The Finance Gem 2023💎 Week #5

Welcome to this week's edition of The Finance Gem 💎 where I bring you my unabbreviated Linkedin posts you loved - so you can save them, and those posts you missed - so you can enjoy them.

This newsletter edition was sponsored by Financiario - The Financing Advisory Firm for Growing Businesses. Financiario helps growing companies to strategically plan, negotiate, and manage their financing requirements. Their unique expertise in banking, finance and accounting complements the capacity of Controllers, VP Finance and CFOs. They provide strategic financial models and financing memorandums that close financing deals while positioning for long term profitability, solvency and liquidity. Check out some case studies on their Blog.

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This week's highlights at a glance:

• Do you know the 5 Steps to Manage your Cash Flow?  

• Cash Flow Management is Not Just for Cash Flow.  

• The 5 Types of Cash Flow and How to Use Them.

• Free Cash Flow isn’t Free.

• EBITDA is Not Cash Flow.

• 16 Cash Flow KPIs You Should Know

• Do you know the 3 Main Cash Flow Drivers?

Without further ado, let's begin:

Do you know the 5 Steps to Manage your Cash Flow?

In Finance:

🎯Your Cash in always King.

🎯Your Resources are always constrained.

🎯Your Objective is to invest available cash and maximize Value. So here is how to manage cash flow for value maximization:

1️⃣ Understand your operating cash inflows and outflows

2️⃣ Calculate the Cash Conversion Cycle (CCC)

3️⃣ Optimize each of the 3 components of the CCC

4️⃣ Finance the CCC using the most appropriate source of capital

5️⃣ Monitor and Repeat

The Cash Conversion Cycle measures how long a company’s cash is tied up in net working capital.

Here’s the formula to calculate the Cash Conversion Cycle (CCC):

➕the average number of days required to sell inventory (days inventory outstanding or DIO)

➕the average number of days to receive cash from credit sales (days sales outstanding or DSO) ➖the average number of days suppliers wait for your cash payment (days payable outstanding or DPO)

And here’s the CCC formula broken down into its sub-components:

➕Average Inventory Balance / Purchases (or COGS as a proxy) x 365

➕Average Receivables Balance / Credit Sales x 365

➖Average Payables Balance / Purchases (or COGS as a proxy) x 365

🎯 The tricky part about the CCC is optimizing it:

⚫ you want to minimize the DIO but avoid stock outs

⚫ you want to minimize the DSO but avoid turning away customers

⚫ you want to maximize the DPO but avoid damaging supplier relationships

🎯 Once you’ve calculated your Cash Conversion Cycle and you have optimized its components, it’s time to focus on Financing.

🎯 Your Cash Conversion Cycle can be financed with internal resources only as long as there aren’t any other competing uses with higher ROI for that capital.

🎯 If there are (which is often the case), the financing of the net inventory and accounts receivable balances during their conversion periods usually needs external capital.

🎯 Cash Flow management should be part of your corporate culture, so once your financing plan is in place, proceed to monitor and repeat.

Cash Flow Management is Not Just for Cash Flow.

⚫You don’t just manage Cash Flow for the sake of your bank account.

⚫You manage Cash Flow for several other business strategic reasons as well.

✅Here are 15 reasons to make Cash Flow Management your No. #1 Business Priority:

1// Improve profitability

🎯Benefit from supplier discounts and reduce your late payment charges.

🎯Reduce your collections management and inventory holding costs.

2// Enable growth

🎯Fund your sales growth, product development and expansion into new markets.

🎯Reduce your purchasing and logistics costs.

3// Finance capital projects

🎯Improve your access to capital for timely funding of maintenance and growth CAPEX.

🎯Leverage valuable investment opportunities as they arise.

4// Build operational resilience

🎯Improve your stability in times of economic uncertainty.

🎯Reduce your risk of insolvency during periods of downturn.

5// Improve operational efficiency

🎯Improve your resource allocation to reduce inefficiencies.

🎯Invest in technology and systems to reduce your process waste.

6// Meet financing obligations

🎯Ensure timely payment of your debt obligations.

🎯Take advantage of repayment flexibility to reduce your cost for borrowed capital.

7// Avoid covenant breaches

🎯Improve cash flow planning to ensure you meet covenant obligations.

🎯Increase financial flexibility to ensure coverage of all your business payment obligations.

8// Improve financing negotiations

🎯Reduce your business risk to lower your cost of external capital.

🎯Reduce your urgency to improve your negotiated terms and conditions.

9// Reduce reliance on outside capital

🎯Use more internal resources to reduce your weighted average cost of capital.

🎯Improve your flexibility by reducing reporting and compliance costs for external capital.

10// Reduce cost of capital

🎯Reduce your dependency on expensive externally sourced capital.

🎯Reduce increased business risk and dilution which would increase your cost of capital.

11// Increase business competitiveness

🎯Invest in technology advancements that improve your market positioning.

🎯Take advantage of first to market opportunities to leapfrog your competition.

12// Increase employee attraction and retention

🎯Attract the best talent through competitive packages and workforce development.

🎯Avoid employee attrition by providing workplace stability and security.

13// Maximize workforce productivity

🎯Improve your proactive planning and resource availability for workforce growth.

🎯Avoid burnout and improve your employee engagement scores.

14// Increase shareholder value

🎯Improve capital allocation to increase your shareholders overall return on investment.

🎯Invest in growth opportunities, repurchase shares, pay dividends, and reduce debt.

15// Maximize business valuation

🎯Increase your valuation from increased profitability and reduced business risk.

🎯Reduce your working capital adjustments and maximize proceeds with better cash flow predictability.

Do you Know the 5 Types of Cash Flow?

They are highly confused, often misunderstood and mostly underutilized.

Here’s what they are and how to use them:

1️⃣ Operating cash flow

⚫ Represents the net cash generated by your company's core operations

⚫ Calculated by adjusting Net Income for non-cash items & changes in net working capital assets.

⚫ Used to assess:

>>your company's financial health

>>your company's ability to meet its financial obligations

>>if your company is generating sufficient cash to fund ongoing business operations

>>trends in how the business generates cash

2️⃣ Investing cash flow

⚫ Represents the net cash generated by your company's investments in long-term assets such as property, plant and equipment (PPE).

⚫ Calculated by totaling the net investments in PPE over the period (purchases less sales of PPE)

⚫ Used to assess:

>>your company's investment decisions

>>your company's ability to generate returns from its investments

3️⃣ Financing cash flow

⚫ Represents the cash generated by your company's net debt and/or equity activity.

⚫ Calculated by totaling net debt and equity proceeds over the period.

⚫ Used to assess:

>>your company's ability to raise capital

>>your company's financing choices and risk profile

4️⃣ Free Cash Flow to Firm (FCFF or Unlevered Cash Flow)

⚫ Represents the cash remaining in your business after accounting for cash outflows that support operations (operating expenses + working capital) and cash outflows that maintain the capital asset base (capital expenditures).

⚫ Calculated by adjusting Operating Cash Flow for after tax interest expense and investments in capital assets

⚫ Used to assess:

>>your company's financial strength and ability to generate sufficient cash for growth and reinvestment

>>your company's value based on the discounted cash flow (DCF) valuation methods.

5️⃣ Free Cash Flow to Equity (FCFE or Levered Cash Flow)

⚫ Represents the cash remaining in your business after accounting for all business expenses, investments in working capital assets, investments in fixed assets, and also all debt obligations.

⚫ Calculated by adjusting Operating Cash Flow for after tax interest expense, investments in capital assets and net debt payments.

⚫ Used to assess:

>>your company's ability to generate cash for distributions to shareholders holders

🎯FCFE is the true residual cash flow available to your company in any given period, and truly “Free” to be used for investments, dividend payments, returns of capital, additional debt repayments, or acquisitions.

Click below to download the infographic.

Despite its misleading name, Free Cash Flow isn’t freely available to your company.

🎯But first, what is Free Cash Flow?

𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 (𝗙𝗖𝗙) = Operating Cash Flow +/- Changes in Fixed Assets

🎯What does it mean?

Cash generated by your company’s core operations and after paying for capital expenditures.

🎯What’s with the name?

The name “Free Cash Flow” comes from the fact FCF is presumably free of obligations and available for:

>>discretionary spending or investing by management

>>distribution to shareholders

🎯Is it really free?

No.

Free Cash Flow only paid for Interest expense on debt, not Principal which means:

>>your company hasn’t satisfied all its payment obligations to creditors

>>your Free Cash Flow is not freely available to you until all creditor claims have been paid

🎯Then which company cash flow is free?

The only truly free cash flow in your company is called Free Cash Flow to Equity, and it accounts for everything Free Cash Flow does + all payments on debt obligations, both principal and interest.

🎯What are the advantages to Free Cash Flow?

✅ Easy to calculate ✅ Available to both capital providers and borrowers ✅ Accounts for both CAPEX and cash consumed by sales growth or working capital efficiency losses

🎯What are the limitations of Free Cash Flow?

❌ Assumes all CAPEX is a required investment, despite the fact most companies have a mix of replacement and growth CAPEX

❌ Overstates CAPEX in the year of acquisition and understates it in subsequent years

❌ Cannot be used independently to establish if a company can afford to service its debt obligations

❌ There is no standardized calculation of Free Cash Flow so it’s important to check with your bank or investor for their definitions

🎯Can Free Cash Flow be manipulated?

Absolutely.

If your company that wants to increase Free Cash Flow, it can simply under-invest in fixed assets.

You’ll have the shareholders celebrating in the short term and double jeopardy in the long term from reduced cash balances and an underproductive asset base. 💣

Image courtesy of Corporate Finance Institute.

It is however a necessary evil, and whether you like it or not, it’s here to stay.

EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is calculated just as the name implies:

E >> Net profit before tax

B >> Before

I >> Interest expense

T >> Tax expense

D >> Depreciation expense

A >> Amortization expense

➡️ Here are 3 Benefits of EBITDA:

1.It is easy to calculate.

