Fortune 500, for the coming year, we could predict with amaz- ing accuracy their likely levels of cash flow. Although there are lots of other factors besides these seven, these are the drivers,and they are the drivers because imbedded
within them are the core issues and rela- tionships of the enterprise. As we focus on each of the drivers in their individual chapters, we will look specifically at what those issues are.
The cash drivers apply not just to large companies but to allorganizations, especially businesses, of virtually any size. In the small enterprise with a handful of employees and sales of up to a few million dollars, the draw that the
owners take may reasonably be considered an eighth cash dri- ver. That account can vary significantly and, in a sense, rep- resents a special subcategory of SG&A expense. We won’t be dealing with this element specifically, but keep it in mind if your situation makes it appropriate.
Some specialized industries may also have their own key measures that can effectively be used as cash drivers—for example, percentage of seats sold (load factor) for an airline, or percentage of homes penetrated on a line for a cable-TV operator. For most of us most of the time, however, the basic seven cash drivers are the appropriate tools. Let’s take a mini case study to illustrate some of the areas in which cash-driver language can make business smoother and simpler.
and development of production equipment, while you and your sales staff negotiated a deal with CyberFun, the world’s leading maker of computer games. CyberFun plans to use your memory membranes in its newest line of hand-held toys, to be launched in time for next Christmas. Three months ago, you began shipping your product, in small batches at first, then in pro- gressively larger shipments as your manufacturing yield and product qual- ity improved. There were a few set- backs, of course, and some of the early batches failed to meet the procurement contract specs, but last month’s ship- ment was near-perfect. You can expect a big check from CyberFun by the first of next month. You’ll finish Year One with a solid $10 million in sales. It’s a huge success story! Or is it?
The problem is that every cent of your $10 million in sales is tied up in a single account receivable from CyberFun.
Meanwhile, you’ve spent all your original $5million (your lot- tery winnings, remember?) plus $2 million more that you bor- rowed from your neighborhood banker, Debby at First InterGalactic BanCorp. The first loan repayment is due tomor- row, and you’ll have barely enough cash left to meet Friday’s payroll.But your balance sheet and income statement look great! What happened?
Your balance sheet and income statement reflect a flow of
$10 million in product value to CyberFun. The balance sheet shows a $10 million flow of value to you in the form of an account receivable from a first-class, blue-chip company. The income statement calls that $10 million sales, though not a penny has actually changed hands, and shows actual expenses of only $5 million and a $2 million after-tax profit. Yet despite all of that accounting profit, you are out of cash because of the big investments made for carrying receivables and inventory, plus building a state-of-the-art manufacturing facility.
Accrual accounting systems, you will recall, track the flow of value, and they do that very well. But except in the simplest
The seven cash drivers can help you think about what drives cash and focus your attention on the critical issues.
They provide an
essential paradigm
not only for business
survival, but for
strategy and success.
cash businesses, there are inevitably significant differences between the cash flow and the value flow. The seven cash dri- vers can help you think about what drives cash and focus your attention on the critical issues. They provide an essential par- adigm not only for business survival but also for strategy and success. Understanding that paradigm will enable you to con- tribute more fully to the success of your organization, regard- less of your job. Each of the cash drivers is crucial. If you understand what they mean and how to manage them, you will have taken a big step toward ensuring the long-term health of your company. Let’s look at a heavily disguised, yet real, company where cash-flow thinking was added on rather than built-in.
The Jones Dynamite Co. is a medium-size wholesaler of explosives in the Southeast. In the early ’90s, there was considerable sales growth because of a successful strategy of renting specialized explosives-related equipment bundled together with the explosives themselves. At the same time, how- ever, a lack of tight controls permitted Jones’s overhead expenses to drift upward somewhat faster than sales, thus increasing SG&A expense as a percentage of sales.
But that’s not all. While it was concentrating on expanding market share, the company did not pay enough attention to customer credit and collection issues. This allowed dollars that were tied up in accounts receiv- able to increase even faster than sales grew. From 1991 to 1994, Jones went from holding an average of approximately 35 days’ worth of sales in accounts receivable to nearly 50 days. Thus Jones not only had to finance the additional investment in accounts receivable that inevitably comes with rapid sales growth; it also had to finance the excess accounts receivable associated with not paying close enough attention to collection and credit practices. This combination of circumstances used quite a bit of cash over and above what was needed to develop the specialized-equipment rental side of the company’s business and to hold larger explosives inventory.
Because of the magnitude of these cumulative cash drains, Jones could Recovering But Still Not a Team
A C A S E S T U D Y
easily have become another of the many basically sound companies that fail at the rate of more than one every hour, with no time-out for weekends or holidays. If Jones had failed and filed for bankruptcy, it would not be because the company ran out of energy, good marketing ideas or a broad customer base.
Surprising as it may seem, chances are that most business bankrupt- cies could be headed off without radical surgery if enough cash was avail- able to keep going just a few months longer—just enough time to solve the new-product bugs, or to absorb the loss of a major client, or to sublet half of that big warehouse, or any number of other problem- solution combinations.
The good news is that with the help of their banker and lawyer, the two brothers who own Jones under- stood that the organization had gotten too big and too complex for their longtime bookkeeper. She had almost no formal training and had come to the com- pany right out of high school as its first full-time office worker. That was ten years after the two owners’ father had founded the company on a shoestring following the Korean War. Jones had long ago passed the stage where it should have hired a controller. Many CPAs agree that when a company passes a half-million dollars in sales, a hundred cus- tomers and dozens of suppliers, as Jones did in the mid ’80s, it should hire a chief accounting officer. And especially in view of the ambitious growth rate in sales that Jones targeted, professional cash-flow planning was a management necessity.
Jones may sound like an extreme example, but it followed an amazingly common pattern. Ignorance of cash-flow dynamics kills more companies than fraud, fire, competition, technological obsolescence or anything else.
There are few circumstances that can’t be handled and recovered from if key executives and managers have internalized a cash-flow mindset and integrated it into their management style. At Jones, an experienced and professionally trained controller was finally brought in with excellent sup- port from the bookkeeper. Some major improvements were made and some financial discipline was imposed. Much of this discipline was a nat- ural byproduct of the controller’s focus on the development and imple- mentation of accounting systems and controls. Another dimension of the job that quite naturally helped was a new emphasis on financial reporting with a view toward identifying implications for the future.