It is a common, and true, statement that “Cash is King”. This is why the Statement of Cash Flows is so important. When you understand what it’s telling you it becomes an enlightening view of the company. It is as if you have been going through a room in the dark for years and then you see it with the light on.

One of the companies where I have been Controller had a division that was privately held prior to it’s acquisition as a division of our company. The company ran about 40+% gross margins with 20+% net margins and wound up being acquired by our company for the amount of its’ debt to us. How could this highly profitable company come to such a demise? The company was excellent in sales, marketing, pricing, and product quality but what they didn’t do was effectively manage the inflow of cash into the business and it cost them the business.

By understanding the Statement of Cash Flow and looking at the information as it applies to your organization you can greatly increase value and longevity for your company.

The objective of the Statement of Cash Flow is to show you both where your cash is coming from and what you are spending it on. That is it plain and simple. By seeing the numbers quantified it will, to a large degree, confirm what you already know – it may be that all of the cash is coming from the bank or investors and the money going for capital investment or customer financing.

The Balance Sheet is a point-in-time report providing a birds-eye view of the financial health of the company while the Income Statement is an operational report telling how well the company did over a period of time. The Statement of Cash Flow is the bridge between the Balance Sheet and Income Statement and, like the Income Statement, is an operational statement and completes the picture of what happened in the business from one Balance Sheet to the other. Knowledge is power and cash is king.

Treatment of Revenue & Expenses

Components of Net Income
Usually a Source of Cash

Treatment of Assets

Types of Assets
Usually a Use of Cash

Treatment of Liabilities

Types of Liabilities
Usually a Source of Cash

Treatment of Equity

Types of Equity Accounts
Can be a Source or Use of Cash

Operational Impact

Effects of extended terms to your customers (A/R)
Effects of extended terms from your suppliers (A/P)
Effects of high Accounts Receivable and/or Inventory
Effects of lowering Working Capital
Digging out of a cash hole

For further explanation and illustrations, check out Understanding Cash Flow

The overall amount you use or sell during a specific timeframe is called the volume.  The number of times you need the product or to be more specific the number of times an employee needs to visit the location holding the product is called the visits or hits.  The difference between the two is you can have an item that uses or sells 50 units within let’s say a week but only have 2 visits or hits.  This could be because the item is used in 25 unit increments or perhaps, if sold, a customer purchased 30 on Tuesday and on Wednesday another customer purchased 20.  Either way if this is the average usage then the volume would be 50 per week while the visits or hits are 2.

Determining the hits and volume is easy.  I recommend exponential smoothing over a 13 week period.

The hits determine the proximity to the usage point while the volume and size of the product determines the size of the location.  That may sound simple but that’s it, but as with all business practices what is easy on paper may not be easy in application.  You may lack space in close proximity to the usage point or you lack the space to have the locations large enough to cover demand.  Generally, depending on your business, you will have a variety of location sizes near the usage point.  In warehousing these are usually pallet, carton and bin locations.  In manufacturing you could also add barrels, drums, spools and a variety of other location types.

To summarize; to properly profile your items:

• Understand the average volume per the time period you choose.
• Understand the average number of times the item is ordered or how often it is needed.
• Rate your items from highest hits to lowest hits (or visits).
• Arrange the highest hitting items nearest to the point of usage in a location that is appropriately sized to handle the volume.

Profiling can be implemented with any 5S projects or it can be a project unto itself.

Proper profiling of your facility will lead to higher efficiencies and lower costs.

 Weighted Average

Weighted average is, perhaps, the easiest of the valuation methodologies. You have no variances to analyze, only variation.

As the title implies, weighted average costing averages the purchase price of products and absorbs any price variation into your P&L through Cost of Goods Sold.

 Standard Cost

In Standard Cost, you establish a standard that you want to value your inventory at.  This may be the initial PO price, a vendor quote, or an estimate based upon industry or process knowledge.

With standard costs, also come variances that must be analyzed for the system to be effective. 

There are Purchase Price Variances (PPV) which are differences between your purchase price and your standard price.

There are Closed Work Order (CWO) variances that are the difference between your standard cost and the actual cost to produce a given product.

There are also Labor Variances, Factory Burden Variances, and Material Burden Variances that, like those already mentioned, are differences between the standard and the actual cost to produce a product.

