chapters and move on to Chapter 5.

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F YOU ARE NOT FAMILIAR WITH THE FUNDAMENTALS OF

accountingthe structure of financial statements, thedebit and credit rules of the double-entry system, con-struction of a cash-flow statement and analysis ofratiosthis chapter and the next are absolutely essen-

tial. And for those whose understanding of these concepts maybe a bit shaky, these chapters can get you up to speed.

This overview of basic accounting will make it far easier tograsp all that follows, starting with the ability to see thatalthough many transactions will affect your cash account aseither debits or credits, many others leave cash entirely unaf-fected. The frequency of each type of transaction, the amountsinvolved and the timing of each will all affect the degree towhich the flow of value differs from the flow of cash. Accountingis the grammar system by which we evaluate and record all theevents that ultimately find their way to the balance sheet andincome statement. These two primary financial statements will beexamined closely to develop the important insights that flowfrom their ratio analysis and cash-flow analysis. Once thesebasics of accounting grammar are in place, you will be ready tofocus specifically on each of the seven cash drivers (Chapters 5through 11).

I

Basic Accounting: The Grammar of Cash-Driver Language

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CHAPTER THREE CASH RULES


The Accounting Equation

Simply put, the accounting equation means that everythingused by the business has to come initially from either itsowners or its creditors. The business entity may be a soleproprietorship, a partnership or some form of corporation, butsince the corporate form is most common, we will use it forillustration. Everything the corporation ownsits assetshasto be financed by someone, whether by you or some associatesas stockholders, by a bank loan or by a supplier.

At this point, perhaps without realizing it, you have alreadybeen exposed to the basic structure of the balance sheet, whichis made up of the same three structural pieces just described:what the business owns (total assets), the interest of owners inwhats owned (net worth, or owners equity), and the interest ofcreditors in whats owned (liabilities).

Lets look at the accounting equation in a slightly differentway:

Assets = Liabilities + Net Worth (A = L + NW)

Take a look at the simple balance sheet on the oppositepage. Everything the business entity itself owns is placed on theleft. Everything it owes goes on the right. Also on the right isthe owners equity, or net-worth accounts, representing the dif-ference between what the entity owns and what it owes. Notethat the balance sheet actually balancesthat is, the asset sideis exactly balanced by the other side, consisting of the liabilitiesand net worth. The accounting equation equates. This funda-mental relationship of balance must be maintained.

Anything added for use in the business is an additionalasset; it has to have its cost covered by either creditors or own-ers. Owners may cover such costs by direct investments in thecompanythat is, by buying stock. More commonly, ownerscover the costs of buying assets indirectly, through earningsretained in the business. The accounting equation, A=L+NW,always holds, unless there is an accounting error. (Just becausethe equation holds and the balance sheet balances that doesntmean there are no errors. It sometimes happens that some-thing gets recorded under the wrong heading but on the

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36|

appropriate side of the balance sheet. In that case the balancesheet still balances and the error has to be found some otherway. That, however, gets to a level of detail that we dont needto deal with here.)

Now that you understand the basic accounting equation ofthe balance sheet, it would be helpful to get a preliminary senseof the kind of insights some basic balance-sheet informationmight suggest in cash-driver terms. Take a moment to study thestructure and the contents of the balance sheet on page 35.

Can you see why this is an enterprise with a possible cashproblem? The cash balance of $5,000 will quickly be used to paythe short-term note due to the bank. Accounts receivable fromcustomers are being turned into cash day by day as customerspay their bills. But just as quickly as that cash comes in, it mustbe turned around and sent back out to pay the accountspayable to suppliers. If those suppliers dont get paid as agreed,they will generally stop shipping product (except maybeC.O.D.), leaving you with an inventory reduction that willalmost certainly cause a sales decline because you wont havethe right quantities in the right mix to meet all your orders.

