The Importance of Differentiating Profit And Cash

Managing Your Company’s Cash-flows

Cash Sufficiency Ratio Of A Company(PartA)

Cash Flow Efficiency Ratio Of A Company(PartB)

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In Part A, we have looked at Cash sufficiency Financial ratio, let’s look at another cash flow ratio namely CASH FLOW EFFICIENCY FINANCIAL RATIO:

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We have looked at the articles:Profit Versus Cash & Accounting on Cash Basis Versus Accrual basis.We should able to understand that the vein of an organization is its cash flow. We also have reviewed the Cash Flow Statement which is an integral part of the financial statements and a very critical report to see how the company’s monies being utilized.

Here,this article showed that we can derive useful ratios from the cash flow statement to assist us to evaluate the cash sufficiency of the entity.

When we say cash sufficiency of an entity, we basically mean the adequacy of the cash flows to meet the entity’s cash needs for long-term debt payments, dividends and acquisition of non-current assets.

This should not be confused with cash flow efficiency of the entity which is really the efficiency with which the entity generates cash from its revenues, profits and assets.

Let’s look at the ratios for Cash flow namely :

• CASH SUFFICIENCY RATIO(PARTA) and

• Cash flow Efficiency(PartB)

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Sometimes, due to unfamiliarity, some managers particularly those without any accounting knowledge might not truly understand what’s Profit and Cash. For them, profit and cash is alway synonymous. They associate highly profitable companies to be those who are highly liquid or have lot of cash in their coffers. In actual fact, failure to understand this simple principle will cause serious repercussion to the financial health of the company.

Let’s look at the following basic traits of Profit & Cash:

PROFIT:

• Is when the Income exceeds Expenses (Loss is when Income is lesser than Expenses). Therefore, profit is the residual amount that remains after expenses have been deducted from income.

• The profit shown in the Income Statement are based on the Accrual and Matching Concepts and not on cash basis. ( Refer to my article on matching and accrual concept )

whereas

CASH

• Cash is basically cash on hand and demand deposits. Cash equivalents include short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Append below the major differences between Profit And Cash:

PROFIT VERSUS CASH:-

• A company makes a profit when its Incomes exceed its Expenses.

• From the Income side, there are billings to customers that the company have not yet received cash for the goods or services rendered to these customers. In other words, the company is giving its customers credit. Only when the company receive the money from the customers, will that become cash in hand.

• Similarly from the Expenses side, the company can be owing to the suppliers. The terms with them can be ranging from 7 days to 60 days. So, we don’t need to pay cash to buy their goods or services.

• Don’t forget that there are some non-cash expenses items in the Income Statements like depreciation which is only an accounting method of allocating costs. (We have earlier used cash to pay for these fixed assets. It is only because of the matching concept that we need to allocate depreciation to the Income Statement.)

So what’s the fuss of differentiating between profit and cash? This is simply because :

• The Company can be profitable meaning that its has income exceeding its expenses but it might not be liquid or cash rich because as earlier explained, the monies owing by its customers has not be received;
• The Company still need money to pay all its expenses like the all-important staff/workers salaries and wages, rental, utilities and many others;
• Hence sometimes, profitable companies can go under because it is not able to stay liquid due to the overextension of credit to their customers

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Many times, whether as a junior or senior managers, top managements will harp on the need of good cashflows and the necessity to implement proper cash management. However, even before embarking on cash management we must firstly need to understand about cash operating cycle of a business and what factors that can contribute to more cash into your organization.

Below is an article which enable the reader to understand about cash flow and proposed many ideas for managers to improve their organization’s cash flow.

So let start with what is “cash operating cycle”:-

Cash operating cycle is a close loop cycle which encompasses the five stages of normal operating business cycle:

(a) The receipt of raw materials from suppliers;

(b) Conversion of the raw materials into work in progress and finally to finished products;

(c) Delivery of goods and billings to the customers/accounts receivable

(d) Collection from the accounts receivable and

(e) From the collections utilized to repay the accounts payable.

Cash Operating cycle is also known as the Operating Business Cycle or Cash Conversion Cycle (depicted in number of days) or Daily Working Capital.(in number of days)

In the Cash Operating Cycle, we have three (3) key components that we should focus upon:

• Inventories whether in the form of raw materials, work-in-progress or finished goods
• Accounts Receivables or trade debtors,
• Accounts payable or the trade creditors

Now, you would have got the idea that the way to improve cash flow is to improve the cash operating cycle or to shorten the gap of this cash operating cycle from the time we received the goods until the time we received money from our accounts receivables and to optimize the time period of payment to our accounts payable.