Many company use the standard system as target costing and then manage to the variances.

 Specific Identification

Specific Identification is probably the most data-intensive method.  Specific identification requires you to serialize every piece of inventory.  While this may be appropriate for tracking blades for a Sikorsky helicopter, it’s definitely inappropriate for producing millions of homogenous, low-cost items.

 FIFO

First-In-First-Out tracks inventory as being used in the same order in which it was purchased, and is probably the way in which most companies consume inventory. 

LIFO

Last-In-First-Out is similar to FIFO, but considers the most recent purchase as the first one to be consumed.

In the podcast I gave as an example of 5S the Batcave from the old Batman TV series starring Adam West.  Here are some photos to show you what I meant.  Notice the signs depicting each gadgets function:

5S stands for Sort, Set in order, Shine, Standardize and Sustain.  If you take a current look around your facility I think you’ll find that you’re already using 5S, but it’s a different form of 5S.  You’re probably using Sponge, Steal, Store, Scramble and Seek.  This means that currently if an employee is looking for something like a tool or another process necessary item they will sponge it off another employee leaving that employee to wait for its return, steal it from another work station or employee, store or hide items at their work station so others won’t be able to inconvenience them, scramble around wasting time and using that as a plausible cause for low productivity and endlessly seek for what they need sometimes getting others to join in the search.  All of these S’s are unproductive and frustrating for management and employee alike.  The 5S’s you need to use are:

1. Sort – This is the first S to work on.  Sorting means going through the materials and tools of a work area and removing the unneeded and leaving the needed.  By properly communicating what is needed at each work station employees become more productive and quality improves through the use of the proper tools and materials.
2. Set in order – This S means to organize the tools and materials of a work station so they are easily accessible to everyone who works at that particular station.  It also makes it obvious what tool belongs where.
3. Shine – This S means just what it sounds like… clean!  This means more than clean it once it means to clean it and maintain that cleanliness.  Shine means putting in place processes and procedures that maintain a clean work area.
4. Standardize – This S means to incorporate 5S into your daily processes or adding them to your SOPs.  This could involve using shadow boards, painted lines outlining functional areas or tools and labeling.
5. Sustain – This is the guard dog of the S’s.  This S will take discipline.  If you don’t put in place the safeguards to maintain your efforts they will be in vain.  You will need empower and hold accountable your employees to maintain and improve the first 4 S’s.

If properly and attentively implemented 5S can not only set you on the right road to Lean it can show you the benefits of Lean even before you begin the more detailed aspects of Lean.  Your productivity and efficiencies will improve and you’ll be excited to continue.  Now you can start your Value Stream Mapping.

There are a number of ways to generate value for your organization through the management of the supply chain. 
One thing that you will want to do is publish your results publicly within the company. 

 This will serve three purposes:
    (a)  Toot your horn – you won’t have to toot your own horn as much because it will be in black and white
    (b)  Good results will set a precedent that will keep you going to constantly improve
    (c)  It will inspire those around you to maybe compete in the process improvement arena
    (d)  If you are an employee, it will set you up for your next review and if you are the owner it will increase your bottom line.

We’re going to pick some low hanging fruit here.  This is by no means an exhaustive list of things to do, but it will get you on the right track and we can do an update in the future to expand the list.  For the carrying cost calculations we will use a rate of 8% which is a reasonable rate for the purposes of these illustrations.

Inventory reduction

This is what almost every company wants to do.  Reducing inventory squeezes cash out of the business on a dollar-for-dollar basis.  There are two numbers that you will want to quantify when it comes to inventory reduction: (1) dollar value of the reduction and (2) annual carrying cost on the dollar value of the reduction.
For instance at one location I was involved with, we reduced the inventory from $17 million to $12 million over the course of a few months.  What this produced was a cash infusion to the business of $5 million and another $400,000 reduction in annual carrying cost.

In episode 2 of CashFlow ABC’s we covered how to find the low hanging fruit, in episode 6 we showed you how to properly determine your reorder points and in episode 8 we address economic order quantities and all of these play a part in the equation.  We’ll spare you a rehash of the three episodes that would surely be as juicy as microwave toast – check out those three episodes for the details.  Suffice it to say, reducing the investment that your company has in its inventories pays off in real dollars to the organization.

