Have you heard this saying “You can’t build your castle on quicksand and expect it not to sink”?
It’s so true when it comes to building a business.
You can’t build a business without cash. You need a solid cash flow foundation so that your business can survive when times are tough and thrive when times are great.
To build a solid cash flow foundation for your business, do the following:
(To make them easy to remember I have organized them as 7 Rs).
- Find the Root cause of the cash flow problem (ROOT)
- Take responsibility for your cash flow (RESPONSIBILITY)
- Learn to read the cash flow statement (READ)
- Adopt a routine that drives results (ROUTINE)
- Understand cash flow ratios (RATIO)
- Know your cash flow return on investment (ROI)
- Understand how financial statements are related to each other (RELATION)
Find the Root Cause of the Cash Flow Problem (Root)
What Do I Mean by the Root Cause of the Cash Flow Problem?
A person keeps on having high temperatures and takes paracetamol to bring the fever down.
After taking paracetamol, the fever comes back, and he doesn’t know why. He has body aches, is constantly sweating, and has a sore throat.
He thought he just needed to take paracetamol to fix the problem, and when it didn’t, the patient went to see the doctor. The doctor examined and found out the root cause of the fever was tonsillitis because of a cold virus throat infection.
When the patient took the medicine doctor prescribed for a throat infection, not only did he not have a fever, he also got rid of body ache, sore throat, and sweating.
In this case, cold virus tonsillitis was the cause of the problem. Not the fever, which is a surface-level problem.
Similarly, in business, you have to go deeper to find out the root causes of cash flow problems.
I remember a conversation with one of my clients, who sells luxury sofas. I told him £98k ad spent generating only £500k sales is the root cause of the problem, whereas not generating enough sales to have positive cash flow is the surface level problem. Going even more profound on that, he had been spending heavily on google ads, around 60% of marketing ads spend, which only brought in 50% of sales. In contrast, FB ads spent 25% of the total which contributed to 37% of the sales, and surprisingly the average order value of the sales from FB traffic was much higher.
Why Do You Need To Find Out the Root Cause of the Cash Flow Problem?
There’s a saying in retail. Retail is detail and evil is in detail.
If you want to find a diamond, you have to look deeper. Same in business, you have to dig deeper and find out the root cause of the cash flow problem.
If you don’t find out the root cause, then chances are you will never be able to solve your cash flow problems, just like a person who couldn’t get rid of a fever.
A Typical Cash Flow Mistake When Finding the Root Cause of the Cash Flow Problem.
Not Tracking Your Marketing Spend Properly
Marketing is one of the most significant expenditures for growth-oriented companies. Even then, we don’t take the time to understand which marketing channels are performing well for your business.
This is super important to know because you want to deploy your resources in places that give you good returns and use that to grow your business. Without it, you may be stuck where you are for a long time.
Take Responsibility for Your Cash Flow (Responsibility)
The word accountability comes from the word accounting. If you want to be rich, you need to be accountable for your cash flow. – Robert Kiyosaki.
He couldn’t have said anything better. Taking responsibility is being accountable for your actions.
If you are wondering, isn’t that the job of my accountant or a bookkeeper? You need to be crystal clear about your responsibility.
What Does Your Bookkeeper Do?
Your bookkeeper will allocate the money in and out of business. Your bookkeeper can also prepare the cash flow statement for you. You don’t have to prepare on your own.
Your bookkeeper can record transactions, but he can’t protect your cash flow.
You can outsource the task to prepare a cash flow report for you, but you cannot outsource the responsibility to manage cash flow because it’s your cash flow.
It’s your responsibility to become a financially savvy entrepreneur and be accountable for your cash flow.
What is your responsibility, then?
Your responsibility is to understand how the cash flows from your client into the business and your bank account and make cash flow decisions accordingly.
Cash flow Mistakes entrepreneurs make when It comes to taking responsibility for cash flow.
Mistake | Not Being Accountable for Your Cash Flow
It is usual to think you can sell more and build a successful business.
That’s part of the equation. But it does not guarantee cash will stay in business.
See, it’s not about getting rich. It’s about staying rich in the business.
To do that, you need to learn to manage your cash flow. It takes time and effort. The starting point is not leaving this responsibility to your accountant.
Most entrepreneurs leave managing finances to their accountants. Accountants are like mentors and not a coach. They can give you tried and tested strategies and tips to protect your cash flow, but that doesn’t mean the strategies are working right now. There’s a big difference between that.
Learn To Read the Cash Flow Statement (Read)
Your ability to read a cash flow statement can be the difference between a business that barely survives and one that thrives.
There’s a problem if you think I don’t know how to read a cash flow statement.
Have you gone to a foreign country and realized that you struggle to communicate because you don’t speak the local language, and it’s so frustrating?
Isn’t it the same when you don’t know how to read a cash flow statement? It suddenly starts to look like a foreign language because you don’t understand what it means.
The language of business is accounting- Warren Buffet
If you don’t know how to read the cash flow statement, then you will not be able to identify:
trends – What are the trends of cash inflow and cash outflow
irregular activities – Are there any irregular cash flow activities that you need to be aware of
patterns- Any specific patterns developing in your cash flow
Are there any spikes up or down, if so, why is that
So you want to be able to see and understand what’s going on with your cash flow, because if you don’t understand it then how can you expect to communicate to others and even to yourself what are you going to do next, in terms of your cash flow decisions. Because a confused person can never make a decision.
