Cash is King

The phrase “Cash is King” is often used to emphasize the importance of having money in the bank. But is this really the case? Holding a lot of cash can sometimes indicate poor entrepreneurship. After all, cash does not generate a return, especially not with the current negative interest rates. However, cash is particularly king during tough times.

Warren Buffett, the world’s most famous investor, had as of the end of March 2021, 137 billion US dollars in cash (in the form of treasury bonds) in his fund. He commented, “We really want to be prepared for anything. We never want to be dependent, not only on the kindness of strangers, but the kindness of friends.” […] “Those treasury bills are paying us virtually nothing. They’re a terrible investment over time, but they are the one thing that when opportunity arises, [we can use] to pay for those opportunities. The rest of the world may have stopped.”

Thus, cash is important as a reserve during crises, when it is difficult to obtain, and to quickly capitalize on promising investment opportunities.

“Cash is King” also refers to the importance of having enough cash (liquidity) to run your business. You need cash to meet your obligations on time. This can be challenging during the off-season or in May when holiday pay is distributed. Insight into your cash flow is important in this regard.

Meaning of Cash Flow

Cash flow is simply the difference between incoming and outgoing money streams. If cash is important, then understanding cash flow is just as important.

Banks that provide loans are interested in a company’s cash flow rather than its profit. The borrower must be able to pay the interest and repay the loan, which is only possible if the cash flow is positive. Cash flow is different from profit. Profit is the difference between income and expenses. Since accounting rules can influence income and expenses, another well-known saying is: “Profit is an Opinion, Cash is a Fact”.

Calculating Cash Flow

To determine if you have enough money in the future, you can create a cash flow forecast. The formula is: beginning bank balance of the period + incoming money streams of the period – outgoing money streams of the period = ending bank balance of the period.

Creating such a forecast is often more complicated than it seems: Revenue is an incoming money stream, but only when the customer actually pays. VAT paid by the customer must also be paid to the tax authorities. Expenses are outgoing money streams, but only when you pay the bill. However, there are also receipts and payments outside of normal operations, such as loan repayments. Additionally, these are future streams, which must be estimated.

Therefore, a good forecast is needed. Knowledge of the business and financial expertise are both necessary to create a cash flow forecast that can be used for decision-making.

Decisions

A cash flow forecast is used to make (investment) decisions. For example: Can I buy an extra machine? Are there payments that I need to postpone to maintain a positive bank balance? However, practice shows that a cash flow forecast often does not materialize as expected. This can be due to the model, but also because things simply turn out differently than estimated. For example, a customer with unforeseen cash problems who pays a month late. Conservative budgeting is wise, but don’t forget to compare actual income and expenses with the forecast. This leads to a better model. Understanding that the cash flow forecast is an estimate and having an understanding of the various outcomes (scenarios) is essential to base decisions on the forecast.

Tools

A cash flow forecast needs to be updated regularly, as reality overtakes the prognosis. Therefore, it’s not enough to do this exercise just once.

There are various automated tools to create a cash flow forecast. A smaller company can often manage with a well-set-up spreadsheet.

Improving Cash Flow

Understanding your cash flow helps improve it. There are various ways to improve a negative cash flow, such as:

Outgoing Money Stream:

• Extending payment terms with creditors (within legal limits)
• Paying less/no dividends/profits
• Renegotiating agreements with creditors
• Increasing inventory turnover: tying up less cash in inventory

Incoming Money Stream:

• Adjusting the billing schedule for sales: asking for an upfront payment or bringing forward payment terms
• Credit limitation: an additional charge on the invoice to your customer, which is waived if they pay on time
• Factoring: selling your receivables, so you get the cash immediately
• Accounts receivable management: quickly following up with customers who pay late
• Shortening payment terms for customers

It’s important to involve the whole organization, as many departments can contribute. For example, Sales can negotiate a favorable billing schedule. Purchasing can negotiate longer payment terms, or manage smaller inventory levels. The improvements are not just about timing: the freed-up cash can be used for other activities. With positive cash flow, you can also consider paying your suppliers faster in exchange for a discount, which again yields additional return.

Cash Flow Statement

For clarification: a cash flow forecast is different from a cash flow statement.

A cash flow statement (statement of cash flows) is, alongside the balance sheet and the profit and loss statement, the third important financial statement in the annual report. It explains the increase or decrease in cash position over a certain period, usually a year.

This statement looks back in time and therefore does not provide an estimate of the future.

Cash flow is sometimes defined as profit plus depreciation. This can be derived from an annual report and is used in financial analyses. However, if cash insight is the goal, then this definition is not relevant.

Summary

Cash flow is the difference between incoming and outgoing money streams. Understanding cash flow is essential. It takes some knowledge and time to set up and maintain a good cash flow forecast. But then you are able to make better (investment) decisions.