The Double-Entry System

Standard accrual-accounting systems operate on the basisof whats known as double-entry bookkeeping. Doubleentry is very descriptive; it is also very logical. It is descrip-tive because every transaction is recorded twice. It is logicalbecause the two sides to every transaction are central to keep-ing the two sides of the balance sheet in balance. The double-entry method is the key to keeping things in such balance. Butwhat about income statementsdoes double-entry accountingwork there as well, or do we have to have a different system?

The Balance Sheet / Income Statement Connection Fortunately, double-entry works just fine for both kinds ofstatements. Here is how the two connect and interrelatethrough the magic of double-entry. Although the balance sheet

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and the income statement are separate and distinct entities,they are closely linked. The linkage from the balance-sheet sideis through its net-worth sectionon the entry called retainedearnings, or profit retained in the business. A useful analogy ofthe balance-sheet/income-statement relationship would be thetwo sides of the brain, whereby each side has its own areas ofspecialized function. The two sides, however, work according tothe same basic rules and are able to cooperate in many tasksbecause they are linked via a communication channel called thecorpus callosum. Think of that retained-earnings part of thebalance sheet as the connection point for one side of the finan-cial corpus callosum. On the income-statement side, the con-nection to the balance sheet is via the line called net income. Itis the point from which income-statement profit gets passed tothe ownership account on the balance sheet as part of the end-of-period closing process. The simplified income statement onpage 38 illustrates to point.

The Common Rules for Balance-Sheet& Income-Statement EntriesAs with computers and digital electronics, accountings basicrules are binary. Everything in computers and digital electron-ics is fundamentally based on a switch being on or off, or acharge being positive or negative. Likewise, there are only twooptions in accounting: We can either debit an account or creditit. Because accounting is a double-entry system, we must haveequal and opposite charges for the two sides of the balance sheetand each of the two partsrevenue and expenseof theincome statement. That balance persists up to and through thepoint of passing data between the income statement and the bal-ance sheet at the close of the accounting period. Preserving thisbalance requires that for every transaction there be an arith-metic balance; that is, debits must always exactly equal credits.

The basic rules for the way debits and credits work are real-ly a lot more straightforward than most nonaccountants think.As with so many other areas of expertise, jargon that wasinvented to deal with specific issues winds up becoming a bar-


rier to understanding by the nonexpert. Humor, though, isoften helpful in puncturing such barriers. An often-repeatedaccounting story tells of the senior partner of a major interna-tional accounting firm who began each workday for his entirecareer with the same ritual. He walked to the far end of theexecutive conference room next to his office and moved asidethe picture of the founder to reveal a wall safe that he pro-ceeded to open. He removed a piece of paper, looked at itbriefly, then returned it to the safe. Upon his retirement, thesenior partner passed the combination to the safe to his muchyounger associate, who had been elevated to managing-part-

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Sales $ 587,456Cost of Goods Sold 400,000DDepreciation in COGS 14,000

GROSS PROFIT/REVENUES $ 173,456

General & Administrative Expense $ 48,000Selling Expense 12,000Officers Compensation 52,000Depreciation 2,300

TOTAL OPERATING EXPENSES $ 114,300

TOTAL OPERATING PROFIT (gross profit - expenses) $ 59,156

EARNINGS BEFORE INTEREST, TAXES $ 75,456& DEBT AMORTIZATION (EBITDA)(principal repayment)

EARNINGS BEFORE INTEREST & TAXES (EBIT) $ 59,156

Interest Expense ST (short term, debt 2,300due in less than one year)

Interest Expense LTD. (long term debt over one year) 4,100INTEREST EXPENSE $ 6,400

PROFIT BEFORE TAXES & EXTRAORDINARY ITEMS $ 52,756

Current Taxes 18,766NET INCOME $ 33,990

BOX 3-2 ABC Co. Income Statement 12 Months Ended 12/31/00

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ner rank. On her first day in the managing partners officesuite, she could barely contain her excitement as she practi-cally ran to the safe, opened it, retrieved the dog-eared scrapof paper and read, Debits by the door, credits by the win-dow. Though not really quite that simple, the basic rules aresimple enough to make mastering the concept worth a fewminutes of concentration.

