Most managers think a lot about cash flow. We forecast it, worry about it, discuss it with bankers, and constantly search for ways to improve it. The reason we do these things is that growing businesses need cash -- for next week's payroll, for overdue bills, for C.O.D.s, for the Internal Revenue Service, for loan payments.
There are, however, significant differences between cash and cash flow. One of these differences is that we all know what cash is, but people seem unable to agree about cash flow. Let me give you some examples.
Writing in The Wall Street Journal in 1983, David B. Hilder reported on the disputes about cash flow between industry analysts and Charter Co., an oil-refining and insurance concern. The experts said that Charter had a negative cash flow of at least $10 million -- and possibly as much as $70 million -- in the first nine months of that year. But Charter insisted that its cash flow was positive. To stress the importance of the dispute, the story quoted a professor who said that cash flow is "a vital measure that would give you a clue as to whether this company is going to continue to function." Charter's senior vice-president for finance, on the other hand, contended that cash flow is a "nebulous term."
Writing in Forbes in February, Tatiana Pouschine discussed a similar problem with defining cash flow. Last year, she wrote, the annual report for Lowe's Cos., a building-materials retailer, reported that 1985 cash flow amounted to $2.31 per share, as compared with $2.20 the year before. "An investor looking at these numbers might have assumed Lowe's had plenty of cash left over for dividends and other purposes," Pouschine continued. "Not necessarily so . . . Lowe's ended the year with hardly more cash than it started the year, and its long-term debt almost doubled from 1984 to 1985 -- despite the positive cash flow."
What's going on here? These people are presumably intelligent, well educated, and experienced in business analysis. They all agree that positive cash flow is vital to a company. But they can't agree on what cash flow actually is. If they don't know, how are you supposed to know what you're doing when you try to calculate and manage your own flow?
My advice is this: don't get bogged down in these conflicting interpretations. Your concern is cash, not cash flow. You can't spend cash flow. In fact, no single measure of cash flow has any meaning; it doesn't exist. (Neither does "cash flow per share," for that matter -- it's number with all the precision and significance of, say, "moderately happy customers per share.")
Now I realize that most bankers and accountants have a standard definition for cash flow. The last time I applied for a business loan, for example, the cash-flow calculation was about halfway down the application form: profits plus depreciation plus other noncash charges equals cash flow. The calculation on this form looked very official -- typeset and all. And maybe it was useful to the bank. But it was worth zilch to me as a manager.
Granted, with everything else being equal, you'll tend to have more cash if accounting profits are high then if they're low. And, at least for a while, you'll tend to have more cash if many of your expenses are for noncash items, such as depreciation. But these accounting numbers only partially help to explain the amount of cash you have available each day to meet your financial obligations. And they're not much help at all if you want to figure out where you should do some fine-tuning to cut down on your cash outflow.
To understand what's really happening with your cash, you should forget about a single cash-flow number. Instead, think about the various reasons that cash flows in and out of your business. Most people agree there are three general categories: cash flow from operations, from investments, and from financing.
Cash flow from financing is pretty straightforward. It details all your cash transactions involving equity and interest-bearing debt. Your net cash provided by financing activities will be the proceeds from any loans, less loan payments, and the proceeds from issuing common stock, less dividends paid. And that's it.
In most private companies, cash flow from investments deals primarily with the purchase and sale of fixed assets. As such, it is a category that generally uses cash, rather than supplies it. At times, however, this category can provide cash. A couple of years ago, for example, I was working with a manufacturer of lawn and garden supplies. Since freight was a significant cost for us, we had started to subcontract manufacturing near our major markets. When a recession hit our industry, we decided to sell our manufacturing plant and simply hire more subcontractors to take over the production. The net effect was that we raised the cash we needed and were still able to satisfy our customers. That's not the first time I've generated desperately needed cash by liquidating underused assets.
Cash flow from operations -- the third category -- is what most people are talking about when they look at cash flow. It's the most difficult of the three categories to get a handle on, though in theory it's simple enough. You want to measure the cash coming in from customers against payments going out. One reason for the conflicts that arise over this number is that outside analysts must back into the calculation because they don't have access to detailed company records and must rely instead on income statements and balance sheets. They begin with operating profits, add such noncash expenses as depreciation and amortization, then adjust for changes in the balances of the assets and liabilities associated with company operations.
The problem is, you too may lack the information you need to report cash flows from operations the way you'd want to. Ideally, you'd get net cash from operating activities by taking the cash received from customer's and deducting from its cash paid for merchandise, administrative and selling expenses, and income taxes. (Since in many ways, the payment of income taxes is a separate issue from day-to-day operations, I occasionally show income taxes as a fourth major category.) This allows you to analyze where your cash is going and to plug leaks if need be.
But if your accounting system is like most, it probably doesn't detail the amount of cash spent each month for inventory, for example, or for individual operating expenses. Instead, your system merely reports the cash you spent on accounts payable. That will give you a total cash figure, but not in the detail that will be useful to you in managing your operating cash flow.
Still, there is hope for the future. Since the accounting profession has begun to place more emphasis on cash-flow reporting, the chances are good that in the next few years accounting software will become available that will report actual operating cash flows. Until then, you too may be stuck with backing into the numbers.
Even if that is the case, there are a number of ways you might want to modify your cash-flow reports. I sometimes calculate a subtotal of cash flows from operations and investments, often called the free cash flow. Free cash flow is the amount of cash that is available to pay lenders and owners their due. Of course, most businesses, when they're growing quickly, will experience negative free cash flows. Keeping this subtotal in front of you, however, emphasizes that for long-term viability a business must be able to generate positive free cash flows.
If you are lucky enough to have a business with excess cash, you probably have a portfolio of marketable securities, which is the equivalent of cash. If so, your statement of cash flow probably would be clearer if you made this a category in its own right, separate from the investments category.
To people who, up until now, always thought cash flow meant net income plus depreciation, these methods of reporting cash flow may come as a shock. But they will help you get a better understanding of where your cash went, why it went there, and what you can do to improve those flows in the future.
When I worked with the manufacturer of lawn and garden supplies, for instance, by categorizing the sources of cash by operations, financing, and investment, we clearly understood how selling the plant affected cash flow. In the operations section, we had recorded that by eliminating an underused plant, we had reduced operating expenses and had thus saved cash. The investment category showed the cash we had generated by selling the plant. And, according to the finance section, we'd also reduced debt by paying off some of the liabilities.
By categorizing the cash flow this way, it demonstrated in a lot more detail where our cash came from. And, perhaps most important, we couldn't deceive ourselves that any more came from operations than actually showed up in the operations section.