Extended terms

As we seen with the discussions about the statement of cash flow, which I know had everyone on the edge of their seats, getting extended terms from your suppliers adds to the cash balance of the company.  In addition, this will have carrying costs implications just like the inventory reduction.  If you have a supplier that you have net 30 terms with a supplier that you normally have a $100,000 balance with.  If you get the supplier to go to net 60 terms, you wind up with the equivalent of an interest free $100,000 loan because you now have an average A/P balance of $200,000.  Like a reduction of inventory, this will inject the additional $100,000 into the company’s bank account and end up with a benefit of $8,000 in reduced carrying costs on this one vendor over the course of a single year.

Prompt pay discounts

Prompt pay discounts are commonplace in every industry.  A supplier might offer 1% 10, net 30 terms or something similar – I’ve seen as little as 1/2% and as much as 5%.  In many organizations, the effect of carrying costs isn’t seen until you get up to parent companies, so it isn’t as appreciated as much at the division or plant level and discounts are more tangible and evident and therefore more appreciated.  Also, some companies can’t offer extended terms because of company policy, but they can offer the discounts.
Objectively, you have to determine your requirements and at what threshold you need for a discount to be preferable.  If cash is an issue in your company, then usually management is valuing extended terms over discounts because the cash need is immediate and, by the same token, the value of reduced carrying costs may be visible to corporate, but terms discount will bring the benefit to your division’s P&L rather than corporate’s.  You have to think logically and actually do some calculations to determine your answer.  As an example, let’s say that you have an average balance of $100,000 with a supplier on net 30 terms offers you 1% 10, net 30 – you now have a decision to make.

Carrying cost benefit of the $100,000 average A/P is $8,000 annually and if you take the discount, you will be giving up 2/3 of the benefit because you will be paying in 10 days instead of 30 – a reduction of 20 days.  To make the decision, take your annual purchases $1,200,000 (12 months X $100,000) multiplied by the discount rate of 1% gives you an annual benefit of $12,000 plus the carrying cost benefit on the 10 days that you have to pay in ($1,200,000 X 8% / 360 X 10 days = $2,667) and you come to $14,667.  That one is a no brainer as long as you have the cash flow to handle it.  This decision would turn around if you had 1% 10, net 60 because the carrying cost benefit would double to $16,000.

Good luck in your efforts and keep us apprised of your successes and opportunities for improvement!

• Frequency of ordering
• Variability of demand (compared to the forecast)
• Desired service level

We’ll address these one at a time:

Frequency of ordering – How often you order or manufacture your products will affect your safety stock.  The more frequent your ordering the less your demand during lead time therefore the amount of replenishment is smaller than less frequent ordering.  However, due to the smaller quantities your risk of a shortage increases but exists for a shorter period of time.  Less frequent ordering decreases the risk of a shortage but stock outs last longer.  It’s been my experience that it’s better to have more frequent stock outs for shorter periods of time than to have less frequent stock outs for longer periods of time.  Customers may understand or have safety stock of their own that will be lower if any stock outs are for only a short period of time

Variability of demand – No matter how accurate your forecasting is you will experience variability in your demand.  Safety stock is primarily to absorb this variability.  To set the proper levels of safety stock you will need to understand the absolute error between your forecast and your demand.  Then you will need to determine the standard deviation of that variance.  This was discussed in episode 4 of CashFlowABC.  Please review that episode for more details and examples.

Desired service level – The amount of safety stock you carry will be directly affected by your desired service level.  For those dreamers or naïve individuals in your company a 100% service level is unrealistic.  It serves as a goal but realistically cannot be attained.  If you do have a 100% order fill rate I guarantee you have too much available stock or your forecast was overstated.  Additionally, if your product is extremely low in cost and stock outs are unacceptable to your customers then it may necessary to carry enough inventory to eliminate stock outs.  But if your product isn’t next to free then you should choose a realistic service level and put waste reduction processes in place to continually reduce your inventory levels while increasing your service level.  For those realistic individuals APICS has come up with safety factor multipliers to help set safety stock levels based on desired service levels.  The higher the service levels the higher the multiplier and safety stock.  As an example, if your standard deviation is 100 and your desired service level is 95% your safety stock would be 100 x 1.65 or a safety stock level of 165 units.  If your desired service level is 99% your safety stock multiplier is 2.33 or a safety stock level of 233.  This means for a 4% higher service level you will need to carry twice the safety stock.  This is why removing waste from your processes and lowering your inventory will save you cash.  Also, reducing your forecast error will reduce the variation and your safety stock.  Below are the service level multipliers for both the standard deviation and the MAD:

You can apply these tools to other variables other than demand variation.  You can apply this to variation in supply.  If you have a production process that provides variable amounts compared to the ordered amounts this can be applied to account for that variability.  Or if you have a supplier that is unreliable but provides other services that increase their value you can apply this method to that supplier to create safety stock to absorb that availability.

To quickly recap:

• Frequency of ordering will affect safety stock in relation to the frequency and duration of the stock out
• Variability of demand must be known so you can determine the standard variation or MAD.
• You must decide on a service level and that level will affect your safety stock profoundly.

We’ve seen a lot of queries lately asking various questions about the Statement of Cash Flow so we’re going to take this opportunity to demystify this alien evil.  We’re going to use a basic Statement of Cash Flow for Little Johnny’s Lemonade Stand that he set up in front of his house.  For further information on how to prepare a statement of cash flow or to better understand cash flow and how cash flows through a business, check out Understanding Cash Flow from InstantController.com.

Cash Flow from Operations is where the meat and potatoes of the company are.  A company can have a down month or year so the Net Income could be abnormally low, but the Cash Flow From Operations will tell the whole of the story of the direction of the company.  You will want to at least see a positive number in the Net Income and Cash from Operations.

The Statement of Cash Flow always begins with the Net Income number.  This is because the Income Statement is the basis for cash flow through the business – if you don’t make money on the income statement, you won’t normally have cash flow to worry about for very long.  When looking at a Statement of Cash Flow, Net Income should be the first number you look for because it tells the story of whether the company is profitable.  Little Johnny’s Lemonade made a net of $5 for the day – not bad for the little entrepreneur.  Then add back into the net income the expenses that really didn’t cost cash – just depreciation for most companies.  This is because depreciation is a non-cash expense – the cash was paid out when the asset being depreciated was purchased. In Johnny’s case, he only had $0.50.

Items that go in this section are changes in current assets (excluding cash) and current liabilities – the higher volume accounts that cash churns through.  If an asset increases, it is a use of cash – it’s an asset to the business, but it takes cash to pay for it.  By the same token, increases in liabilities are a source of cash because you are delaying the payment of a bill and you have the opportunity to use that cash for something else.

In Johnny’s case, his friend Henry said he would pay Johnny tomorrow for some lemonade today and he drank eight cups at $0.25 each! Thirsty bugger!  So the 8 times 0.25 equals $2.00 in AR that Johnny has.  While he had the sale, he still doesn’t have the cash until tomorrow when Henry pays him.

Mr. Wilson across the street said Johnny could have all the lemons he wanted for $3.00 and he could pay him tomorrow, after he had made his money selling the lemonade.  So Johnny had the $3.00 in Lemons, but he didn’t have to pay for them on the spot, so this is a source of cash because Johnny can now use that $3.00 to buy Dixie cups for the lemonade!  Johnny’s Accounts Payable at the end of the day is $3.00 to Mr. Wilson.

For the first day of operation, Johnny’s Cash Flow from Operations is Adjusted Net Income of $5.50 – $2.00 due from Henry + $3.00 payable to Mr. Wilson, for a total of $6.50.  Any prepaid expenses would also be listed in Cash from Operations with the same rules as any other asset – increase = use of cash, decrease -= source of cash.

Cash From Investing is the section where any long term assets show their effects.  For most companies, this is only Fixed Assets (gross). At the beginning of the day Johnny had to spend $10.00 on PVC lawn furniture to set his stand up with, so he has $10.00 tied up in fixed assets.

Cash from financing is where the effects of debt and equity show up.  If you issue stock, the cash received for the stock would show up in this section as well as any proceeds received from the sale of bonds or from obtaining cash financing.  In this case, Johnny was only 7 years old and had to get $20.00 in venture capital from Dad.  It sounded risky, but Dad chose to roll the dice any way and loan him the $20.00.

From all of this, Johnny had an increase in cash of $16.50, which he had in his cash box at the end of the day.  To prove this out, we can do it by looking at the actual receipts and disbursements:

For further information on how to prepare a statement of cash flow or to better understand cash flow and how cash flows through a business, check out Understanding Cash Flow from InstantController.com.

– John

• Identify what measurements are most important to your business
• Measure the “current state” of the KPI’s
• Establish targets for where you want them to get to
• Measure the KPI’s on a regular (usually monthly) basis
• Analyze the results and identify opportunities for improvement
• Hold employees accountable for the numbers that they are responsible for

Working Capital
Working Capital (WC) is Current Assets minus Current Liabilities.  It is a measure of how well you churn cash through your organization.  The two largest components of WC are Accounts Receivable and Inventory.  If your inventory is too high, you are probably paying cash out too early and if A/R is too high, you’re not collecting fast enough.

Working Capital Turns
WC Turns are Sales/WC.  It is a measure of liquidity and how well you utilize your WC.  Higher turns are better – it indicates that you are converting your investments in the business into cash quickly.

Inventory Turns
Invetory Turns are calculated by Cost of Goods Sold (COGS) / Average Inventory.  Higher turns are better.  6 turns means that you turn the inventory six times per year or, conversely, you have two months of inventory on hand.  This ratio indicates how quickly your business is turning over inventory.  A high ratio may indicate positive factors such as good stock demand and management. A low ratio may indicate that either stock is naturally slow moving or problems such as the presence of obsolete stock or good presentation. A low ratio can also be indicative of potential stock valuation issues.

Days of Inventory
This is a sister to Inventory Turns – just expressed in days.  The calculation is 365 / Inventory Turns.

Accounts Receivable Turns
Accounts Receivable (A/R) Turns are a measure of how quickly you are turning sales into cash. The calculation is net sales ÷ average trade accounts receivable.  High ratio means shorter time between sales and cash collection. Lower means the opposite. If ratio is lower than peers, the quality of AR should be examined. Note that ratio may be affected by seasonal fluctuations in sales or if a large portion of sales are cash based.

Days Sales Outstanding
Probably the most prevalent of the A/R related KPI’s.  There are several ways to calculate DSO, including the clawback method, but the most common is 365÷ A/R Turns.  DSO is an expression of the A/R turns in terms of days rather than annual cycles.  The higher the number, the greater the probability of delinquencies. Interpret this in line with the company’s credit and collection policy or payment terms.

Past Due Percent & Past Due Dollars
These are two different measurements, but I list them the together because they should always be looked at together.  Past due percent is the past due dollars divided by the total A/R.  Because of fluctuation in sales month to month or quarter to quarter, the percentage can be skewed one way or the other by the fluctuation in sales.  When analyzing the past-dues always look at both together or you’re only getting half of the picture.

For further assistance in measuring your KPI’s check out the Financial Analysis templates in Excel from InstantController.

For monthly A/R tracking templated with graphs that are ready for your data, check out the A/R Management Bundlefrom InstantController.

- John

• That demand is relatively constant and known.
• The order quantity is usually the same.  (The EOQ will remain constant until the review period or if changes in the supply chain warrant a reformulation of the EOQ.)

EOQ has some additional requirements and assumptions:

• The product is purchased or produced in batches or lots.
• Order preparation costs are known.
• Inventory carrying costs are known.
• Annual usage is known.
• Replenishment occurs all at once.

Let’s look at EOQ’s requirements and assumptions one at a time:

• The assumption that the product is purchased or produced in batches or lots is due to the consistent nature of the EOQ and the demand that determines it.  In other words, you won’t be ordering 7 now, 3 tomorrow and 12 next week.  The EOQ is formulated and is set until the next review period.  However, if the EOQ calculates to a number not divisible ty the batch or lot size you will need to round the EOQ up to a quantity divisible by the batch or lot quantity.
• You will need to know your order preparation costs.  This holds true for both purchased and manufactured items.  You’ll need to know:
     – The number of orders placed annually.  This is determined by the annual demand / the standard order
       quantity.  If there is no standard order quantity use the average order quantity understanding you will need
       to review the EOQ sooner than anticipated.
    – How long it takes to process an order and the overhead costs associated with that process such as employee 
       salaries and the costs of purchase orders.
• The inventory carrying costs in the EOQ are expressed as a percentage of the average annual inventory.  The inventory carrying costs fall into 3 main categories with the following sub-categories:
    – Capital
       – Inventory capital
       – Insurance
       - Taxes
    – Storage
       – Handling
       – Security
       - Storage
       – Record keeping
       – Space
    – Risk
       – Deterioration
       – Theft
       – Obsolescence
• You will need to know your annual usage.  If that isn’t known you can extrapolate the data but you will need to review the EOQ sooner than anticipated.
• Replenishment arrives and is ready for use all at once.  No partial shipments or a portion of the order quantity held in a QC queue for example.

 The calculation for the EOQ is: the square root of 2 x the annual demand x ordering costs / annual carrying costs x the unit costs.  As an example:

Annual usage = 1,000,000

Ordering costs = $5

Inventory carrying costs (as a percentage) = 0.20 (20%)

Unit costs = $2

Square root of:

2 x 1,000,000 x 5 / 0.20 x 2  or…

Square root of:

10,000,000 / 0.40  or…

Square root of:

25,000,000

EOQ = 5,000

If you wish to lower your EOQ you must take into account the following:

• As your annual demand increases so does your EOQ to satisfy the increased need.
• If your inventory carrying costs decrease your EOQ will increase as it is now more cost efficient to carry more inventory compared to unchanging unit costs and ordering costs.
• If the unit costs decrease your EOQ will increase as it is now more cost efficient to purchase more inventory compared to unchanging carrying costs and ordering costs.
• If you decrease your ordering costs your EOQ will decrease as it is more cost efficient to place more frequent orders compared to unchanging carrying and unit costs.

So, to lower your EOQ batch size you must lower your ordering costs.  This can be achieved through applying lean principles or mapping the process, identifying the waste and then removing the waste from the process.

If the EOQ assumptions and requirements are not valid for your company there are many other methods for ordering replenishment but you should always use a method that will keep your carrying costs and ordering cost to a minimum.

Form an LLC or incorporate to protect your personal assets - Don’t comingle.  Use a business entity to separate your personal and business self.

Priorities

Payroll first – pay your employees first or they will soon be former employees.

What will generate cash?  Figure it out and and pay those bills first to generate the short-term cash flow and keep the cash churning.

Communication

Don’t vanish – keep the communication going with your suppliers, customers and employees.  No matter how bad it is, never let them see you sweat – always be confident or they won’t be confident either.

Kill the rumor mill – as the environment gets worse, the rumor mill will take on a life of it’s own.  Show confidence and kill the rumor mill before your competitors start feeding it.

Use the business’ resources

Customers – look for sales and prompt-pay opportunities.

Suppliers – look for sales, return opportunities as well as extended terms.

Cut the crap

Fire-sale the overstock – it’s time to get rid of the crap that you’ve been leaving in the back of your shop -turn it into cash!

Look at new opportunities on Ebay, Craigs List, etc..

Think unconventionally

Can I leverage what I do into other markets?  This is a great opportunity to grow the breadth of your business doing the things that you already know how to do!

Cost control

Don’t throw the baby out with the bath water – control the costs rather than cut them.

Employees – take care of them!  If you’ve normally bought lunch every Thursday try to continue it to avoid throwing up a red flag with your employees.

Marketing – This goes along with not throwing out the baby with the bath water.  Tough times are when most companies cut back, but the ones who do the best and recover the strongest are the companies who come out of the funk with a strong marketing effort.

Loan covenants

Don’t let them bite you – If you’ve normally not had to worry about your covenents, they can sneak up on you really quick if you’re not careful.

Work with your banker – Your banker wants you to succeed too!

Cash forecasting

Start small – 4 weeks:  It’s tough (and inaccurate) in the beginning until you get over the initial learning curve.  As you get better at it, start extending out into the future.

Grow – 8 weeks:  If you can effectively forecast cash eight weeks out, you are probably miles ahead of the competition.

Triumph – 13 weeks:  13 weeks is the goal of most cash forecasts – that’s three months!  Of course, the further out it is, the less accurtate, but it at least starts to paint the picture.

– John