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HOW TO ACHIEVE
FINANCIAL MASTERY ON YOUR BUSINESS
Ian Judson Judsons Financial Management Services Pty Ltd March 2014
The tools that will enable you to work out how to double your cash flow and earn three times your industry profit! Have you ever wondered what wealthy business owners know about finance and accounting that you don’t? Were you always hoping that owning your own business would provide financial freedom to you and your family but it hasn’t quite worked out that way? Do you wish you had bankers lining up wanting to lend to your business rather than saying, “No”? All businesses have, at their core, 3 key functions – sales, operations and finance. In simple terms, this covers what you sell, how you make or buy what you sell, and then keeping good records to determine how well you are going. Most business owners tend to know their products and services intimately and have had to learn how to sell those products as part of the development of their business. However, understanding finance is one aspect of the business that most business owners still struggle with. It doesn’t need to be this way! This e-book provides you, the business owner, with proven finance tips and methods to: 1. better understand your business model; and 2. determine ways to improve the underlying cash flow and profitability of your business.
What to expect? I am confident that by applying the tools provided in this e-book, you will gain an understanding of your business that may even be stronger than your current accountant or banker. More importantly, these tools will enable you, as the business owner, to identify existing sources of cash that do not need to funded by the bank. By having stronger cash flow, your business will be able to afford the people and improvements that can make a difference to your business. By having more money to spend, you can make decisions focused on improving the functionality of your business and therefore achieve higher profits. Alternatively, you can take the extra earnings for personal investment or enjoyment. Businesses that have used our tools have been able to identify ways of doubling their operational cash flow and achieve a higher profit margin than their competitors.
What’s stopping you? he classic reasons I hear why people do not undertake some financial training as part of their business development include: • “I don’t have the time”
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• “I’m not an accountant” or • “I’m not good with figures” The tools that I will go through with you in this e-book are not difficult to use. You do not need to be an accountant to understand the results. As long as you have a calculator or spreadsheet available, you will be able to do all of the maths that is required.
Use of the tools The tools presented in this e-book are a collection of the best tools and tips I have collected through the course of my development as a business advisor and chartered accountant to small business for the last 20+ years. Many of the tools have been adapted into software packages that are used by the banks and financial advisors to examine businesses. Some of the concepts that I go through in this e-book are used by professionals who undertake due diligence of businesses to determine whether to buy that business or not. I am confident that the tools and commentary provided in this e-book will benefit your understanding of your business exponentially.
Why believe me? Around 5 years ago, I decided to leave my well-paid position as a partner in a worldwide accounting firm based in Brisbane, Australia. Despite being recognised as successful in that environment, I had a desire to run my own business, so I left the comfort of the big firm and went out on my own. At the time, the Australian economy had entered into a downturn following the global financial crisis of 2007. Many people were surprised by my decision to set up a business at that time. However, I figured that if I knew how to run a business during a downturn, then I should learn more through that experience than running a business during the good times. At times, it wasn’t easy. I went through the same pain that many of you might have experienced. At times, I was unable to pay my salary. I have had to ask for payment arrangements with the Australian Tax Office more than once. My business and personal credit card limits have been exceeded. Because of those negative experiences, I know the hardships of small business. I believe that, despite my years working in corporate finance teams, it is not until you have run a business yourself that you can truly understand the life of the small business owner.
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What did I learn? Given that I was running an accounting and financial advisory business, I didn’t think it was a good advertisement for the firm to be financially insolvent! When things were at their toughest, I turned to my own skill set to determine what was happening financially to my business. By using the tools that I will go though in this e-book, I was able to identify where the problems in my business were causing me financial difficulty. I was able to undertake my own analysis to determine a path out of my situation to one of more prosperity. Quite simply, I took what I had learned from successful business owners, financial seminars and my own experience and put it into practice. Once I did this, my business turned around significantly and I was able to achieve solid levels of growth in my practice. This in turn led to the recruitment of new employees and better systems being put in place. It wasn’t until I had the facts at hand, that I was able to make the necessary decisions. In order to make better decisions, I needed better information. In order to get better information, I needed tools that showed patterns in the data or provided comparisons to other firms or my past results. The tools that I used are the same tools that I share with you now and the framework is called the “Financial Mastery Framework”. Each business has a story to tell and it is not until we review each component of that business, that we know its full story.
Myth-busting Some of the things that I’ve learned along the way, which I thought were correct, but were not. 1. It’s all about revenue. Making more sales does not always get you out of trouble. At the end of the day, the truth is that revenue is for vanity, profit is for sanity. I would rather be a little smaller and more profitable than gloat about the top line revenue figure and be broke. 2. You can determine your business health just through the bank account Too many business owners still use their bank account to determine the financial health of their business. While it can be a handy lagging indicator as to how things are going, when there is no money left, the owner is often puzzled as to how they got there. You need to use a combination of leading and lagging indicators to determine the financial health of the business. 3. I need to spend heaps of time maintaining the information An Excel spreadsheet and half a day a month is probably all that you need to keep on top of the financial activity within most small businesses. While the initial information load may take a little while, once the templates are set up, you can use easy formulas to do the calculations for you. If you know how to use Excel, this is all you will need to use the tools efficiently.
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The Financial Mastery Framework
Step 1 – Collect the financial Information for your business To start becoming a financial master of your business, you will need to obtain an up-to-date Profit and Loss Statement and Balance Sheet. If you can’t produce or source this sort of information quickly, I suggest that you may want to start making an investment here in order to improve your business. Running a business without these key reports is like playing a football game without a scoreboard. There’s a lot of activity but no one knows whether you’re winning or losing. How regularly you will need to review these reports will depend on a few factors: • the size of your business; • the type of industry that you are in; and • the financial accounting resources at your disposal I would suggest that, at a minimum, you should be reviewing the overall financial results of the practice on a monthly basis. The ability of your business to prepare these sorts of reports monthly will depend greatly on your accounting resources and how quickly data is recorded in your accounting system. It is important to note at this stage that if the data is incorrect or not kept up-to-date, the information gleaned from the data is also likely to be incorrect. As a result, any decisions made on incorrect information are no better than calculated guesses.
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In my view, financial data needs to be maintained at 3 levels before it can be relied on for true analysis. These levels are: 1. Data Integrity – Is all the data recorded in the accounting system? Missing credit card statements, bank transactions and employee reimbursements can all hinder the completion of the account process on a regular basis. We would typically expect a bookkeeper or internal data entry operator to be responsible for this function. Completeness is the key here. 2. Reconciliation - Does the data match available third party documentation? One of the most critical activities at this level is to ensure that the bank reconciliation is completed. Without properly reconciled bank accounts, the quality of the financial information is greatly reduced. All major debt facilities, debtor and creditor listings should also be reviewed for accuracy and reconciled in the accounts. We would suggest that a qualified or very experienced accountant should perform the reconciliations for the business. Ideally, this person should be different to the data entry person. 3. Overall sense check – Are any major transactions missing? Were any capital expenditures made with debt financing that just haven’t been recorded yet? All too often, we have reviewed financial statements that appear correct, yet have missed major transactions due to a failure in communication within the organization or lack of relevant paperwork. Once you have a reconciled profit and loss statement and balance sheet that appears correct, you are now ready to learn the secrets of the financial experts in analysing your business. For the purposes of illustration, we have included the financial statements of a fictional company called XYZ Furniture. The financial statements that have been used for all calculations are included as an appendix to this e-book.
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#1 Profit and Loss Mastery
Every business owner needs to have a core understanding of their underlying business model. In particular, a business owner needs to be able to recite the following facts at the drop of a hat: Example What is my target annual revenue? What is my average Gross Profit % What is my overhead %? What is my net profit before tax %?
$ 4,200,000 31% 23% 8%
While the revenue figure is not as important as profit, it does form the basis for most of the percentage calculations that will use total revenue $ for the period as the base. Why are these figures important? The Gross Profit % should indicate how much profit you are likely to make each time you make an additional sale. If your overheads are fixed and stable, any additional gross profit represents extra money to your bottom line. Most business owners should have a good understanding of their margins. The overhead % represents how much of the business revenue is directed towards keeping the doors open. Overheads still typically include things like rent and administrative salaries. Every owner should have a good idea as to their overhead % so they can then work out their net profit %.`
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The net profit after tax figure % indicates the level of net profit that is available for reinvestment or drawings after taxes are paid. In an Australian corporate environment, the amount of tax applicable to net profit is generally 30%. Therefore if a company’s gross profit was 30% and their overheads 20%, net profit would be 10%. Tax of 30% would reduce the available profit of the business from 10% to 7% (10% - 30% x 10%).
What about EBIT (Earnings before interest and tax) and EBITDA (Earnings before interest, tax, depreciation and amortization)? Many higher level accountants and advisors use the term EBIT or EBITDA when discussing business models. In theory, by using these measures, the analyst will get a better idea of the business model by removing the impact of the choice of business structure (which affects tax) and the impact of how much financing is used in the business (which affects interest). EBITDA goes one step further and also takes out depreciation and amortization from the analysis. By doing this, one can calculate the underlying cash flow being generated by the business by removing the typical non-cash deductions from the analysis. However, because interest and depreciation are a real cost of most small businesses, I do not tend to use these more technical calculations as much. Interest and depreciation can normally be left safely in the analysis for the purposes of most small business. Tax is one item I will generally leave out as businesses can be conducted through a trust (which generally pay no tax) or a company (which pay tax on profit). That is why I generally prefer most small businesses to concentrate on calculating their net profit before tax result.