Here is the basic debit/credit ruleexpressed in the form of two definitions.If you want a real mental comfort withbasic accounting and the cash-flow issueson which the cash drivers depend, I sug-gest you go so far as to memorize them:

Debit: any increase in an asset or expenseaccount, or any decrease in a liability, networth or revenue account.Credit: the opposite of the above; anydecrease in an asset or expense account, orany increase in a liability, net worth or rev-enue account.

The assumption is that buying an asset ultimately takes cashand reducing a debt or liability likewise ultimately takes cash.The reverse is also true. Any decrease in an asset, or increase inan obligation, presumes cash coming in. Once you becomecomfortable with these basic mechanics and rules of financial-statement structure, along with the debit and credit rules, youwill be able to use the cash drivers more effectively and get ahandle on cash-flow issues more clearly. Beyond that, howev-er, you will also be in a position to absorb a broad range offinancial information and participate effectively in financialdiscussions as your career and business continue to develop.

Using the Debit and Credit RulesThe most common transaction in a business involves a sale.Because a sale represents revenue, we go ahead and debit salesfor the amount of the salesay, $1,000. In fact, though, we did


The basic rulesfor the way debitsand credits workare really a lot morestraightforward thanmost nonaccountantsthink. Essentially,for every transactionthere must be anarithmetic balance;that is, debits mustalways exactlyequal credits.

not collect $1,000. Instead, we got $200 down, which increasedour cash accountan assetand we also created an accountreceivable, thereby increasing that asset due from the customerby the difference of $800. The basic accounting-system entriesto begin reflecting this transaction, then, are as follows:

Debit cash: $200Debit accounts receivable: $800Credit sales: $1,000

Note that the entries are balanced, as they must bethedebits equal the credits. Yet something doesnt seem rightwhat about inventory? We have sold something from inventorybut havent accounted for it, even though we know that itdecreased by an amount equal to our product cost, say $500.Part of the transactional-analysis task in accounting is to be surethat there is an entry for every affected account. Since invento-ry is an asset, we must credit it to record a decrease, so we goahead and credit inventory for $500.

Credit inventory: $500

But now the debits no longer equal the credits, and thatsnot OKthe system wont be in balance until we offset thecredit entry that reduced inventory by $500 with one (or more)appropriate debit(s) totaling $500.

What debit could logically offset the inventory credit of$500?

We know that inventory is an asset, but the actual use ofinventory is an expenseand we did use some. The offset we arelooking for, then, must be an expense item. In the earlier dis-cussion of cash-versus accrual-accounting systems, I pointedout that in the cash-based system, you dont really need torecord inventory as an asset; you could just expense it as itspurchased. But neither the accounting profession nor the IRSwill let you do that, and so accrual accounting becomes thestandard. We establish inventory as an asset when we acquire it,regardless of when or how we pay for it. We then expense itonly as used to fill customer orders. The result in this accrual-


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based system is that it is the use of inventory that is an expense,whereas its original acquisition is an asset creation. The trans-action entry, then, is:

Debit cost of goods sold: $500 (an expense), reflecting an increase. Credit inventory: $500 (an asset), reflecting a decrease.

We do, of course, have lots of other costs in the businessbeyond inventory, so lets further assume that the otherexpense debits for the period total $450. That covers all of ourpayroll, occupancy, delivery costs, and so forth. Some of thesewe have perhaps paid in cash: debit X, Y or Z expense, andcredit cash for the same amounts.

Debit X expense: $150Debit Y expense: $150Debit Z expense: $150

Credit cash: $450

In other cases, though, despite having incurred the expens-es, we have not yet paid for them; in that case we would accruethe expense itemsfor example, debit A, B, or C expense,which affects the income statement, and credit accruedexpensea liability on the balance sheet. Accrued expense issomething we actually owe, a liability. Perhaps it is an accruedpayroll expense because the payroll checks wont actually bedrawn until next month. Perhaps it is an accrued payroll taxwe owe to some government entity. An accrued expense, or anaccrued liability generally, differs

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