So, if you can’t read, then you can’t communicate. If you can’t communicate well, you can’t convince the bank for funding to fix the cash flow gap you may have right now. So, you want to show how much cash flow you have right now and how much you need to borrow, for how long, and when you can repay the bank or angel investor.
Adopt a Routine That Drives Results (Routine)
A cash flow statement is a mark sheet of your cash flow performance. so you need to have an updated cash flow statement regularly, i.e., monthly cash flow or weekly cash flow so that you can be on top of cash flow. how?
Routine drives results to set up a routine to regularly prepare and analyze cash flow statements to identify trends, irregular activities, and patterns spikes.
You don’t just prepare a cash flow statement once a year or when you have to submit it to the bank.
You set up a routine on a monthly or weekly monthly and quarterly basis to see the trends in cash inflow and outflow, irregular activities, patterns of some particular line items, and spikes so that you can understand why it happened with the commercial activity. This makes the process powerful. E.g., let’s say you did a one-off JV partnership to offer your product and some people bought it, and suddenly you saw a spike in cash inf flow. Maybe you made a bigger purchase in a particular period. That is why there is a spike in cash outflow.
The key is to analyze the cash flow information and relate it to the commercial activity.
Understand Cash Flow Ratios (Ratio)
Let’s learn more about cash flow ratios.
What Is a Cash Flow Ratio?
The cash flow ratio is a ratio that tells us if the cash flow your business is generating is enough to meet current liabilities.
How Is the Cash Flow Ratio Calculated?
Cash flow ratio formula = cash flow from operating activities/current liabilities.
Why Is the Cash Flow Ratio Important?
The cash flow ratio is important because it reveals the cash position in relation to the financial aspect of the business. The cash flow ratio is a more accurate measurement of the business’s liquidity.
What Is a Good Cash Flow Ratio?
A ratio greater than 1 indicates good financial health for a business, indicating that cash flow is more than sufficient to meet short-term financial obligations.
In other words, means that cash flow is greater than what the business needs to meet current liabilities.
A ratio less than 1 indicates short-term cash flow problems.
As an entrepreneur, you don’t need to go through ratios for academic purposes. You need the cash flow ratios that affect your business performance.
I am going to share with you FOUR crucial cash flow ratios you should be aware of:
- Cash flow to sales ratio
- Operating cash flow ratio
- Cash Conversion Cycle
- FREE cash flow ratios
Let’s go through them one by one.
Cash Flow to Sales Ratio
There is a massive difference between cash received from a client to sales made to that client.
Let me explain.
You sell your £6k package, which lasts for three months. So you have to deliver your service for three months.
Option 1
The client pays in full.
So in month 1, you have received full payment, but you have only earned 1/3 of the sales as you have delivered 1/3 of your services.
So your cash flow to sales ratio = 6000/6000 = 100%
Option 2
The client pays in 2 installments
So in month one cash flow to sales ratio= 3000/6000 = 50%
Option 3
The client pays in three equal installments
So in month one cash flow to sales ratio = 33%
Why is the cash-to-sales ratio essential and what’s its use?
The cash to sales ratio reveals cash-generating ability per sales volume. If the cash is tied up in debtors, the business can’t re-invest cash although the business has made a profit.
Operating Cash Flow Ratio
The operating cash flow ratio formula = cash flow from operating activities/current liabilities.
You can get cash flow from operating activities from the cash flow statement and current liabilities from the balance sheet.
The operating cash flow ratio shows whether the cash generated from operating activities can pay its current creditors.
Cash Conversion Cycle
The cash conversion cycle is the number of days from which sales are converted to cash.
If the sales invoice is dated 1 January 2021 and the payment is collected on 10th January 2021, the cash conversion cycle is ten days. The lesser the days, the better the cash conversion cycle
Free Cash Flow Ratio
The free cash flow ratio is an amount rather than a ratio.
Free cash flow formula= Cash generated from operating activities- capital expenditure- working capital needed.
Know Your Cash Flow Return on Investment (Roi)
Cash flow return on investment (CFROI) is a measurement of your cash flow investment in relation to marketing activities and a specific project or team. Etc. in terms of capital invested in the business.
This shows how a business finances its operations and how investors are paid.
This gives you an idea of what worked and what didn’t work so that you can double down on the things that worked for you.
Here’s the CFROI ratio formula
CFROI = Cash Flow Return on Investment
Understand how financial statements are related to each other (RELATION)
HOW ARE THE THREE FINANCIAL STATEMENTS LINKED?
Three financial statements – the income statement, the balance sheet, and the cash flow statement – are linked together. They usually act as guides to one another. Fitting together, they paint an overall picture of your business and its financial health.
The cash flow statement is vital to the other two because it will show increases and decreases in cash flow over an expressed period of time. The others will be the end-of-year statements, while the cash flow fills in the blanks between them. So, in a sense, the cash flow acts as the plot of your business year. It’s easy to see
where you ended up by looking at the other two, but how you got there is left up to the cash flow statement. This is how the statement of cash flows is connected to the balance sheet.
Looking at a cash flow statement in isolation does not tell you everything you need to know about your business and cash position. You need to be looking at the balance sheet and profit and loss statement simultaneously. Here’s the link if you want to go deep into this section.
SUMMARY
In this section, we looked at how you can build a solid cash flow foundation in your business. I always say the name of the game is to stay in the game until you win the game. You stay in the game of business to go further in your business by building a solid cash flow foundation.
