Cleinman Performance Partners Weekly Message

Understanding Cash Flow – November 30, 2023

This week, a short lesson on cash flow.

Harold Geneen, the great CEO of the conglomerate ITT Corporation, once said, “the only unforgivable sin in business is to run out of cash.” Truer words were never said. But with the past decade’s ready access to credit at low rates, I have a fear that many are experiencing a cash flow squeeze, the result of two forces at work.

“Al, I’m very profitable but I don’t ever have any cash” is a comment that I hear more often than I’d like. It is surprising how many professionals fail to understand the difference between cashflow and profit. It is entirely possible to have large profits but no cash…as it is to have cash but register a loss. This is simply because items like principal payments on debt do not show up on your profit and loss statement. They’re not an expense but a balance sheet item.

Let’s suppose that you bought a practice in 2018 and borrowed $250,000 to do the deal. You took out a 15-year loan at 4.5% interest. Your payment in your first year was about $23,000, of which about $11,250 was deductible interest. However, the $11,750 you paid out in principle isn’t recorded on your P&L Those funds are a reduction in cash and your liabilities…such outflows are a balance sheet time. Thus, to have positive cash flow, you must first have profit more than the principal payments on debt and other similar items.

Now let’s roll that clock forward to today. You’re five years into the loan, which had a five-year repricing as part of its terms. The loan that started out at 4.5% is now 7.5%. That loan was costing you $23,000 but now costs $28,000, of which a bigger percentage is principle. Principal payments increase as your loan amortizes, so each year of the loan you need to make more money to have the cash necessary to fund the principal payment.

Many of you took out large loans in the past five years when credit was readily available at historically low interest rates. Unfortunately, many of those loans had variable interest rates and are now repricing upward…substantially. And this cash squeeze is being exacerbated by large jumps in inflation. Indeed, between 2018 and 2022, cumulative inflation has reduced the purchasing power of your $1.00 by 18%! In other words, the $1.00 you had in 2018 is now worth only 82 cents!

My point? If you’re not managing your balance sheet along with your P&L, you could soon find yourself in a cash flow squeeze.

Your balance sheet records and manages Assets, Liabilities and Net Worth. Awareness of how your assets are deployed, and the understanding of certain ratios, is key to building wealth and having financial peace-of-mind. Let’s talk about these balance sheet ratios of which you should become very familiar.

The first is Working capital. It’s the difference between current assets…that’s cash, investments, inventory, accounts receivable…and current liabilities like payables, accrued time off, taxes due and this year’s interest and principal payments. While Working Capital is typically depicted as a dollar amount, we can translate that into what’s called the Quick Ratio to help determine your business’ health. The quick ratio is current assets divided by current liabilities. It’s an indicator of a practice’s short-term liquidity and measures your ability to meet your short-term obligations. A good Quick Ratio is 1 to 1 or higher…in other words, your current assets equal current liabilities…but you don’t want it too high. If yours is 2.0 to 1 or higher, in other words, twice as much in current assets as current liabilities, you may not be deploying your assets effectively.

Another very important balance sheet ratio is Days Receivable Outstanding. Let’s say you generate $800,000 in annual revenue. You divide that number by the number of business days in the year, let’s use 250. In this case, the result is $3200…the average amount of your daily collections. Now take your accounts receivable…let’s say it’s $100,000 and divide by your daily collections amount. The result of this calculation, $100,000 divided by $3200, is 31.25. That’s the number of workdays that you’d need to collect your accounts receivable based on your average daily collections. In our industry, a good Days Receivable Outstanding is 25 or lower. Thus, in this case, the practice has an excess of 6 days receivable outstanding. Your DRO is too high…by about $20,000. Collect that cash and put it to work.

Another important Key Performance Indicator that’s tied to your balance sheet is inventory turnover. Let’s say you sell 2000 frames a year. If you want the desirable inventory turnover of 4 times or higher, you should have only 500 frames in inventory. This can be measured in dollars as well. If your inventory is $100,000 and you sell $300,000 in frames annually, your turnover rate is only 3 times. That means that, in this case, $25,000 worth of inventory assets are not being effectively deployed. Remember that there’s a carrying cost to inventory. That $100,000 in inventory doesn’t appreciate as money would in a bank. You can reasonably figure that the value of inventory depreciates by about 5% per year because were it cash, you could earn that amount by investing elsewhere.

In our work, we often discover that a client simply doesn’t manage their balance sheet…both business and personal…very well. It pains us to come across clients who struggle to build wealth. Indeed, most doctors are the working rich. They have income but not liquidity. This is because doctors start their careers later, and often have large student debt. But it’s also because many doctors live above their means. It pains me that we often encounter optometrists who must work well into their 60s because they haven’t been prudent with investing their income.

Managing cash flow is mission-critical to building wealth. If you’re not currently saving at least 15% of your income, we should talk. Odds are that you have unproductive assets that can be better deployed. Give us a shout for a no-obligation chat.

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