Business owners generally have a good feel for their profit and loss statements. However, when it comes to the balance sheet, it is akin to the dark side of the moon.

Imagine a small business run by a couple, David and Diane. Their business has an Income of $500,000 a year and the Cost Of Goods Sold (COGS) is $200,000, leaving a Gross Profit of $300,000.  A further $175,000 is spent on Expenses, leaving an Operating Profit of $125,000.

David and Diane’s Profit & Loss statement has been laid out below…

Figure 1 – David and Diane’s Profit & Loss

Who wouldn’t want a small business like David and Diane’s, making $125,000 in profit?

Yet, if you were to run into David and Diane at a barbeque this weekend and ask them, “how is business going?” They are most likely going to respond by saying, “our bookkeeper keeps telling us how much profit we are making, but we never seem to have any cash.”

Business owners like David and Diane often can have a reasonable grasp on their profit structure through the workings of a Profit & Loss. However, it requires a fundamental understanding of how Balance Sheets work to get a grasp on their cash flow structure. This is where cash flow issues in business usually arise.

David and Diane’s Balance Sheet includes accounts receivable (Receivables) of $80,000, Inventory and/or Work-In-Progress (WIP) of $100,000 and accounts payable (Payables) of 20,000. Keep in mind, Balance Sheets carry Receivables and Inventory/WIP as assets, with ‘debit’ or positive balances for accounting purposes.  Banks will often lend money against those balances. 

cash flow issues in business

However, as far as cash flow is concerned, Receivables and Inventory/WIP are costs to cash flow – the $80,000 is money David and Diane invoiced to customers and has included in Income in his Profit & Loss but has yet to be received in cash. The $100,000 is either stock purchased, and yet to be sold, and/or work performed, and yet to be invoiced, so similarly a cost to cash flow.  This amount is included within the COGS amount in the Profit & Loss.

Further to these amounts is the $20,000 in Payables, which is for some of the COGS or Expenses included in the Profit & Loss.  Payables are yet to be paid for, thereby a benefit to cash flow, and for our purposes, shown with a positive balance. The net of these three amounts is -$160,000 (-$80,000 + -$100,000 + $20,000), which is David and Diane’s Working Capital.

So many business owners might think their bank account is their working capital. Rather, your bank account is the result you get after going through the process of operating your business and then having movements in your working capital. This determines what your bank account balance is going to be, from an operating point of view.

Figure 2 – David and Diane’s Balance Sheet

So, why is it that this seemingly strong, profitable business is struggling with its cash flow?

In order to help David and Diane to understand that even though they are making plenty of profit, they ‘never have any cash’, we establish an index of a business’s cash flow – known as the CASHFLOWNAV Factor.

The CASHFLOWNAV Factor takes each of the key drivers contributing towards overall cash flow issues in business – Income, COGS, Working Capital, and Expenses – and indexes them against the Income of the business.  Accordingly, we divide each of these cash flow drivers by Income, and multiply by 100, to establish their individual CASHFLOWNAV Factor, or Factor. Income ($500,000) ÷ Income ($500,000) x 100 = 100, which is our starting point, demonstrates the index relationship to Income.

This process has been applied to the profit and loss and balance sheet, as seen below. Remember, if the cash flow driver has a negative, this is carried across to the CASHFLOWNAV Factor.

Figure 3 – CASHFLOWNAV Factor Calculation

As you can see above, Working Capital (B) is taken across, underneath Gross Cashflow (A). Then, we add A and B together to get our Working Cashflow of 28. The last step is to add the Working Cashflow (28) and the Expenses (-35) together, which gives us a CASHFLOWNAV Factor of -7.

David and Diane are left sitting there scratching their heads. So, what does this mean to us?

This means that this business could continue operating as it is, turning over $500,000 and it will keep producing $125,000 in operating profit. This would then go towards David and Diane taking care of their family, putting food on the table, a roof over their heads and education for their children, but it would not leave much left after the fact.

If they were motivated to grow and indeed, they are, they would want to grow their Income. However, as they grow their income, they are going to be short 7 cents to the dollar – This is what the CASHFLOWNAV Factor means.

Let’s prove that. Imagine David and Diane’s business experiences a growth of 10%: their Income would become $550,000 ($500,000 +10% of 500,000), COGS would be $220,000, Gross Cashflow becomes $330,000, Expenses increase to $192,500 and they would make $12,500 extra in Profit ($137,000 total).

Now, given the fact that small business owners are generally not aware of what is happening in the balance sheet. Similarly enough, the Receivables will go up ($88,000), the Inventory or Work In Progress has gone up ($110,000), payables have increased (22,000), and all of a sudden, we have $176,000 invested in working capital.

What is interesting about this process is that David and Diane have gained an extra $12,500 in profit, but they have spent $16,000 in getting there. Leaving them with a difference of -$3,500…

At this point, David and Diane were in shock. David’s posture became stiff, and tears began to well up in Diane’s eyes. How could they have been so naive?

cash flow issues in business

This is where knowing the CASHFLOWNAV Factor (-7 or 7%) gives us the opportunity to pick this up at an earlier stage and avoid some of this pain.

Let’s clarify that. David and Diane have an extra $50,000 in budgeted growth (Income of $500,000 increased by 10% is an extra $50,000), therefore, knowing this Factor we can multiply the $50,000 by 7%. And low and behold 7% of $50,000 is $3,500. So rather than David and Diane going through all the pain of short falling themselves by $3,500.

They could have picked this up early on if they would have known what their cash flow structure was.

Not to mention, small business owners like David and Diane having originally budgeted the extra $12,500 profits, it would not be unusual for them to commit the $12,500. Whether it be a piece of equipment or some investment in the business that would help generate the $50,000. Or perhaps they want to use this money to renovate their house, David might want to buy a boat or Diane might want to go on holiday.

Either way, they commit and spend the $12,500 and it leaves them with this major issue of a $16,000-short fall. So somewhere between the $3,500 and the $16,000 is a shortfall that business is going to have in growth, and this is exactly what underpins the importance of knowing the CASHFLOWNAV Factor.

Want to discover your businesses cash flow position today? Download the free CASHFLOWNAV app today, now on the App Store and Google Play store. You can find out more about the app by clicking the button below: