In my first two articles, I laid out building blocks to begin creating a foundation for an efficient cash management system. Before we take the plunge into cash forecasting, it is imperative to visit an issue that plagues countless business owners: making sense of cash.
Business owners tend to be persecuted by accountants involuntarily forcing internal accrual accounting conventions down their throat; thus setting up a simmering pot of discontent that generally boils over when performance hits a wall and cash runs low. The simple reason is that the owner likely understands cash better than accrual. Before I get too far promulgating an egalitarian universe of cash and accrual accounting, let’s answer an important question.
“Why not cash accounting?”
First, businesses of any appreciable size will require accrual accounting to obtain debt or equity financing. Banks and investors do not deal in cash-only accounting.
Second, accountants understand and work with accrual accounting. Cash-only accounting is so uncommon in business practice that finding skilled accountants that understand it is hard to accomplish. It is an uphill climb when it comes to finding good talent.
Third, accrual accounting allows for both accrual and cash reporting. We will get into how this works later on in the article. Cash accounting cannot be reversed into accrual accounting whereas the opposite is true.
Fourth, most useful accounting packages are geared toward accrual accounting only. Quickbooks is a partial exception – it will provide cash and accrual accounting – except that all journal entries are treated as cash and accrual (and journal entries are usually an accrual item), so an organization of any useful size would find this functionality almost useless.
Since a wholesale conversion to cash only accounting is counterproductive, then we are left with accrual accounting as the most sensible basis. To make sense of cash in a business, it is necessary to back into cash reporting from accrual statements. In November 1987, the Financial Accounting Standards Board issued Financial Accounting Statement No. 95 requiring a “Statement of Cash Flows” as part of all ‘full sets of financials’ from July 15, 1988 onward. Embedded into this report is the basis for which an organization can back from accrual accounting to cash reporting.
The Statement of Cash Flows is the most powerful, overlooked and misunderstood portion in a set of financials. A cash flow statement is nothing more than net income plus/minus changes in balance sheet accounts. The statement is reconciled to changes in cash balance. FAS 95 requires a breakdown of cash flow items into three categories: operations (includes net income), investing and financing activities. In the confines of these categories, the usefulness of the statement varies by company – particularly in relation to how the balance sheet is presented. Simply put, if the balance sheet is loaded with voluminous and superfluous accounts, then the statement of cash flows will equally be burdened with volume and superfluousness. It is at this juncture that non-finance management generally loses focus on the statement based on an inability to understand it. From there, a chain reaction of management decisions takes place trying to ascertain cash equilibrium. Sometimes, it can be done with minimal damage. On the other hand, it can be a horror story of figuratively chasing one’s tail.
A Solution for non-Accountants
The biggest hurdle to a useful statement is how the accounts are presented. For example, in the “Changes from Operations” section, each working capital account is listed separately (AP, AR, Inventory, accruals, credit cards, lines of credit, etc) generally in one mass cesspool of numbers. To make sense of it, customizing report output to segregate into sub-categories or sum multiple accounts is useful. Keep it simple. For example, total AR, AP and inventory into “Changes in Working Capital.” Total all accruals as one line. Total all credit cards as one line. When it comes to “Investing Activities”, total all capital expenditure amounts as one line. For “Financing Activities”, total term debt separate from balloon payments, dividend payments, additional paid-in capital, etc – each as one summarized line.
For businesses that are relatively consistent (i.e., minimal fixed asset activity, minimal loan turnover), a method to quickly diagnose cash activities is to track AR, AP and inventory relative to sales using DSO, DPO and DIO. DSO (“Days Sales Outstanding”) tracks AR relative to sales. DPO (“Days Payables Outstanding”) tracks AP relative to sales. DIO (“Days Inventory Outstanding”) tracks inventory size relative to sales. For example, DSO of 45 means that total AR = 45 days of sales. In effect, we can surmise that the company is being paid on an average of 45 days after the sale takes place. DPO and DIO function in a similar manner. As an example, lets take a “normal” company with DSO of 40, DPO of 30 and DIO of 30 – we are assuming that they are paid slightly past terms, pay on time and stock one month of inventory. If sales doubled and AR, AP and inventory exactly doubled, days outstanding would remain the same and healthy capital volumes are being kept. If sales remained the same and DSO increased, then some cash was allocated to customers paying late; i.e., an unhealthy direction. If DPO went down, some cash would be allocated to vendors. Days outstanding ratios make fantastic graph items to watch trends and are an easy way to pinpoint cash performance.
When Cash Matters
Most businesses get by without staring too hard at cash flow reports based on the assumption of 1) continuity and 2) profitability. A typical example of a business with little cash flow reporting and “keeping a pulse” is having a working capital line of credit. If the business is profiting well and the LOC is growing in size, then management knows something is wrong. This is a delayed method and mildly effective. Where cash flow reporting becomes an absolute necessity (when people start asking “WHERE DID ALL THE CASH GO?”) is when a business has cash burn or performance oscillating between earning and losing money. It is at this point that effective cash flow reporting becomes critical. Accountants should also take heed that if they do not generate and explain this kind of cash flow reporting as a cash flow crisis develops, to expect a chain reaction of [possibly destructive] decision-making trying to grope for an understanding on cash and what to do about it.
The next logical question after answering “Where did all the cash go?” is “Where is it going to go?” – i.e., cash forecasting. Depending on the business and the situation it is in, various forms of cash flow forecasting are needed and absolutely critical. It is also one of the areas most overlooked by accountants. My next article will discuss cash flow forecasts.
