The Basic Tenets of 'Cash is King' & "Hug the Revenue Line"

Keeping a keen eye on the revenue line is akin to monitoring a patient's most important vitals for proper circulation. Just like our own human blood, cash needs to flow smoothly. It is also one of my top career suggestions to 'Hug the Revenue Line'; That an individual looking to scale their professional position themselves with the least degrees possible away from the revenue line and/or to be able to have a direct and measurable impact on it. Seldom is this top of mind for an individual and they easily miss the premise of a business. In the great book, The Corporation: The Pathological Pursuit of Profit and Power, Bakan gives a precise development on how corporations came to be and their responsibilities to shareholders to make a profit....at times, acting like psychopathic creatures in this pursuit (EG: Enron).

Yet, while a deep focus on profit is vital, it is trumped by cash flow. Profit is more indicative of your business's success, but cash flow is more important to keep the business operating on a day-to-day basis. Yet, financial statements seem to be written in a different language that only accountants know and because of such, most tend to avoid dealing with any proximity to building their Financial Acumen.

Savvy business managers, lenders, and investors pay a lot of attention to cash flows. Cash inflows and outflows are the heartbeat of every business. Without a steady heartbeat of cash flows, a business would soon have to go on life support, or die. (Diamantino De Sousa, MBA, 2016)

A firm’s ability to convert materials into cash from sales is a reflection of the firm’s ability to generate returns effectively from its investments. Three factors directly influence a firm’s access to cash: (i) cash from accounts receivables is not available to firms while they are awaiting customer payments for delivered goods; (ii) cash invested in goods is tied up and not available while those goods are held in inventory; and (iii) cash may be made available to a firm if it chooses to delay payment to suppliers for goods or services rendered." (Kroes & Manikas, 2014)

The first failure of a business is a lack of industry benchmarks for financial KPIs that aid in leading and/or lagging information for liquidity - Benchmarking shows business owners how their gross margins, expenditures, inventory, administrative expenses, and other factors compare with similar operations. At a minimum, these KPIs will provide quarterly and YoY benchmarks for measurable improvements.

"As for capital expenditures, if a business owner has gear-head tendencies, the desire to have the newest and latest can eat away at cash. Each new investment must be evaluated to make sure it is absolutely necessary, and existing infrastructure needs to be either fully utilized or liquidated." (TBP, 2007)

"Over a company's lifetime, from start-up to liquidation, cumulative accrual-based profits and cash flow (exclusive of cash flows from debt and equity financing transactions) are equal.....As a company moves through its life cycle - from start-up, through growth, maturity, and eventual decline - operating profits and cash flow have certain characteristic relationships." (Comiskey & Mulford, 1993)

I particularly like the article by Comiskey and Mulford (1993) with the below quadrant diagram (personal notes included) that details the life cycle of a business in relation to profits and cash flows. It provides good details on how a business can show profits but no cash flow, and vice versa, along with suggestions of what to look for and actions to take. In Quad 2 & 3, there is a transition that can occur and if not managed correctly, or even noticed, then the transition can be negative and toward Quad 4 with no profit or cash flow, and ultimately towards liquidation.

• Quad 1 - Reporting positive operating profits and cash flow. These companies can use their operating cash to reduce the principal on debt balances, pay dividends, and for CapEx. Providing the profits and cash flow are generated from recurring sources and sufficient to satisfy required principal reductions on debt financing and the replacement of fixed assets consumed in operations a company can operate in the quadrant indefinitely.
• Quad 2 - Reporting positive profits but negative cash flow which cannot be sustained. Either operating profits will turn to losses, moving the company to Quad 4 and eventually liquidation, or the company will begin generating positive operating cash flows, moving it to Quad 1.
• Quad 3 - Reporting losses and positive cash flow which cannot be sustained. Either their operating losses will turn to profits, moving them to Quad 1 or the company will begin generating negatie operating cash flows, moving it to Quad 4. Without improvement in performance, liquidation will be the likely outcome.
• Quad 4 - Reporting losses and negative cash flow. As with Quad 2 & 3, a company is unlikely to remain in this quadrant. Either it will move to one of the other quadrants, and eventually to Quad 1, or operations will eventually cease.

