What every CEO should know about cash flow

Written by ProfitGuide

Philip Campbell knows that many CEOs consider cash flow a dull subject they don’t have time for. But for well over a decade the Houston-based CFO, business consultant and author of Never Run Out of Cash has made it his mission to convince business owners that managing cash flow properly is essential to building a successful firm.

In his sharp Texas twang, Campbell — who has managed the finances for growth companies with revenues ranging from US$5 million to US$600 million and been involved in the acquisition or sale of 33 companies — contends that much of what CEOs think they do know about cash flow is misinformed. Here, in an interview with PROFIT senior editor Jim McElgunn, he explains why cash-flow management is vital and how to get started.

Why does cash flow matter?

Cash-flow management strikes a lot of people as boring, not too sexy or grunt work. But it matters for two reasons. If the cash ever runs out, everything a person has worked so hard for goes right down the toilet. And your success in business is ultimately determined by the degree to which you both create and hang onto cash. You have to have some kind of tool for managing and measuring that so you can get to where you want to go.

Why does the CEO need to worry about this? Why can’t you leave cash flow to your CFO or controller?

The CEO is charged with the overall growth and strategy of the business. And in almost every case, you have to lay out cash to invest in something ahead of that cash generating a return. If you’re adding another plant so you can take on new customers or supply more to existing customers, you first need to spend money to build the plant. When you’re making decisions as a CEO about how to grow the business, you need a view of the impact your decisions will have on cash flow.

Accountants usually focus on financial statements, but those focus on the past. It’s like a rear-view mirror: it’s an important tool, but when you’re cruising down the freeway an occasional glance in the rear-view mirror isn’t all that you need. What you really need to get where you’re going safely is a clear view through the windshield. And what’s really important to that is cash flow. That’s why it’s so critical to have a good set of financial projections, because you’ll be making decisions that affect the obstacles that lie ahead.

What are the most common consequences of failing to manage cash flow properly?

The first thing that usually happens is you start to squeeze your vendors. If you had a good reputation with them, they don’t squeal too loud right away. If, say, you had to create $300,000 of cash that way, you do it and you think everything’s fine. In many cases, the CEO doesn’t have a clue what’s going on. If no one is paying attention to the payables, and if the controller or CFO, instead of squealing, says, “This is how we’ll get through this little phase,” you as the CEO won’t even know it’s happening until the vendors start to squeal.

They squeal when they get tired of it. And then they start requiring prepayment or COD, or calling your salesforce. By then you’ve already dug yourself a hole. The next step is to try to get a line of credit, or increase an existing one, or try to borrow some additional money. But when your banker reads your financial statements, they’ll immediately see that you owe a ton of money to vendors. They’ll know any money they might lend you will go immediately to pay your vendors. The more you need the money, the less the banks want to loan it to you.

What do companies typically do wrong when managing cash flow?

One of the biggest mistakes business owners make is thinking they can look at their profit and loss — their P&L or income statement — and understand their cash flow. They’ll say, “Am I making money? Well, let me look at my P&L.” But cash flow doesn’t work like that. The rules of accounting are not meant to create a P&L that tracks cash flow; rather, they’re meant to track earnings as defined for tax or financial-statement purposes.

How should you instead track cash flow?

Understanding cash flow so you can manage your business comes down to two questions. Number one is “What’s my cash balance right now?” Number two is “What do I expect my cash balance to be six months from now?” To answer number one, you need to know you have a solid set of books. If you have a controller, you need to meet with them to make sure you’re recording transactions as they happen, not two or three months behind. The only way you can answer the second question is to have a set of cash-flow projections — not just the budget, not just the P&L, but a projection showing each cash-flow component.

Never Run Out of Cash provides what I call the Peace of Mind Schedule, a simple way of putting each of those components onto two pieces of paper so you can answer that second question. Each piece has four sections that show you each component, giving you a view of the last four to six months of actual cash flow results and a projection for the next six months. The primary drivers of cash flow are what’s going on with the P&L, the difference between revenue and expenses, capital expenditures, debt service or other investments in the company, accounts receivable, estimated taxes and accounts payable.

Even if cash is tight and you’ve got yourself in a bind, it’s very important to be able to answer that question of “Where do I expect my cash-flow balance to be six months from now?” If it’s not where you want it to be, then you’ve got a heads-up of six months to do something about it. That avoids probably the biggest mistake people make, that they don’t know they’ve got a cash-flow problem until it lands on their doorstep and there are more bills to pay than cash available to pay it.

We’ve focused on the risks of mismanaging your cash flow. What about the upside of managing it well?

You’re making the business worth more and more. Generally, there are two ways to generate cash in a business. One is where it generates excess cash every month or quarter that can be distributed to the management or ownership. The second is when it’s sold, which it will be at some point. For most every business, the selling price will be based on its cash flow. So your mission in life becomes to make that business generate as much cash as humanly possible. That’s how you reap the rewards.

If a business looks good on the P&L but has to plough all its earnings back in order to generate that kind of income, then it won’t be worth near as much as a business that’s generating excess cash. Because in the end that’s what people are buying when they buy a business: they’re buying its ability to generate excess cash.

Originally appeared on PROFITguide.com