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Operating Cash Flow (OCF) is a practical measure of a business? cash flow and may be the single most important metric for measuring the health of your core business operations.
This presentation describes the importance of Operating Cash Flow to a business, what it is, and how to calculate it, including examples.
How important is the use of words? Is it important for business owners to be precise in their use of business and financial terminology? Can distorted or inaccurate communication lead to incorrect conclusions and actions that are harmful?
Ask the average business owner if he or she wants to make more money and the answer will be yes. Ask that same question of a more experienced or sophisticated business person and the answer might be, ?Just what do you mean by more money?? As you might now imagine, the term ?make more money? has different meanings to different people.
We?ve all heard a newscaster say things like the movie Unbroken made $47.3 million during its Christmas weekend opening or the auto maker GM made $39.6 billion in the second quarter of 2014. To be accurate, the reporter should have said Unbroken grossed $47.3 million in ticket sales and that GM sold $39.6 billion of autos and other products. The ?making of money? is an expression that refers to profit, the money left after paying all operating costs and expenses. The figures quoted in the newscast represent sales made during the period, not profits.
At this point you may say, ?So what? Does it really matter?? Let?s look at a different scenario.
A business owner at a cocktail party talks about how much money he made. Most listeners recognize he is boasting a bit and they pay no attention. But what if the same statement is made to his banker, a potential investor or lender, an important supplier, or a prospective customer? The meaning now becomes critical because the credibility of the owner will be judged based on his use of business and financial terminology.
A banker or investor won?t make a loan or investment solely on the ability of the owner to use an accurate vocabulary. On the other hand, an inaccurate usage of terms and an inaccurate communication of business results, however unintentional, will cause them to wonder about the knowledge and acumen of their applicant.
If a vendor has a choice of two customers to promote and sell their products or if a customer has the choice between two sources to supply their needs, credibility may be very important. If the decision is low risk, meaning the acumen of the owner is of no import, the usage of terms may not matter. On the other hand, if the reputation, stature, and sophistication of the business are important to the vendor or customer, the impression created through vocabulary may be critical. Although perhaps an extreme example, the former CEO of a large St. Louis corporation would not consider suppliers if the representatives were sloppy in their use of language. We know a supply chain manager at a Fortune 50 company declines to use suppliers in critical areas if they cannot speak knowledgeably about their financial situation.
Think of it this way. There is no disadvantage to using business terms in a correct and proper manner, but there may be advantages to creating the image of a person who knows what they are talking about. Using improper or imprecise language runs the risk of damaging image or reputation. Why take that risk?
Our suggestion is to avoid using the term ?making money?. Instead, refer to ?making a profit?. After all, isn?t making more profit what the financial aspect of business is about?
Brenda headed a multi-million dollar consulting firm primarily focused on government projects. Now in her 20th year, she was a thought-leader in her field and considered herself quite successful. Her current P&Ls showed decreasing profit and her cash flow had reduced to a trickle. The bank had reduced her line of credit.
Puzzled, she asked us to help her figure out the problem. An analysis of her financial statements showed two problem areas. First, accounts receivable were coming in slower than in the past and her bank had reduced her line of credit because collateral, the accounts receivable, was too little to support the original line of credit.
The crush of three new contracts landing at once put staff under pressure to complete their initial fact finding and analysis work. As a result, invoicing and accounts receivable follow up were overlooked and computer reports did not show the deviation from standard.
Brenda was surprised when we told her that the second problem was not a downturn in profit. In fact, her profit margin had actually increased. The problem was in her accounting system. When Brenda installed her system, she used the default Chart of Accounts for service businesses as suggested by her accounting software. This resulted in ignoring her major asset ? work in progress (WIP). The standard setup used the cash basis method of accounting. This means income was recognized when it was actually received and expenses were recorded when paid. This resulted in Brenda?s booking a great deal of consultant salary expense while receiving no income. The result ? the appearance of greatly reduced profit.
We added an account called WIP. All job costs such as wages and travel were placed in this account until the job was billed. At that point the costs were deducted to match the timing of the income. WIP is really a kind of inventory account and is recognized as an asset on the Balance Sheet. Once Brenda?s bank understood she not only had significant profit, but also had substantial assets in the form of WIP inventory to serve as collateral, her problem was over. The credit line was restored.
Both of Brenda?s problems arose because she, like most independent business owners, was not intimately familiar with the use of her accounting system to provide management information. Her accountant had not mentioned the discrepancy because he was thinking of her records from a tax preparation point of view. Her books gave him the information he needed to prepare tax returns. Unfortunately, it did not give Brenda the information she needed to run her business and make sound decisions.
Unfortunately, Brenda?s story is not unique. At businessmoneyinsights.com, we?re dedicated to providing practical business financial education in plain English. We?re a ?jargon-free zone? where high-level theory that can?t be implemented is not allowed.
We like theory only if you can apply it and get it to work for the benefit of your business, your clients, customers, and patients.
Ultimately, we help dedicated entrepreneurs who have big dreams to make more money in record time and keep more of what they make, so they can continue to make a positive contribution to the world.