As opposed to Operating Cash Flow, Free Cash Flow or Economic Value Added.

2. It has become universally used as the language of (proxy) cash flow.

Your company likely uses it to manage internal performance, as do your bankers to measure your business financial risk profile.

3. It allows you to compare financial performance results across businesses and industries.

It (presumably) levels the playing field by removing the impact of several variables from financial analyses:

☑️ the company’s capital structure (interest)

☑️ the company’s operating leverage (depreciation & amortization)

☑️ the company’s tax circumstances (tax)

➡️ And here are 10 Critical Flaws of EBITDA:

1. It is not a GAAP metric.

Which means there is no standardized formula to calculate it, and companies will choose to calculate it however it benefits them most.

Such as in the case of Earnings per Share, when a company may exclude stock based compensation from its GAAP earnings while another may not.

2. It implies that all net income translates into cash the same way.

For example, using EBITDA as a proxy for cash flow ignores the required investment into working capital assets to support the business future growth.

3. It does not consider the amount of required capital reinvestment.

While Depreciation and Amortization may be non-cash items, every business has CAPEX investment needs which aren’t captured in EBITDA.

4. It does not account for the amount of cash absorbed into working capital assets.

Changes in receivables, payables and inventory balances can mean that an EBITDA of $1 million disguises the reality of an operating cash flow deficit of $2 million.

5. It implies that loan repayment will be prioritized.

In fact, a company may choose other uses for its cash, such as investing in growth, acquisitions or plant capacity expansions, and leave no residual capital left to repay loans.

6. It doesn’t say anything about the quality of earnings.

Which means earnings and EBITDA may be inflated with deferred expenses, aggressive accounting policy choices, or underfunded pension liabilities.

7. It is a poor measure of profitability.

For example, GAAP revenue recognition criteria differs around the world which can overstate earnings; meanwhile, interest and taxes are usually real cash outflows which reduce earnings in practice.

EBITDA’s ability to proxy for cash is also distorted in all instances where revenue recognition doesn’t correlate with the receipt of cash, such as percentage of completion in long term contracts. In those instances, customers are billed in accordance to contractual terms, while the company recognizes revenue based on costs incurred, and the true profitability of the contract could be wildly overstated until it is actually completed.

8. It is an inadequate comparison for acquisition multiples.

EBITDA doesn’t capture industry specific capital investment requirements nor company specific underlying strength in operating earnings.

It is trying to level the playing field and strip out so-called noise from the profitability picture of a company, but when the noise is inherent in the make up of an entire industry, stripping out critical components like CAPEX maintenance results in a distorted image of the earnings potential of that entity.

9. It can be severely misleading when used as a measure of cash flow.

EBITDA ignores several real cash outflows as well as understates the future expected increase of those cash outflows.

10. It can easily be manipulated through aggressive accounting policies.

There are numerous financial reporting areas where management can manipulate company earnings and artificially inflate EBITDA, such as with percentage of completion revenue recognition, deferred expenses, pension liabilities, or depreciation assumptions.

16 Cash Flow KPIs You Should Know

Your Business Success starts with Revenue and ends with Cash Flow.

Here are 16 Cash Flow KPIs to Know:

There are 3 Main Cash Flow Drivers you should Know.

Operating Cash Flow is generated from:

☑️ Revenue Growth

☑️ Operating Profits

☑️ Working capital efficiency

How does it work?

The formula for Operating Cash Flow, CFO or OCF is as follows:

=Revenue

-COGS

-Operating Expenses

+Depreciation and Amortization

+Other non-cash items (e.g. gains/losses on assets sales)

+/ Changes in Working Capital

Here’s how each of these components impact your ability to grow your Operating Cash Flow:

1️⃣ Revenue growth refers to the increase in your company's revenue over time.

A higher rate of revenue growth generally leads to more cash flow, as more money is flowing into the business.

🎯 What drives revenue growth:

• Sales volume: the number of units sold

• Pricing strategy: price increases for new and existing clients

2️⃣ Operating Margin refers to the operating income divided by revenue.

A higher operating margin means that a larger proportion of revenue is being converted into profit, which can further be used to generate cash flow.

🎯 What drives operating margin growth:

• Reduction of COGS relative to revenue: better contractual agreements with suppliers, automation

• Reduction of Selling, General and Administrative costs relative to revenue: marketing, payroll, overhead, shipping costs

3️⃣ Capital Efficiency refers to how effectively a company uses its assets and liabilities to generate cash flow.

A company that is capital efficient is able to generate a higher return on its shareholders’ investment and has better access to funding, which can help it generate more cash flow.

🎯 What drives capital efficiency?

• Efficient use of long term capital assets (PPE): your company’s ability to generate profit from the operation of its assets (ROE)

• Efficient use of short term working capital assets: your company’s ability to optimize its cash conversion cycle (Days Inventory Outstanding, Days Sales Outstanding, Days Payable Outstanding)

Image courtesy of Corporate Finance Institute

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