In the words of Peter Drucker, “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” (Emphasis added.) No matter where you are on your Wealthpreneur journey, the importance of cash flow cannot be overemphasized! Even if you own a very profitable business, you may find yourself asking, “Where did all the cash go?”
Profit ≠ cash
Fluctuations in accounting profit and operating cash flow are very common. But changes in accounts receivable (what your customers owe you), accounts payable (what you owe your vendors), and product or parts inventory levels (if applicable) can create meaningful differences in your reported monthly accounting profit and the amount of cash in your bank account. This graph shows how meaningful these differences can be. Your business will probably experience months with negative operating cash flow.
Wealthpreneur Lesson
Cash Flow According to Warren Buffett
“We are interested in businesses that provide cash rather than use up cash. We’re willing to have them use cash, if what they use will produce high enough returns. But we’ve got this bias toward things that throw off cash.”
“Show me the money!”
In a scene from the movie Jerry Maguire, characters played by Tom Cruise and Cuba Gooding Jr. scream, “Show me the money!” Wealthpreneurs who successfully implement the 4 Essential Pillars of cash flow management know exactly where their cash goes.
In order of priority, the 4 Essential Pillars of cash flow management are:
- Pay taxes
- Repay debt
- Achieve core capital target
- Distribute profits
Without knowledge of the 4 Essential Pillars, business owners may unwisely use their business’s cash to buy an expensive vehicle (supposedly used in the business), pay lavish personal expenses (that should have been paid from the owner’s market-based wage), or fund a down payment on a non-business-related real estate asset. When applied properly, these pillars support good decisions and can prevent purchasing mistakes. Savvy Wealthpreneurs don’t finish a profitable year wondering, “Where did the money go?”
Know your CAD
Calculating cash available for distribution (CAD) provides you with insight regarding when and how to use the cash your business generates. This knowledge can decrease the potential for unknowingly spending cash that is not “available”, and thus reduce your chances for entering dangerous financial territory.
This example shows how to calculate cash available for distribution.
Check your tax pulse
- Enlist a qualified tax planning advisor to perform an annual Tax Checkup. This professional will identify customized strategies for you and your business, which you can proactively implement. As a byproduct, you will be well prepared to estimate each year’s tax liability. Every year is different, so I recommend you regularly reassess and update your plan.
- Don’t pay your taxes until you absolutely must without incurring a penalty. An underpayment “penalty” is simply a nondeductible interest charge. For some taxpayers with high short-term ROI opportunities, borrowing from the government may make financial sense.
- Set aside sufficient cash to pay your taxes on time. Many Wealthpreneurs temporarily hold these funds in a separate account pending payment to the tax authorities. This approach guards against this money unwisely being used for an unaffordable purchase.
Is debt your friend?
- Building a business that is burdened with debt creates challenges most Wealthpreneurs can avoid. By taking a low-debt or no-debt approach, you can handle difficult economic news more easily and live more stably.
- To bridge occasional cash deficits, take out a business line of credit. Your bank officer will view you and your business more favorably if your credit line balance goes to zero for at least 30 consecutive days in a 12-month period.
- In some industries, making large purchases (such as equipment and real estate) is essential. To facilitate these purchases, use term debt: a fixed monthly payment over a specific period of time.
Prepare For Opportunity
Zig Ziglar once said, “Success occurs when opportunity meets preparation.” Businesses that have cash and no debt attract amazing opportunities! Wealthpreneurs with cash can make transformational deals in tough economic times.
Hit the core capital bullseye
- For many businesses, core capital is equal to 2 months of operating expenses in cash, with nothing drawn on a line of credit.
- To calculate and achieve your core capital target, fund your accounts receivable, inventory, and equipment costs with operating cash flow or term debt.
- Analyzing past results can help you determine the appropriate targeted core capital level for your business. For some companies, 6 months may be more accurate than 2 months. Raising the target amount can also increase your owner comfort level.
Retain or distribute?
- Remain consistently profitable over time and retain profits in your business for the opportunity to build equity. In accounting jargon, this is your retained earningsaccount. These profits can fund your core capital goal.
- Profits accumulated in excess of your target (which may be redetermined if circumstances change) can be distributed to the owner!
The insights above were inspired by the teachings of Greg Crabtree. For those interested in additional information, I recommend his book, Simple Numbers, Straight Talk, Big Profits!.
