How to NEVER Run Out of Cash in Business

Over 80% of small businesses fail because of one thing: cash flow. Now, that may not surprise you, but what surprises me is that most business leaders who are operating these companies, they can't even compute cash flow. And if you can't compute it, you can't measure it. And if you can't measure it, you can't forecast it. And if you can't forecast it, you're not going to know whether you're about to run out of it. So today I'm going to walk you through what is cash flow and how to compute it, especially for those who have a non-financial background.

So I'm going to keep things very simple. So you don't have to look stupid next time you're presenting in front of your company, in front of investors, in front of the board, and they ask you about cash flow. I'm also going to show you how to avoid running out of cash flow. So let's go ahead and jump right in.

If we look at the income statement, the very top line is revenue. Revenue represents the amount of income that you generate from selling your products and services. I think you got this, right? Now underneath revenue, we have COGS. COGS is just short for cost of goods sold. It represents all the costs associated with producing your revenue. It may include items such as materials, direct labor, and other costs associated with putting in place the work or delivering the product or service into the hands of your customers.

All right. So we have revenue minus cost of goods sold, and we arrive at gross profit. Gross profit just represents how much profit you earn from pricing your products and services, selling them at a certain volume, and then incurring cost in order to deliver the product or service. So this is your gross profit. But we're not done yet. We also have to account for OpEx. OpEx is just short for operating expenses. It includes all the costs associated with running your business, also known as overhead. It may include general and administrative wages, sales and marketing, occupancy expenses like rent and utilities, office supplies, etc. — all the costs associated with running your company.

So if we take gross profit minus OpEx, we arrive here at EBITDA. Like I said, I'm keeping things very simple and very high level. Now you may know this term and you may be familiar with this, but EBITDA just represents earnings before interest, taxes, depreciation, and amortization. Now there are so many different ways to look at this. Like I said, I'm keeping things really simple and I'm trying to use terms that you're going to run across as a business leader operating a company. EBITDA is very common.

Now, oftentimes depreciation and amortization is recorded up here in cost of goods sold and in OpEx. It's spread between the two depending on how those assets relate to the business. That's a whole other conversation, but let's just keep things high level.

Now interest — the reason why I exclude interest is because we want to look at cash that's generated from normal operations of the business. And interest income and interest expense is an other income or other expense item that we're not going to account for in this video. Usually it's pretty immaterial and I just want to focus on free cash flow, which I'll get to, and how it then gives us a number to repay that debt and repay that interest.

So let's keep going. We have EBITDA, and we're just going to subtract out depreciation and amortization. This is the DA. So we'll just strike that out because depreciation and amortization is tax deductible. So think about it. You go out there and you buy a truck. The truck is 50,000 bucks, right? Now you can't just record the $50,000 as an expense in one year because the IRS and generally accepted accounting principles (GAAP) says, no, no, no, no, no — you have to recognize the depletion of the truck or the economic benefits of the truck over its useful life, over the period in which you're going to use it.

So instead you say, okay, this truck's going to last for five years and then it's going to be worth zero. So we'll depreciate it over that time period — five years. And that equals $10,000 per year in depreciation. The only difference between depreciation and amortization is that depreciation is for tangible assets. Amortization is for intangible assets like patents, customer lists, software that you develop, and other intangible things that you can't feel — that you can't touch.

So we have EBITDA minus depreciation and amortization. We arrive at EBIT. This just stands for earnings before interest and taxes because we got rid of the depreciation and amortization. We pay taxes — fortunately or unfortunately — and we arrive here at NOPAT. NOPAT is just a fancy way of saying net operating profit after taxes.

Like I mentioned before, we're looking at operating profit and now we're looking at operating profit after we pay taxes. There are some nuances here. If you're an LLC or you're an S corp, your company doesn't pay corporate taxes. Instead, taxes are paid by the individuals who own the company and that flows through the K1. But we want to account for those taxes here for the company because ultimately somebody has to pay for the taxes. So if the company doesn't pay the taxes and it doesn't show up on your financial statements, you have to make adjustments because if you don't account for this, you're tricking yourself.

You're looking at your financials and you're like, wow, we're making all this profit — but profit is not cash flow. So you have to account for these things and make adjustments. And that's why your CPA is typically not your CFO, right? Your bookkeeper is not your CFO. So you have to make adjustments to the numbers so you understand what's really going on.

All right, let's keep going. We have NOPAT. Now we're trying to get to cash flow and depreciation and amortization up here. This is not a true cash outflow because when we buy the truck, we have investments in capital expenditures — which I'll get into in just a minute. So we want to add this back because this is just for tax purposes and it's not a true cash outflow. So we have to add the non-cash item back to our number to get free cash flow.

Okay. So we add that back. Then we account for changes in CapEx. CapEx is when we invest in trucks, trailers, equipment, buildings, etc. — capital investments, capital expenditures in other words — to support the business. So these are the assets we invest in. So we account for these. So we subtract CapEx. And then we also have to account for working capital.

Working capital is just the difference between your current assets and your current liabilities. There are some nuances here when it comes to adjusting for things like excess cash and interest-bearing debt that may be in working capital, but let's just keep things simple. It's really the difference between your accounts receivable and your inventory and your accounts payable. There are other items in there, like I said, but those are the main things we're talking about here.

So we have working capital. And then if we take these three items and we net them against NOPAT — your net operating profit after tax — we arrive at cash flow. Sometimes you'll hear the word free cash flow, and all this represents is the amount of money that's left over to do three things:

1. Pay yourself. And you could do this through a distribution or a dividend in your company.

2. Pay off debt. So you could pay down debt with your free cash flow.

3. Reinvest.

That’s it. That’s the breakdown of cash. Now, maybe I lost you somewhere up here. And if that's the case, that's fine, because I'm going to make it even simpler for you.

If you just want the simple version, you'll just take your profit after taxes, you'll account for your capital expenditures (your CapEx), and your working capital, and then you'll arrive at cash flow. So if you want the simple explanation in your business, you can just say, look, it's profit after tax, less our capital expenditures and our working capital. And that gives us cash flow.

Now, I talked about how not to run out of cash flow in your business, and that's super important. The way you don't run out of cash flow is you pay attention to eight main levers.

Now the levers are these as follows. Number one, we have price. The price you set in your business or the price premiums you get on your product or service will ultimately dictate how much profit you earn, because price is typically the biggest lever in your company. I created a calculator at coltivar.com. If you go to our website, there's a four-lever profit calculator. You could put in two numbers for your business — it’s really simple — and it'll spit out how each of these levers that I'm about to show you are impacted in your business. And the numbers are specific to your company. So be sure to check that out. But you have price.

Number two, you have volume. This represents the number of units you're selling in your business. So if you set the right price and you have a sales team and your marketing’s working and you're doing the right amount of volume, guess what? These two things will give you revenue.

Then we have cost of goods sold. And this lever right here includes negotiating with your suppliers. So making sure you're paying the right price for your materials, for your inputs, managing your labor, investing in equipment — so your labor is efficient, they're productive, they're streamlined — eliminating all distractions, giving them technology, giving them production rates, giving them training, everything they need to feel supported and to maximize the labor efficiency in your business. And then other direct or indirect costs that are associated with producing revenue. Those are the two main things: materials and labor. And if you use subcontractors, you can lump that in there too.

Number four, we have OpEx. Remember, this just represents your overhead, your operating expenses. So you could pull this lever and make sure you're managing your overhead correctly so you don't incur all these costs unnecessarily and tank your profit and ultimately run out of cash.

So these things right here impact profit. But remember from over here, that's just one part of the equation. We also have CapEx and working capital. So let's keep going.

CapEx involves making smart investments when it comes to your business. Years ago, I was running a landscape company and I had an accountant. And the accountant would always tell me at the end of the year, if you want to pay less in taxes, then go out and buy a bunch of equipment at the end of the year. We'll rely on this thing called section 179, where you get to depreciate the entire asset in the given year, get the tax write-off in other words, and reduce the amount of taxable income. And I thought, that's great. So we'd go out there and we'd buy dump trucks and tractors and skidsters and all these things, and we'd depreciate them using this accelerated method. But then we're sitting on all this invested capital, right, in our business — which was a terrible idea.

So with CapEx, I always like investing in businesses that have low capital expenditures. So when you go out there and you invest in trucks, trailers, equipment, buildings, whatever it is to operate your business, you want to be very, very careful with this because you could over-invest, and that will tank your cash flow. And this doesn't show up on your income statement. CapEx is on your statement of cash flows.

The sixth lever is going to be your accounts receivable — making sure you collect from your customers in a timely fashion. When I was in business, this was the thing I was psycho about. So if customers paid late — let's just say they're one day late — they would get a phone call from us, from our team. "Hey Susie, just wanted to reach out, follow up on this invoice. It just went past due. Can I collect payment right now? Do you have a credit card where you could settle this?" And we were just relentless. Because if you're not relentless with your customers, they're going to know that they can get away with paying you late. And this right here — not managing this — is probably one of the biggest reasons why companies struggle with their cash flow. So you want to manage the amount of money your customers owe you.

The next thing is inventory. I can't tell you how many companies I go into and they have tons of inventory on their shelves or in the back office. That's real money sitting on the shelf or in the shop. And if you don't manage your inventory carefully, you're basically just taking cash out of your business, putting it on a shelf, and saying, "I'll get to you one day."

Same thing is true with construction companies. This could be tied to your over/under billings. And if you're not careful and you're not billing correctly, you can get yourself into a lot of trouble. Or with retention, right? Retention kind of ties into accounts receivable. So if you're doing construction work and you do a job and 10% of it is retained for 60 or 90 days, you have to float that cash.

So managing inventory is super critical. And then number eight is accounts payable. This represents the amount of money you owe your vendors. So you go buy supplies from them, and then they say, "Pay us in 30 days." That's accounts payable. It sits on your books as a liability. But some companies, even though they have 30 days to pay their vendors, they just want to pay them in 14 days. But if you're collecting your money from your customers in 30 days and you're paying your vendors in 14 days, guess what? That spread you have to finance with your cash flow.

So all of these things right here represent your working capital. And this is just your CapEx. So now we have all the ingredients that tie back to cash flow. And remember, cash flow does three things. It allows you to pay yourself through dividends and distributions, or pay your equity providers — other investors in your company. It allows you to pay down your debt. And then it allows you to reinvest in your business.

So now you understand cash flow. And you have a very simple equation here, or you have a more complex breakdown right here. But either way, you should feel empowered now to go out there and crush it in your next meeting where you're talking about financials.

And remember — profit is not the same thing as cash flow. Profitable companies can go bankrupt. It happens all the time because they run out of cash. So when you focus on cash, you will put yourself and your business in a wonderful position.

If you need help with any of this, if you ever want to talk strategy for your business, you can always hop on a 20-minute call by going to coltivar.com.

That's all I have for you. And until next time, take care of yourself. Cheers.