Example KPIs: (NB: Some terms may go by different names in different organizations, further fueling the anxiety of those who avoid learning the lingo)

• Days of Sales Outstanding (DSO): This measure represents the average time from when a sale occurs until the revenue is collected. It is calculated as the end of period accounts receivable divided by the sales, multiplied by the number of days in a period. Similarly, both.DSO and.DIO was shown to be an effective measure for managing cash flows. WARNING: If A/R is stagnant, the ability to collect becomes exponentially harder and unlikely.
• Days of Inventory Outstanding (DIO): This measure captures the average time that goods are held in inventory before they are sold. It is calculated as the end-of-period value of inventory divided by the cost of goods sold, multiplied by the number of days in a period. firms often are able to reduce inventories without sacrificing service through methods including Lean/Just-In-Time management programs, automated replenishment systems, Vendor Managed Inventory (VMI) programs, and consignment inventory programs. Similarly, both DSO and DIO was shown to be an effective measure for managing cash flows. WARNING: Leverage the Pareto 80/20 Principles and/or deep dive with a Quad Analysis to create a continuous process for simplifying your product line, reducing your SKU's, and addressing bloating inventory.
• Days of Payables Outstanding (DPO): This measure expresses the average time that a firm takes before paying its creditors. It is calculated as the end-of-period accounts payable divided by the quarterly purchases, multiplied by the number of days in a period. DPO was not found to be related significantly to firm performance changes.
• Cash Conversion Cycle (CCC): The CCC metric (also called the Cash-to-Cash Cycle) combines the three cash flow metrics to provide an overall indicator of a firm’s cash position. It is calculated as the sum of Days of Sales Outstanding and Days of Inventory Outstanding, minus the Days of Payables Outstanding. The CCC represents the time period required to convert cash investments in supplies into cash receipts from customers for goods or services rendered. The analysis found that changes in the CCC did not translate into significant changes in firm performance. The lack of significance for changes in the CCC implies that changes in the payables cycle appear to mute the combined impact of changes in receivables and inventory cycles. For managers, this finding intimates that reducing the CCC only by reducing DPO likely will not translate into improved firm performance.
• Operating Cash Cycle (OCC): The OCC metric uses only a subset of the CCC metric. It is calculated as the sum of Days of Sales Outstanding and Days of Inventory Outstanding. OCC differs from CCC in that it includes only inventory and sales outstanding. It does not consider payables and therefore equates to the number of days that cash is held as inventory before payment is received from the customer. In contrast, changes in the OCC metric were significantly and negatively associated with changes in firm performance for a period lasting four quarters. The examination of the temporal impacts of changing these metrics shows. OCC is a superior tool for managers.

APPENDIX: Additional useful terms

• OPERATING CASH FLOW - Estimates if a business can generate enough positive cash flow to pay expenses and grow its operations.
• FREE CASH FLOW - Tells investors that there is enough cash to pay creditors, buy back shares or pay out share dividends.
• WORKING CAPITAL - Gives a clear indication if a business can clear its short-term debts.
• CURRENT RATIO - Is the same as working capital. This metric is calculated by taking current assets that are cash or will be converted into cash within a year and subtracting liabilities that can be paid off in less than a year.
• DEBT-TO-EQUITY RATIO - Measures how much leverage the business is using. The debt-to-equity (D/E) ratio provides this key metric by comparing a company’s total liabilities to its shareholder equity. A high result typically indicates that a business is a high risk.
• ACCOUNTS PAYABLE TURNOVER - Ratio measures liquidity in the short term and represents the ability of a business to pay off its suppliers.
• ACCOUNTS RECEIVABLE TURNOVER - Used to determine how much efficiency a company generates in collecting money owed by clients.
• INVENTORY TURNOVER - Low turnover may represent poor sales or inventory management.
• RETURN ON EQUITY - Indicates how effectively a business uses its assets to create profits.
• NET PROFIT MARGIN - Net profit margin is the ratio of net profits to revenues and demonstrates how much net income is created as a percentage of revenue. It provides a reliable measure of profitability by demonstrating how much each dollar collected from revenue is being converted into profits.

Reference: Comiskey, E. E., & Mulford, C. W. (1993). Anticipating trends in operating profits and cash flow. Commercial Lending Review, 8(2), 38. Retrieved from http://0-search.proquest.com.aupac.lib.athabascau.ca/trade-journals/anticipating-trends-operating-profits-cash-flow/docview/229668654/se-2