Brett is a cowboy from southwest Colorado who was living his dream. He did leather work. His main product was panniers, the ?suitcases? that fit on either side of a pack horse. Brett?s reputation for high quality work assured he was kept busy. He was serious about his work because he himself used his panniers. He grew up using inferior quality panniers that came apart after just a season or two in the high country and vowed he would create and deliver a product that would not let a ?packer? down.
I met Brett in the late 80s when he came to my office to discuss his business. His profit was so small he could not live on it.
Analysis indicated that Brett had to raise his prices. He immediately objected. His customers were working cowboys and hunting guides. They didn?t make a lot of money and Brett was afraid he would lose their business if he raised his prices. Brett was not conversant with his key business financial report, the Profit & Loss statement (P&L), and didn?t understand much of the financial case I was making. He just knew he couldn?t raise his prices.
I asked Brett to explain his product warranty. He proudly replied that he stood behind his work and his products and warranted his panniers for lifetime against any defects. I then asked him how he would make warranty repairs if he was no longer in business. He was quiet for a few moments. He then replied that he got it. He had to make an adequate profit if he was to remain in business to deliver on his warranty promise.
Brett had a dream. He had energy and drive to work hard. He was honest and delivered a high quality product. What Brett lacked was financial savvy. He didn?t understand that his financial statements were warning him that he was headed for financial difficulty. Because he didn?t understand the clues, he didn?t recognize that he was in trouble until he was about out of money. Brett is not alone. Most entrepreneurs are not financially literate. They don?t understand basic principles and best practices for business money management. It?s not their fault. This subject matter is poorly taught.
At businessmoneyinsights.com, we?re dedicated to providing practical business financial education in plain English. We?re a ?jargon-free zone? where high-level theory that can?t be implemented is not allowed.
We like theory only if you can apply it and get it to work for the benefit of your business, your clients, customers, and patients.
Ultimately, we help dedicated entrepreneurs who have big dreams to make more money in record time and keep more of what they make, so they can continue to make a positive contribution to the world.
Probably the financial terms least understood by entrepreneurs are Accrual accounting and Cash accounting. The difference is an important one, especially when you are trying to determine how your business is doing. Let?s define them.
Accrual accounting records a sale when it occurs regardless of when money is collected and records an expense when it is incurred regardless of when payment is made. Cash accounting, on the other hand, records sales when payment is received and records expenses when payment is made.
Why is this important? Your CPA will say the understanding is important for properly reporting and paying income taxes. Most small and medium size service firms report their taxable income using the Cash accounting method. You often hear the term ?Cash Basis Accounting? (CBA), which is another way to say Cash accounting.
CBA is simple to implement and maintain.
Your business advisor will say Accrual Basis Accounting (ABA) provides a more accurate picture of how your business is actually doing and this is so. Let?s look at a simplified example of how the two methods work.
Sally developed a marketing program for one of her clients. She completed the work in December and gave her client a bill for $25,000. The bill was paid the following January. Her related expenses of $12,500 were all paid in December.
CBA says Sally lost $12,500 in year 1 and made a profit of $25,000 in year 2. ABA says the income and expenses were all generated in year 1 with a resulting taxable profit of $12,500 for that year.
Which method of accounting accurately presents the results of Sally?s work for both years 1 and 2? ABA presents the income when earned and expense when incurred. Since both happened in year 1, the ABA profit of $12,500 accurately shows that she earned $12,500 for her consulting work.
CBA presents Sally?s taxable picture as though the project spanned two years. In year 1, she had a loss of $12,500 (when she paid her expenses) and a taxable profit of $25,000 in year 2 (when the client paid her bill). You may ask if it actually makes any difference from a tax viewpoint. Probably not. In this admittedly biased case study, Sally runs a risk of paying more tax than necessary. This can happen, but the difference in tax rates is usually small.
From a business perspective, CBA is not helpful for evaluating her operation since it shows income and expenses happening in unrelated years. ABA puts both in the year in which they belong and shows Sally that she did quite well on her project.
Now imagine a business with many items of income and expense each year ? your business. CBA makes it difficult to understand profitability from month to month, season to season, or year to year because income and related expenses are not matched. ABA makes it easier to analyze operations and determine how well you are really doing.
There is nothing wrong with using CBA for calculating taxes while using ABA for management purposes. Many businesses use both. This is an instance where two sets of books are not only legal but are also helpful. In fact, important financial analysis can only be performed using ABA. Service businesses can often use a less complex method of management accounting known as Hybrid Accrual. In this method, sales and expenses directly related to sales are reported above the gross profit line on an Accrual basis and general overhead expenses are reported on a Cash basis below the gross profit line in your P&L. You may well benefit from most of the ease of CBA while gaining the management information of ABA by using Hybrid Accrual accounting.
There is no difference between CBA and ABA if you receive payment when service is rendered and pay expenses promptly. In that case, CBA works quite well. The rest of us may benefit from understanding and using some ABA.
Talk to your accountant or business advisor about the methods that are best for calculating your taxes and for managing your business.