My top 5 Profitability measures & how to calculate them* *(using XYZ Furniture for our figures)
1. Gross Profit % = Gross Profit $ (Revenue less cost of goods sold)/ Revenue$ = $1,302,000/$4,200,000 = 31% For a goods business, the cost of goods sold will include inventory movements. For a services business, you should put the wages cost of the people that generate the revenue for the business in the cost of goods sold. Normally owners and admin wages are left in overheads. 2. Overheads % = Overhead (include interest) $ / Revenue $ = $976,463 / $4,200,000 = 23.25%
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Even if your overall overhead costs are relatively stable, the overhead % will usually vary depending on the revenue figure. The goal for most businesses is to ensure that the overhead percentage is lower, year upon year. A general goal is to ensure that any increase in overhead % is lower than the growth in revenue % from year to year. 3. Net Profit before tax% = Net profit before tax $ / Revenue $ = $325,537 / $4,200,000 = 7.75% I would suggest to most business owners that they need to achieve a net profit before tax % of over 10%. This assumes that the owners are paying themselves a commercial wage for their involvement in the business as an employee. Anything below 10% for a private small business should be a sign that improvements to the business model are required. 4. Revenue Growth % vs COGS Growth % Revenue growth is a calculation of growth in this year’s revenue over last year’s. (Revenue $ this year Revenue $ last year / Revenue $ last year). COGS growth is similarly calculated (COGS $ this year – COGS $ last year / COGS $ last year). A positive result in Revenue Growth indicates business growth. A negative result would indicate that the business has shrunk. This comparison enables the owner to see whether their margins are worsening, being maintained or improving as the business grows. If Revenue Growth is negative, it is important to see if, overall, the COGS have also reduced. 5. Revenue Growth % vs Overheads Growth % This comparison is made to ensure that overheads are not growing disproportionately to revenue. An ideal goal is to have overhead growth at a lower rate than revenue growth. Once these 5 calculations have been made, the owner will have a pretty good idea as to the business model that they have and how they have gone compared to last year. If you have a budget, then it is common to do the comparison against the budgeted results.
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#2 Balance Sheet Mastery
Many business owners seem to struggle with understanding the purpose of the balance sheet. A good analogy to describe a balance sheet is to think of it as a photograph of your business’s position at any given moment in time. Similar to photographs of family members, your business will change in size and appearance as time goes on.
My top 2 balance sheet measures & how to calculate them. The 2 key questions business owners should ask in order to gain a better awareness of their balance sheet are the percentage of ownership of their business and the return on their business. 1. How much of the business do I own? In order to answer this question, I suggest looking at your financial statements in a slightly different way than they are normally presented. Typically, the balance sheet has assets totaled with liabilities listed below that total to come up with a net assets figure. The net assets figure will then need to agree (otherwise it isn’t balanced!) with the equity position of the business. For a company, the equity position will consist of the share capital of the business plus any retained earnings and reserves. For a trust, this may only consist of the settlement sum and any reserves. In short, the presentation is: Assets – Liabilities = Equity
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What I suggest is that you, the business owner, reconfigure the equation to show the ownership status of the assets. In this regard, the equation can be rewritten as: Assets = Liabilities + Equity Once the balance sheet is reconfigured in this way, it will give you a better understanding as to how much of the assets you own in the business. Liabilities will generally include both non-interest bearing debt (trade creditors or suppliers, Australian Taxation Office, etc) and interest bearing debt (banks & third party financiers). The equity section normally indicates the amount of ownership held by you, through your initial capital and the profit you have made along the way. In the case of XYZ Furniture, Total Assets are $3,242,164, Total Liabilities are $2,283,762 and Equity is $958,402. Using our reformatted equation, this will now look as follows: Assets = Liabilities + Equity $3,242,164 = $2,283,762 + $958,402 Or in percentage terms: 100% Assets = 70.4% owned by others + 29.6% owned by you
If any of the liabilities are loans owed to shareholders, then it would be correct on an economic basis to include these loans in the equity percentage rather than including them in the amount owned by others. This calculation is similar to an equation you may have heard about called the debt/equity ratio. Typically the debt/equity ratio is calculated by dividing the interest bearing debt (usually just the bank debt) of the business by the equity total. Trade creditors that are, for the most part, interest free would be excluded from the debt/equity calculation. I tend to leave the debt equity calculation for the banks to worry about rather than for owners who like to know how much of their business they own and whether that figure is increasing or decreasing. 2. What is the return on my investment? Too often, when I have had business owners review their profit and loss statement and find that their net profit% is, say 3%, they’ll state their money would be better off in the bank! While I can empathise with the plight of the business owner on many occasions, this calculation is not correct when trying to determine your return on assets.
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You, as a business owner receive a return on your assets, not your revenue. As such, the proper comparison must be to calculate a return on the net operating assets of the business. Calculating the net operating assets of the business is relatively straightforward. Net operating assets are calculated by subtracting the total liabilities of the business (excluding any bank or interest bearing debt) from the total assets of the business. Net operating assets = Total assets – Total liabilities (excluding bank debt) =$3,242,164 – $555,781 = $2,686,383 The relevant return that I would suggest, for the purposes of calculating return on capital, is EBIT. Because we are removing interest bearing debt out of the net operating asset total, we cannot leave the interest cost in the figure used as a return. To calculate EBIT, simply have a look at your net profit before tax figure and add back interest as it appears in the profit and loss statement. Return on Capital Employed = EBIT / Net Operating Assets = $461,885 / $2,686,383 = 17.19% This is the return that is being achieved for all stakeholders – both you, as the owner, and the other liability holders (bank and creditors). This is the return that will ultimately be used to repay those holders of capital. 3. What should be my return on capital employed %? Once the figure is calculated, you will want to know whether this is a good figure or not. The figure on its own has little meaning, as the return can be very high for services type businesses and very low for capital intensive businesses. The comparison needs to be made to similar businesses in the same industry or past or budgeted results in order to provide determine whether the figure is acceptable.