So what else can we do to improve our enterprise’s cash flows?

To facilitate easy reading, append below a checklist which might give a quick snapshot on how to improve cash flows whether in terms of quantum and/ timing:-

1. Marketing/Business:

Improving Pricing policy

With more innovative pricing, higher gross profit margin can be achieved and assuming constant cost hence when the money is collected , there is then a larger quantum of “liquid profits”

• Attempt to increase Sales VolumeAgain, the impact means a higher sales and assuming costs maintained. So, if cash are collected back, then there is a larger quantum of “liquid profits”
• Seek deposits or multiple stage payment.

2. Be Thrifty/Adopt a Good mindset on Cost Effectiveness:

• Reduce or manage effectively the business expenses. Look at Return on Investment and how individual expenditure can be spent more effectively to get the require results.

With this, cash outflow in terms of payment of goods or services can be smaller hence overall net cash flow can be saved/improved

3. Manage Your Cash Flow Spending For Capital Expenditure:

• Manage your cash outflow of capital expenditure by ensuring that the fixed assets are absolutely necessary before incurring it. For a business, there is a need to weigh profitability and cash flow in investment appraisal .Hence, payback basis might be one answer to improve cash flow.

• Defer projects that cannot achieve acceptable cash paybacks.
• Focus on short or quick payback though profitability level might not be the desirous level. Perhaps, balancing this cash flow with other projects that give higher yields might be more appropriate
• Defer unnecessary and unproductive capital expenditures

4. Get More lee-way/installments :

• Seek to extend/re-negotiate debt repayment periods & banking facilities.

• Apply for tax installments to the Authority for the payment of any income tax payable

5. Get More alternative sources of financing:

• Obtain other sources of financing like bank overdrafts, term loans, debentures, and longer credit terms from suppliers.

• Use factoring facility to convert your billings to customers into cash.

• Instead of using one lump sum to paid for fixed assets, go for leasing or hire purchase terms to alleviate cash flows problems

6. Do consider injecting additional Owners Equity:

• Strategically, when the business is expanding drastically and to prevent overtrading or under-capitalized ,it is critical that the shareholder need to put additional money in the form of paid up capital into the business instead of relying on external parties

7. Top Management Must Seriously Review Its Risk Appetite:

• A business cash flow can be improved if top management exercise less risk appetite and are more conservative/ prudent so that cash flow can be conserved within the business instead of aggressive investments into the projects.

8. Top Notch Planning for Cash flows:

• To improve the cash flow, it is important to review all cash flow projections whether cash inflow or outflows and the ability to PLAN, TIME or MATCH it accordingly. This might “help” to alleviate some challenges posed by cash flow deficit though this is a short term gap measure.

9. Watch Out For Effective Asset Management:

• Hive off or dispose off unwanted, surplus/idling fixed assets and investments
• Any non-core business assets to disposed off?
• Plan strategically by looking at innovative means of unlocking cash out of your fixed assets like Sale and Leaseback, creating Real Estate Investment Trust (REIT)
• Make your fixed assets investment turn faster. For example, convert it into warehousing facilities to lease out to others or sub-lease your office which has surplus space or share common facilities and leave balance for rental, etc

10. Be Innovative:

• Minimize your cash dividend payout by issuing script dividend or bonus issue

• Use barter to acquire goods and services

11. Managing Working Capital

General:

• Improve your Order to Cash cycle by simplification, standardization and automation leading to error free process flows to enable money to be collected without much disputes
• Use the 80/20 rule to manage current assets.

(a) Managing Inventories:

• Establish better planning and forecasting to reduce the lead time of inventories from suppliers.
• Convert raw materials into work-in progress to anticipate for sale to customers. This needs great efforts for both production,sales department and the customers.
• Sell off or return obsolete/excess inventory(even with a loss just to generate the cash flow)

(b) Managing Accounts Payables/Creditors/Suppliers:

• Encourage suppliers to keep stock for us ( just in time concept) or on a consignment basis
• If you are a big corporation, can you get your suppliers’ factories to be close to you to supply the JIT stock requirements?
• Review any cash term with our creditors, if need be to extend the credit terms by ensuring long term relationship and promise to pay timely
• Make prompt payments only when we need to enjoy discount from the creditors.

( c )Managing Accounts Receivable

• Improve systems for billing and collection.
• Review credit terms with our customers wherever possible
• Be more selective (if possible) when granting credit.
• Offer a well structure cash discounts scheme to enable faster collections from customers (add deterrent charges like late payment charges /fees if debtors have not settled on time)

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