Do you manage by bank balances?
Today I address why that's bad and 4 alternative ways to measure your cash.
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4 WAYS TO MEASURE CASH IN YOUR BUSINESS
When speaking to business owners, what is the most recited metric?
First is almost always revenue. Then you’ll hear about employees, number of offices, names of big clients, and whatever sort of accolade they’re proud of.
All of these are great, even potentially exciting.
But do they really matter?
You know one that never comes up? Cash flow.
When I talk to business owners, I like to ask how often they look at their bank account. More than half the time that answer is daily.
Don’t get me wrong, cash balances are important. But managing a business off cash balances only works for so long.
If you think of your financial health as an iceberg, the bank balance is the tip above the water you see. What’s hiding beneath that tip are current profitability, pending liabilities, and the specifics behind all the numbers you’re seeing flowing through.
It can work for a little bit, but long term it’s a recipe for disaster.
Cash in the bank is a lagging measure, meaning it’s only a reflection of what has happened in the past. Cash movement today is a result of actions taken weeks, months, or even years in the past.
What typically happens is cash balances are good, giving you a level of comfort. But then one day they tick down. Then the next. Then the next again. You start to wonder… hmm, what’s happening?
When it keeps going, you not only should have acted weeks (or months) ago, but you don’t have the tools to take the action needed even if you could.
To stop this cycle of cash crunches and cash flow problems, you have to truly understand this cycle and how to make material changes to the “flows.”
So, how do we measure cash flow?
- Track your account balances in the trial balance
- Create a 13-week cash flow forecast
- Operating Cash Flow
- Free Cash Flow
Let’s break each of these down and which one matters most for your business.
TRACK YOUR ACCOUNT BALANCES IN THE TRIAL BALANCE
I’ll repeat again: tracking cash balances by looking at your bank account is wrong.
Even those who say they look daily, likely don’t have as good a grasp on their balances they think they do.
Instead of looking at your bank account, look at the trial balance in the accounting system.
The trial balance is a list of your accounts with their balances on that specific day.
What your trial balance takes into account that your checking account doesn’t are checks written but not cashed. Thus, it’s representing what your balance would be if everything outstanding hit the account today.
For example, say you have $1,000 in your bank account today (looking at your bank’s online portal). So you decide you can write that $1,500 check because you know you’re receiving some checks in the next few days. Well, your bank will still show $1,000. Now your coworker looks, sees that, and writes a check for $1,000 to a vendor they’ve been waiting to pay. Now you’re negative $1,500 instead of $500! Your deposit was only for $1,250, meaning you’re overdrawn by $250. O no!
But, if you look at your trial balance, as soon as you write the $1,500 check, it will reflect in the balance. Often, you can write checks out of an account and then use the trial balance to know what to transfer into that account to cover those checks if you’re short(just by looking at the balance).
My recommendation is that you use your trial balance and then look at it once a week. This allows you to create systems to assure all transactions are recorded, which assures you have an accurate balance.
Then, I’ll create reporting that shows me the weeks side-by-side so I can easily see the trends.
Over time you’ll learn what they mean and the horizon is long enough it means something, whereas a daily balance quickly becomes noise and overwhelming.
Software like NetSuite will allow you to track your trial balance and create reporting that automates the process.
Thanks NetSuite for sponsoring this issue.
NetSuite is the #1 Cloud ERP that gives you complete visibility and control over your business operations, including financials, inventory, HR, CRM and more. Over 37,000 organizations have turned to NetSuite to help grow their top and bottom lines.
Click here to learn what top CFOs complete every day to become more strategic and efficient.
Create a 13-week cash flow forecast
A 13-week cash flow model maps the ins and outs of cash today, as well as predicts what they’ll be over the next 13 weeks.
In businesses that are tight on cash, this is essential to make sure you’re not surprised by an expense or lack of deposits.
I won’t break this down here, as we’re long overdue to write about this (so it’s coming…), but instead, I’ll give you a Twitter thread where Michael Girdley shared his process for the 13-week cash flow.
I don’t recommend this for all businesses, as those who are extremely profitable with minimal cash swings might find it overkill for their situation.
Operating Cash Flow
Operating cash flow is the cash that was generated during a period of time from the operations of the business.
This can be represented on the Statement of Cash Flows. It takes into account:
- Non-cash transactions from the Income Statement
- Changes in Working Capital (AP & AR) on the Balance Sheet
The Income Statement will record sales before you receive the money, so this number helps you see what cash has actually entered the business.
Ultimately, cash drives your business forward. If you don’t generate operating cash flows, your business is having to generate cash from other places which is rarely sustainable.
Free Cash Flow
Free cash flow is Operating cash flow minus capital expenditures. If you’re in a capital-intensive business, Free Cash Flow confirms you’re generating enough cash to cover the capital reinvestment needed in the company.
A high FCF can be used to:
- pay off debt
- reinvest in the business
- as a dividend for the owners
This really gives you flexibility and consistently high FCF is the holy grail of running a company.
If you don’t have significant capital expenditures, you might not need to track this one.
SUMMARY
Making this shift from bank balance focus to cash flow focus won’t be easy.
It’s a really hard habit to break.
Some systems don’t try and break this habit and put complex systems into place to let you operate that way (hello Profit First, I’m talking to you). I think that’s the wrong approach.
We need retraining. Take away your own access to your bank account online. Allowing you to keep access would be like an alcoholic still going to the bars every night. You might resist it some, but you couldn’t resist it forever.
Good luck!