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#3 Working Capital Mastery
Working capital means different things to different owners. For the purposes of my analysis, I always view working capital as the amount of money that is tied up in inventory and debtors, less any amounts funded by creditors. It represents the additional money that needs to be contributed into the business on top of physical cash and fixed assets.
My Top 5 working capital measures & how to calculate them 1. Debtor Days Debtor days represents the amount of time it will take from when an invoice is rendered to when the business will receive payment for that invoice. The method of calculating the debtor days is relatively simple. The typical carrying value of your debtors is compared against your yearly revenue, to get an indication of how quickly revenue is turned into cash. = Trade Debtors$ / Revenue$ = $863,014 / $4,200,000 = 75 days The above calculation assumes that a full year of revenue is being considered. Should you be considering interim or periodic financial statements, an adjustment will need to be made to convert the revenue amount to a yearly figure. For example, if you have 6 months of revenue in your profit
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and loss, the revenue figure will need to be doubled in order to do the above calculation correctly. 2. Stock/WIP Days Not all businesses will record stock in their financial accounts. For a goods business, it is important to keep a regular stocktake of goods that are on hand to be sold in the course of the business in order to determine your true profit position. For a services business or construction business, the value of any work-in-progress (WIP) representing amounts that are yet to be billed, is something to be monitored. Because work in progress or stock amounts represent costs of production or the costs of purchasing of goods, it is typical to divide the stock or WIP amount in the balance sheet by the total cost of goods sold amount. This is different to debtor days where revenue is the basis for comparison. = Stock$ / Cost of Goods Sold$ = $1,429,151 / $2,898,000 = 180 days 3. Creditor Days Similar to stock days, we will generally use the cost of goods sold amount to confirm the creditor days for the business. Because creditors will generally represents the costs incurred by the business and not the revenue it will make from those goods, the cost of goods sold figure is the correct base for the calculation. = Creditors$ / Cost of Goods Sold$ = $555,781 / $2,898,000 = 70 days Creditors should only represent amounts that are directly included in the costs of production or purchasing for your business. Creditors should not include payroll or GST liabilities in the above calculation, despite some business owners referring to these as creditors. The days calculated above essentially indicate how long the business has to purchase goods on credit before payment is required. Ideally, creditor days should be at least as long as debtor days so that additional cash is not required to pay suppliers before the business receives payment from its customers. 4. Working Capital Days In order to get a feel as to how much capital is tied up in your business, it is very common to combine the three results above to determine the total working capital days. Working Capital Days = Debtor Days + Stock/WIP Days – Creditor Days
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Creditor days are subtracted as they represent money contributed by others and not the owner. 5. Marginal Cash Flow A useful measure for performance that will also provide an appreciation of your business model is marginal cash flow. Marginal cash flow is essentially a measure that dictates the effect of an additional sale on the cash position of the business. The working capital % of the business is compared to the gross profit % to determine whether each additional sale is going to require more or less funding from the owner. The working capital % is calculated slightly differently to the first three measures, in that a single common denominator is used for the calculations. Typically the denominator used is sales. Working capital % = (Debtors + Stock – Creditors) / Sales = (863,014 + 1,429,151 – 555,781) / 4,200,000 = 41.3% This result is then compared to the gross profit margin: Marginal Cash flow = Gross Profit % - Working capital % = 31% - 41.3% = -10.3 So, assuming the business wants to consider making a $1,000 sale, the above marginal cash flow results shows that you will need to provide additional funds of $103 in order for the current working capital levels of the business to be maintained. If no additional funding is available from the bank, this will require the business to source funds through accelerated receipt of debtors or the sale of stock to reduce inventory levels. Alternatively, the business could stretch its creditors further, which is a common approach for businesses in this situation. The effectiveness of the management of working capital in any business is generally the difference between strong businesses and weak ones. Of all the measures listed in this e-book, we would suggest that working capital measures are the best ones to monitor and try to adjust in order to generate more cash out of the business without seeking additional finance from the bank.
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#4 Cash Flow Mastery
The classic comment I hear from business owners when reviewing their financial statements is, “If I made a profit, then where’s all the money?” This is where you need to understand a very important principle - accounting profit does not equal cash. In order to understand the proper cash flow of the business, the profit needs to be adjusted to reflect payments that will be included in your balance sheet. I have even heard one financial commentator describe it like this “Your balance sheet steals from your profit and loss”. While listed companies are forced, under accounting disclosure standards, to prepare a cash flow report for their shareholders, small businesses have generally dispensed with the use of this important tool. This trend is also reflected by the major accounting software packages not allowing a cash flow statement to be easily prepared from within the package. The format that I use for cash flow statements is different to the one you will find in listed company reports. The trouble I find with the listed company reports is that they use terminology that is mandated by accounting standards, rather than terminology the business owner will understand. I have devised 4 separate categories of cash flow for discussions with owners. These are: • Operational cash flow • Structural cash flow • Investing cash flow • Debt & Owner cash flow
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How to create your own cash flow statement in 5 easy steps. 1. Calculate your operational cash flow For the purposes of this calculation, I will assume that your financial statements are prepared on what is known as an “accruals” basis. Under this assumption, sales are booked as revenue when the sales order is complete and not when someone has paid for the sale. If your business model is one where people pay for your goods or services at the time of sale, then the cash sales figure and accounting sales figure will be the same. However, if your business provides credit to its customers so that the customer can pay your invoice later, there will be a difference in what you have received in cash from sales, compared to what is in your profit and loss statement. The difference will be hidden in your “trade debtors” or “accounts receivable” (I use these terms interchangeably). Similarly for any supplier payments of overhead payments where you are provided goods or services on credit i.e. you receive them before you have to pay for them, then a similar discrepancy will arise between what you show as expenses in your profit and loss and what you have outlaid in cash to your suppliers. In order to perform the calculations for your cash flow, you will need the balance sheet for the starting date that you wish to review, and the balance sheet at the end date of your review. For example, if you are reviewing the annual cash flow position for your business for the year ended 30 June 2013, you will need the balance sheet at 30 June 2012 and also 30 June 2013. The profit and loss statement for the 12-month financial year up to 30 June 2013 will reflect the movement in the balance sheet. Revenue Here is the template to calculate the revenue component of your operational cash flow: Revenue from sales of goods/services (per the P&L) Change in accounts receivable +/- Cash received from sales
$ $ $
If debtors have gone up from one period to the next, the business will have less cash as compared to its sales for the period. If debtors have gone down, the business will have more cash, as it will have received payments from customers from a prior period.
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In our XYZ Furniture example, debtors were $671,233 at 30 June 2012 while they increased to $863,014 at 30 June 2013. As a result, the business received less cash than the sales it recorded in the profit and loss statement. This can be shown as follows: Revenue (per the P&L) Change in Accounts receivable ($671,233-$863,014) Cash received from sales
$4,200,000 ($191,781) $4,008,219
Note that the upward change in accounts receivable is subtracted from the sales figure to calculate the cash received from sales. This is because the balance sheet has stolen $191,781 of cash from the profit and loss! The increase in debtors as at 30 June 2013 reflects cash payments that customers will make in future periods and not the one we are reviewing. Direct Costs Here is the calculation template to calculate the direct costs component of the operational cash flow: Cost of Goods Sold (per the P&L) $ Change in accounts payable/creditors +/- $ Change in Work in Progress or Inventory +/- $ Cash paid to suppliers $ If creditors have increased over the period, this will represent additional credit that has been provided by the suppliers of the business and will therefore save the business paying cash in that period. Quite often the saved cash will result in the purchase of more stock. Should more stock be on hand at the end of the period as compared to the beginning, this would represent cash that has been spent and locked up in the balance sheet. In the XYZ Furniture example, creditors increased from $402,855 to $555,781 over the period. Stock increased from $1,033,696 to $1,429,151. As a result, the business has outlaid more cash than the cost of goods sold per the profit and loss statement. Using the calculation above: Cost of Goods Sold (per the P&L) Change in accounts payable (555,781-402,855) Change in Stock (1,033,696-1,429,151) Cash paid to suppliers
($2,898,000) $152,926 ($395,455) ($3,140,529)
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Overheads The calculation template for overheads is similar to the direct costs template: Overheads (per the P&L) Add back: Depreciation expense Change in GST liabilities +/- Change in payroll liabilities +/-
$ $ $ $
Any increase in GST or payroll liabilities over a time period will generally represent cash that has not been directed towards paying those liabilities. As such it represents a cash saving to the business. The methodology above can be applied to all sundry asset and liabilities accounts. Remember the basic rule when doing the calculations. An increase in assets will represent cash spent. An increase in liabilities will represent cash saved. Depreciation is taken out of the overheads figure as it represents a non-cash expense of the business. Because no cash is expended through depreciation, it can safely be deducted from the overheads total for the purposes of calculating the cash spent on overheads. In the case of XYZ Furniture, the calculation for cash spent on overheads is: Overheads excluding interest (per the P&L) ($840,115) Add: Depreciation expense $nil Change in GST liabilities +/- $nil Change in payroll liabilities +/- $nil ($840,115) Bringing the 3 elements together, the operational cash flow can be calculated as follows: Cash received from sales Cash paid to suppliers Cash paid as overheads Total operating cash flow
$4,008,219 ($3,140,529) ($840,115) $27,575
In the XYZ Furniture example, while the business appears profitable, we can see that very little operational cash flow has been generated by the business. When the owner asks, “Where’s the cash”, this analysis shows that cash has been stolen by the balance sheet through increases in debtors and stock. While the increases in creditors have helped fund operations during the period, it is insufficient to cover the amount of money that has been paid into stock and the provision of credit to customers.
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2. Calculation of Structural cash flow Each business is different in the way it is structured. Under my analysis approaches, I tend to review any costs associated with the finance structure and the income tax structure of the business. In this regard, I make allowance for interest payments and income tax payments made by the business. Note that I like to exclude interest from overheads so that it can be included in this part of the cash flow analysis. The template for calculating the structural cash flow is straight forward: Interest payments made (from P&L) Income tax payments Total structural cash flow
$ $ $
The calculation of the income tax payments is two-fold. Firstly you will need to source the income tax payment amount from the profit and loss statement. Secondly, you will need to adjust that amount for any movement in the provision for income tax account in the balance sheet of the business. In the case of XYZ Furniture, the structural cash flow can be calculated as follows: Interest payments made or received +/- Income tax payments or refunds+/- Total structural cash flow
($136,348) ($117,235) ($253,583)
Because there is no income tax provision in the accounts at either 30 June 2012 or 30 June 2013, the total cash spend on tax is per the profit and loss statement. If there was an increase in the amount of the provision for income tax, the amount of cash paid would need to be reduced by the increase. Conversely, if a provision has decreased over the period, this would represent additional cash that has been paid to reduce the income tax liability of a prior period. 3. Calculation of investing cash flow Each time a business acquires a new fixed asset, there will be a cash payment that will not show up in the profit and loss, but will be displayed in the balance sheet. Under this heading, I like to include any purchases of motor vehicles, plant and equipment or real estate of other similar investments. When these acquisitions are also funded by third party finance, the amount of finance contributed will be covered separately in the cash flow calculation (see 4. below). For any assets that are subject to depreciation, it will be important to calculate the movement in the fixed assets, without the depreciation being included. This will ensure that the actual cash outlay for the purchase of the asset is calculated.
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The template to calculate the investing cash flow is as follows:
Acquisition of Fixed Assets +/- Acquisition/Disposal of Other Investments +/- Total investing cash flow
$ $ $
In applying this template to XYZ Furniture, the investing cash flow is: Acquisition of Fixed Assets ($100,000) Total investing cash flow ($100,000) 4. Calculation of debt & owner cash flow As explained under balance sheet mastery, there are essentially two core groups that have ownership rights to your assets – the bank and you. Under this component, I like to highlight the drawings or loans of the directors that haven’t been included in the profit and loss statement. Also, it is important to show the amount of debt reduction that you have made against your debt facilities. Quite often, the owners of a business feel a little happier knowing that the cash they thought was theirs, has at least reduced the level of ownership the banks may have of their business assets. The template to calculate debt and owner cash flow is as follows: Reduction of debt facilities Director loan account movements +/- Dividend payments Total debt and owner cash flow
$ $ $ $
In relation to the XYZ Furniture example, I would calculate the debt and owner cash flow as follows:
Increase in debt facilities Director loan account movements Total debt and owner cash flow
$100,000 $0 $100,000
5. Showing the total cash flows and reconciling it to your cash position For the purposes of my cash flow statements, I like to consider cash as being made of cash in working accounts, petty cash, cash on hand and term deposits or investment accounts less any amounts in overdraft facilities.
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The reconciliation process should list the 4 components of the cash flow statement above and then the total should be added or subtracted, as the case may be, against the opening balance of the cash position for the business. The opening cash position of the business will be determined from the balance sheet from the prior period. The template would look as follows: Total operating cash flow Total structural cash flow Total investing cash flow Total debt and owner cash flow Total cash movement Opening cash balance for the business Closing cash balance for the business
$ $ $ $ $ $ $
When the template is applied to XYZ Furniture the result is as follows Total operating cash flow Total structural cash flow Total investing cash flow Total debt and owner cash flow Total cash movement Opening cash balance for the business Closing cash balance for the business
$27,575 ($253,583) ($100,000) $100,000 ($226,008) ($501,974) ($727,981)
In this case, we can see that while the asset acquisitions were funded completely by debt finance, the business is still struggling to generate sufficient cash flow to cover its interest costs and taxes. The key to improving this business would be to review the operational cash flow position, to ensure that a break-even cash position can be calculated, so that goals can be set for working capital and profit levels. That’s It! You now have in your hand the tools that will help you identify where the cash has been generated and spent in your business.
21
The Financial Mastery Framework
Tips for success While the above framework may seem overwhelming initially, I guarantee that by going through each step of the framework, you will develop an excellent understanding of the financial position and results for your business. I list below 3 tips that you might find useful in undertaking the mastery steps above.
Tip #1 - Use a Microsoft Excel or Similar Financial Spreadsheet Your financial results continually change. What will be useful for you is to prepare a spreadsheet that will allow you to input your profit and loss and balance sheet data. You can then create formulas to do all of the calculations included above. If you think that process is too daunting, I would suggest the purchase of a financial analysis package that will do the calculations for you. Some of the more known financial package programs include MYOB Profit Optimizer and My Cash Flow Story.
Tip #2 – Review your financials on a regular basis If your review of financial statements consist of a once-a-year visit to your external accountant, it will be very difficult for you to have a good idea as to how well your business is tracking. As suggested earlier, I would recommend a monthly review of your position once the data for your month has
22
been included into your accounting system. If this is not able to be done in your business due to lack of resources, I would suggest investing some money into your finance function or at least allowing your external accountant to be involved in reviewing your figures.
Tip #3 – Ask questions of your internal and external accounting providers Even if it takes you some time to achieve financial mastery as indicated above, you can at least ask the right questions of your finance team. At the end of the day, it is your business and it pays to have good information at your disposal to enable you to maximize your financial return on your investment.
