Analyzing Operational Cash Flow

by Zach De Gregorioin Uncategorizedon Posted on

This week we are continuing to talk about cash flow. Last week, I made a video about the difference between cash flow and profit. This week we are going to dive deeper into how to analyze cash flow. Just a warning, this is a more advanced accounting topic, so if you are new to accounting, just hang in there because we are covering some really important concepts. WATCH NOW

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VIDEO SUMMARY

Any business is a cash flow generating machine. If you are not generating cash, your business is going to die. As a business leader, a lot of your job is managing cash flow. When we talk about cash flow, we are describing how much cash is coming in the door, and how much cash is going out.

This is captured on an organization’s Statement of Cash Flows. Your statement of Cash Flows is split up into:

  • Operating
  • Investing
  • Financing

I am going to stop here, because everything beyond this point in this video is not GAAP. GAAP (or generally accepted accounting principles) says that you write you statement of cash flows with three categories for your investors. What I am going to tell you, is that you need to do even more work on top of this. You write your financial statements for your investors, but if you are a business leader, you have a lot more stakeholders than just your investors, so you need a more detailed breakdown of this report to make better business decisions. So you meet your requirement for GAAP first, and then you do more work on top of that. In fact, most financial analysis that is done in business is on top of GAAP, but the reason you are going to want to do all this extra work is because it is so powerful for your business.

Here is what you are going to want to do. Under the operating category, you can use the direct method or indirect method. We are going to use the direct method because you can actually see your operating expenses. You are going to start with your direct method for operating and split the expenses into two new categories: Discretionary and Non-discretionary.

Just so you understand what I am asking. You need to go through every single one of your expenses and put them into one of two buckets. One for discretionary and one for non-discretionary. The reason this is beneficial, is that for a business leader, not all your expenses are really within your control. A lot of things that are impacting your financial statements, you have no control over. The price of things like rent, utility prices, and insurance cost are not going to change. You can be as good a business manager as possible, and you just will not impact some of your costs. The goal is to identify what is within your control, and what is not in your control. This will help you focus on where you can really impact your costs.

Now I know you are going to say, Zach, this is impossible. There is no way I can label every single one of my expenses. It is really not as difficult as it sounds. Most of your non-discretionary expenses like rent and utilities are handled at the administrative level already. So it should be fairly simple to label your expenses at a department level. In fact, if you have department managers managing non-discretionary expenses, I would recommend pulling those expenses away from your managers and giving ownership of handling all non-discretionary expenses too accounting. All these expenses are not going to change anyway, so why are your managers wasting their time on it. This goes back to our goal to identify what is within your control. You are using accounting to focus everyone on where they can have the biggest impact managing expenses.

The trick to doing this analysis successfully is to define the term discretionary. When you start going through this process, you will find out it is actually very difficult to define discretionary. People will argue about the line where an expense becomes non-discretionary. I have a very simple rule to define a discretionary expense. Any expense you can defer for six months without destroying the business is discretionary. If you can put off an expense for six months, that means you have adequate control over managing that expense. For example, you cannot defer your rent for six months. You will be kicked off your property. That is non-discretionary. You cannot defer your utility payments. They will turn the lights off on you. That is non-discretionary. Under this definition, payroll is also non-discretionary. You have to pay your people. However, what is discretionary is bonuses. In most cases you can go to your people and say “we need to wait six months to pay out bonuses this year.” That means it is discretionary.

So here are some examples:

Non-discretionary:

  • Rent
  • Utilities
  • Insurance
  • Payroll – I know people will argue with me that managers control their staffing plans. But in reality, that is not what happens in a business. Most staffing plans are set giving people a certain number of hiring slots per year. Staffing plans is a whole other topic that I am not covering in this video. Once your hiring targets are set, you cannot control that expense anymore, so from a financial standpoint, you should not use payroll as a way to do cost control. Payroll is off limits, and that is why it is non-discretionary.
  • Taxes – You have no choice but to pay your taxes.
  • Software licenses – You will have annual IT subscription and internet costs that you have every single year.
  • Inventory for orders – If you have orders to fill, you obviously have to pay for the materials you need to fill those orders.
  • Required maintenance – Maintenance is one of those difficult areas, because people will argue that all maintenance is necessary. However, that is not true. Any maintenance that can wait for six months is discretionary. That is not to say you will wait, you are just trying to figure out what you have control over and what you do not have control over.
  • Debt payments (Financing) – You always have to make your debt payments. This is in your financing section of the statement of cash flows. Under GAAP there is some flexibility how this is displayed on the statement of cash flows. You need to separate out interest and principal. However, for this exercise you just need to know you have to make your debt payments.

Discretionary:

  • Bonuses
  • Travel
  • Marketing – Now of course, this will impact your business, but if you had to, you could probably stop your marketing activities and delay them six months.
  • Donations – This will be expenses you incur for community outreach.
  • Research and Development – This is another really important expense that can be delayed six months if needed.
  • Computer upgrades – If you want to buy new laptops for your staff, that can be delayed six months
  • Deferrable maintenance
  • Capital Improvements (Investing) – This will be any large purchases of machines or equipment, usually over $5,000. You would generally want to capture this in your investing category on the Statement of Cash Flows.
  • Dividend payments (Financing) – These are going to be payouts to investors captured in the financing section of your Statement of Cash Flows.

When you go through this exercise you will notice a couple of things. Most of your expenses will be non-discretionary. For most business, rent, inventory, and payroll are your biggest expenses. What you actually have control over is a smaller, more focused part of your financial statements.

Now that you have all your expenses defined, you are going to get to the real heart of the issue. How do you spend your discretionary money? That is really what you want to know. You have a pot of money that you have control over. What is the most effective use for those funds? How you answer that question will determine your effectiveness as a business leader. To answer that question, you need to look at your stakeholders.

Any business will have at least these stakeholders, if not more:

  • Employees
  • Customers
  • Vendors
  • Community
  • Media
  • Trade unions
  • Business
  • Government
  • Investors

I am not going through each one of these, but you should. As a business leader your job is to figure out how your business is serving each one of these stakeholders. Is it adequate or not? For example, employees: Are you taking care of your employees by paying them enough bonuses? Another example is community: How much are you donating to your community? The business itself is important. Are you continuing to reinvest back into the business to continue to grow. You have a pot of discretionary money. You need to look at your expenses and split them up so you are servicing each one of your stakeholders.

One of the main takeaways is that investors are only one of your stakeholders. You are writing your financial statements for investors, however you still have to think about all these other people. A major problem a lot of businesses have, is they take their discretionary funds and allocate them too much towards one group of stakeholders, at the expense of the rest. So they might be paying out too much to investors, or they managers might be paying too much to their own bonuses. When these things happen, the business becomes unbalanced, and that becomes difficult to sustain long-term, because you need all these stakeholders for a healthy business. That is why business leadership is so difficult, and why you need to do this additional analysis beyond writing your financial statements. You have a limited amount of money, and you are trying to manage a healthy business and make sure that everyone is taken care of. Your goal is to make sure your business continues to be a cash flow machine for everybody.

This was a lot of information. Some of this you have probably never heard before. Next week, I am going to show you how to take all this information and put it into a chart. Not many people use this cash flow chart because it takes so much work to put all this together, but it will change the way you look at your business, so stay tuned for that next week.

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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.