What do I do now? As a first step to starting the above, I would recommend getting a copy of your most recent financial statements and work out what period you want to review. Once those are obtained, try to replicate the processes described above to create the financial story for your business. If you get stuck, ask for help from your internal and external finance providers. Good luck!
23
XYZ Furniture (example) Prepared for XYZ Furniture 26 March 2014
Prepared by Judsons using Cash Flow Story
Page 1/11
XYZ Furniture XYZ Furniture (example)
Setup Reporting Period Year End
30-06-2012
30-06-2013
12
12
Revenue
3,500,000
4,200,000
Gross Margin ($)
1,050,000
1,302,000
EBIT
374,886
461,885
Net Profit (After Tax)
165,268
208,302
0
0
116,590
136,348
Other Income/Expenses
0
0
Distributions/Dividends
0
0
2,554,929
3,242,164
0
0
671,233
863,014
Stock
1,033,696
1,429,151
Total Current Assets
1,704,929
2,292,165
850,000
950,000
1,804,829
2,283,762
Trade Creditors
402,855
555,781
Total Current Liabilities
904,829
1,283,762
Bank Loans - Current
501,974
727,981
Bank Loans - Non Current
900,000
1,000,000
Period Length (months)
Profit & Loss
Other Information Depreciation & Amortisation Interest Paid
Balance Sheet Assets Total Assets Cash Trade Debtors
Fixed Assets
Liabilities Total Liabilities
Funding
Prepared by Judsons using Cash Flow Story
Page 2/11
XYZ Furniture XYZ Furniture (example)
Summary Story Your Profit Story
-
Revenue $4,200,000
COGS $2,898,000
=
Gross Margin $1,302,000
-
Overheads $840,115
=
EBIT $461,885
Current Year
Change
$4,200,000
+20.00%
Gross Margin %
31.00
+3.33%
EBIT %
11.00
+2.67%
4.96
+5.03%
Revenue
Net Profit %
Your Balance Sheet Story
+
Net Debt $1,727,981
Funding
Debtors Days Stock Days Creditors Days Working Capital Days
Prepared by Judsons using Cash Flow Story
Equity $958,402
=
Working Capital $1,736,384
+
Other Capital $949,999
Net Operating Assets
Current Year
Change
75.00
+5.00 days
180.00
+26.00 days
70.00
+9.98 days
185.00
+21.02 days
Page 3/11
XYZ Furniture XYZ Furniture (example)
Your Cash Flow Story
1,727,981 727,981
1,295,986 501,974
Bank loans current Bank loans non current
863,991 431,996
900,000
1,000,000
Total Debt 30-06-2012
Total Debt 30-06-2013
0
Marginal Cash Flow Operating Cash Flow Net Cash Flow
Prepared by Judsons using Cash Flow Story
Current Year
Change
-10.34
-43.60%
27,575.00
+100.00%
-326,007.00
+100.00%
Page 4/11
XYZ Furniture XYZ Furniture (example)
Chapter 1 - Profitability 30-06-2012 12 months
30-06-2013 12 months
Change
3,500,000
4,200,000
20.00%
N/A
20.00
100.00%
Gross Margin %
30.00
31.00
3.33%
Overheads %
19.29
20.00
3.70%
EBIT %
10.71
11.00
2.67%
EBITDA
374,886
461,885
23.21%
4.72
4.96
5.03%
Chapter 1 - Profitability Revenue Revenue Growth %
Net Profit %
Profitability Trends
36 30.0
31.0
27 30-06-2012 - last period 30-06-2013 - this period
18 10.7
11.0
9
4.7
5.0
0 Gross Margin %
EBIT %
Net Profit %
Revenue Growth vs COGS Growth
28 21
20.0
18.3 Revenue Growth % COGS Growth %
14 7 0 30-06-2013
Revenue Growth vs Overheads Growth
28 24.4 21
20.0 Revenue Growth % Overheads Growth %
14 7 0 30-06-2013
Prepared by Judsons using Cash Flow Story
Page 5/11
XYZ Furniture XYZ Furniture (example)
Chapter 2 - Working Capital Chapter 2 - Working Capital
30-06-2012 12 months
30-06-2013 12 months
Change
70.00
75.00
7.14%
154.00
180.00
16.88%
60.02
70.00
16.63%
163.98
185.00
12.82%
37.20%
41.34%
11.13%
-7.20
-10.34
-43.60%
1.88
1.79
-5.24%
Debtors Days Stock Days Creditors Days Working Capital Days Working Capital % Marginal Cash Flow Current Ratio
Working Capital Days
188
180 154
141 94 60
70
70
30-06-2012 - last period 30-06-2013 - this period
75
47 0 Creditors days
Stock days
Debtors days
Working Capital Timeline at 30-06-2013 This Period Day 0
Day 70
Day 180
Day 255
185 Working Capital Days Stock arrives
Creditors paid
Stock sold
Cash banked
Last Period Day 0
Day 60
Day 154
Day 224
164 Working Capital Days Stock arrives
Creditors paid
Prepared by Judsons using Cash Flow Story
Stock sold
Cash banked
Page 6/11
XYZ Furniture XYZ Furniture (example)
Gross Margin vs Working Capital
48 41 37
36
30
31 Gross Margin % Working Capital %
24 12 0 30-06-2012
30-06-2013
Your Gap
0 -4 -7 -8
-10
-12 -16 30-06-2012
Prepared by Judsons using Cash Flow Story
30-06-2013
Page 7/11
XYZ Furniture XYZ Furniture (example)
Chapter 3 - Other Capital 30-06-2012 12 months
30-06-2013 12 months
Change
1.63
1.56
-3.87%
Return on Capital Employed %
17.42%
17.19%
-1.30%
Return on Total Assets %
14.67%
14.25%
-2.91%
Return on Equity %
22.03%
21.73%
-1.35%
Chapter 3 - Other Capital Asset Turnover
Return on Capital % EBIT %
Asset Turnover
Return on Capital
EBIT
Revenue
EBIT
$461,885
$4,200,000
$461,885
x
=
=
$4,200,000
Net Operating Assets $2,686,383
Net Operating Assets $2,686,383
11%
1.56
17.19%
Revenue
Return on Capital 17.19%
Your Strategy Last Period
This Period High growth in Assets, low growth in EBIT - Alert
A
B
D
C
EBIT
Net Operating Assets
Prepared by Judsons using Cash Flow Story
Page 8/11
XYZ Furniture XYZ Furniture (example)
Chapter 4 - Funding 30-06-2012 12 months
30-06-2013 12 months
Change
1,401,974
1,727,981
23.25%
Net Cash Flow
N/A
-326,007
100.00%
Debt to Equity
1.87
1.80
-3.53%
Interest Cover
3.22
3.39
5.35%
Operating Cash Flow
N/A
27,575
100.00%
Chapter 4 - Funding Net Debt
Profit vs Cash Flow Profit
Cash Flow
Change
Revenue
4,200,000
Cash from Customers
4,008,219
-191,781
COGS/DC
2,898,000
Cash to Suppliers
3,140,529
-242,529
Gross Margin
1,302,000
Gross Cash Profit
867,690
-434,310
840,115
-
27,575
-434,310
Overheads excl Depreciation
840,115
Overheads excl Depreciation
EBITDA
461,885
Operating Cash Flow
Other Cash Outflow Interest Paid
-136,348
Tax Paid
-117,235
Other Income
0
Dividends Paid
0
Fixed Assets Acquired
-100,000
Other Net Assets Decreased
+1
Capital Introduced
0
Net Cash Flow
-326,007
EBITDA vs Operating Cash Flow 461,892 346,419 EBITDA Operating Cash Flow
230,946 115,473 0 30-06-2013
Prepared by Judsons using Cash Flow Story
Page 9/11
XYZ Furniture XYZ Furniture (example)
Results 30-06-2012 12 months
30-06-2013 12 months
Revenue
3,500,000
4,200,000
COGS
2,450,000
2,898,000
Gross Margin
1,050,000
1,302,000
Overheads
675,114
840,115
EBIT
374,886
461,885
0
0
Interest
116,590
136,348
Net Profit before Tax
258,296
325,537
93,028
117,235
165,268
208,302
0
0
165,268
208,302
0
0
671,233
863,014
1,033,696
1,429,151
0
0
1,704,929
2,292,165
850,000
950,000
0
-1
850,000
949,999
2,554,929
3,242,164
Trade Creditors
402,855
555,781
Bank Loans - Current
501,974
727,981
0
0
Current Liabilities
904,829
1,283,762
Bank Loans - Non Current
900,000
1,000,000
0
0
900,000
1,000,000
1,804,829
2,283,762
750,100
958,402
Profit & Loss
Other Inc/Exp
Tax Net Profit Dividends Paid Retained Profit
Balance Sheet Cash Trade Debtors Stock Other Current Assets Current Assets Fixed Assets Other Non Current Assets Non Current Assets Total Assets
Other Current Liabilities
Other Non Current Liabilities Non Current Liabilities Total Liabilities Equity
Prepared by Judsons using Cash Flow Story
Page 10/11
XYZ Furniture XYZ Furniture (example)
30-06-2012 12 months
30-06-2013 12 months
3,500,000
4,200,000
N/A
20.00
Gross Margin %
30.00
31.00
Overheads %
19.29
20.00
EBIT %
10.71
11.00
EBITDA
374,886
461,885
4.72
4.96
70.00
75.00
154.00
180.00
60.02
70.00
163.98
185.00
37.20%
41.34%
-7.20
-10.34
1.88
1.79
1.63
1.56
Return on Capital %
17.42%
17.19%
Return on Total Assets %
14.67%
14.25%
Return on Equity %
22.03%
21.73%
1,401,974
1,727,981
Net Cash Flow
N/A
-326,007
Debt to Equity
1.87
1.80
Interest Cover
3.22
3.39
Operating Cash Flow
N/A
27,575
Chapter 1 - Profitability Revenue Revenue Growth %
Net Profit %
Chapter 2 - Working Capital Debtors Days Stock Days Creditors Days Working Capital Days Working Capital % Marginal Cash Flow Current Ratio
Chapter 3 - Other Capital Asset Turnover
Chapter 4 - Funding Net Debt
Prepared by Judsons using Cash Flow Story
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