Being a financially sound and healthy company involves more than turning a profit on paper. For-profit businesses shouldn’t simply strive for a positive net income—they should strive for positive cash flow and a strong balance sheet to maximize the value of their businesses.
The benefits of profit on the income statement may be diminished if at the end of the accounting period the business has less cash in the bank than it did at the beginning of the period. It is critical to understand where the company is in its life cycle and what metrics, ratios and financial levers can be used to create cash in the short- and long-term. Equally as important for maintaining a healthy business is establishing a sound strategy to develop financial intelligence within the organization.
Maintaining financial health is a product of financial intelligence, which consists of understanding the following: foundation of the business (company goals and financial measurement); the art and nuances of financial statements (rules, estimates and assumptions); the analysis (using numbers to make decisions) and the big picture (putting the numbers in context).
Financial intelligence is important for a number of reasons, including:
- Understanding if the company is healthy, sick or terminal
- Finding any potential bias in the numbers and raising appropriate questions
- Gauging the profitability of your product and service lines
- Evaluating the ROI on growth or efficiency initiatives
- Diversifying decision making within the organization to create strength and balance
Financial intelligence leads to long-term financial health. Although all companies are different, whereby some are in the start-up phase, some in the growth phase and some in the mature phase, financial health can be generally defined as liquidity, solvency, repayment of debt capacity, profitability and efficiency. More broadly, the collection of these factors translates to the company’s ability to produce profit and cash flow. Financial health can mean the ability to access funding sources, to diversify revenue and payer sources and the ability to create shareholder value and net equity.
Financial health can be measured in four primary ways: financial statements, financial ratios, benchmarking and business valuation. Financial statements tell you what’s happening in the business.
There are three basic statements that tell the history of the business: the balance sheet, the income statement and the cash flow statement. The balance sheet is a cumulative statement of financial condition of where the business is right now, capturing both the current accounting periods as well as the past history of the company.
Think of the balance sheet as the overall grade point average (GPA) of the business, whereby multiple “grading” periods are taken into consideration. Savvy investors and business managers usually look at the balance sheet first (before the income statements) to get a general idea of the company’s financial health. Another way to look at the balance sheet is from a net equity perspective: Owns – Owes = Net Worth.
The income statement is an operational and profit scorecard in a distinct period of time. Following the same GPA analogy above, the income statement is a measure of the company’s grade in a single semester or defined period of time. It is important to keep in mind that there are several forms of accounting and tax policies that companies can utilize, and that in some cases net income or profit on the income statement may be only an estimate of performance. For most businesses, what really matters is the creation of cash flow, not just net income. Theoretically, over time the income statement and cash flows of the business will track each other—whereby profit actually turns into cash—but managers need to be astute enough to reconcile these things.
The cash flow statement can be considered the reality check of business health because it accounts for both the balance sheet and the income statement activity. There are three sections in the cash flow statement: cash flow from operations, cash flow from investing activities and cash flow from financing activities. Cash flow from operations is a result of the core operations of the business and is the real indicator of how well the business is performing. Cash from investing and financing activities relates to how the company uses leverage (debt) or equipment financing to fund operations.
The financial statements alone only tell part of the story in terms of financial health. Ongoing calculation, monitoring and benchmarking of financial ratios are the key to deciphering what those financial statements are actually telling you about the business. Profitability ratios (return on sales and net sales to inventory), liquidity (current and working capital ratios), productivity (revenue per FTE employee) and debt ratios (debt to equity) are the four key areas that should be given the most attention. Select ratios are used to compare strengths and weaknesses of the company. Ratios are only useful if compared against past performance, other companies or other industry-wide data. Ratios are also important for external parties such as banks or equipment manufacturers to help them evaluate the credit worthiness of the borrower. CMS uses ratios to determine the minimum acceptable financial requirements for being a contracted supplier in the competitive bidding program, although there is a lot of ambiguity as to what they have deemed acceptable.
In terms of cash flow management, measuring and improving working capital is the best way to create cash. Working capital is loosely defined as current assets less current liabilities. The most important pieces of the working capital equation are AR, inventory and AP. Too much working capital can mean that there is too much cash tied up in accounts receivable and inventory. Measuring these primary working capital elements is done by calculating DSO (days sales outstanding), DII (days in inventory) and DPO (days payables outstanding). (See formulas above.)
The most common levers that companies use to manage working capital include reducing inventories and implementing just-in-time systems, increasing receivables collections and revising payment terms with creditors and vendors to increase the payables cycle. Improvements in these areas will lead to a smaller cash conversion cycle, which is an indication of how much cash a business needs to have on hand (minimum) to finance the business. The lower the cash conversion number, the more cash is created and the less a company has to depend on outside sources of financing.
For a typical company with $1 million in annual revenue, decreasing DSO 10 days, decreasing DII 10 days and increasing DPO can create an extra $50,000 to $75,000 in cash per year without increasing sales or cutting costs. These improvements will also reduce the cash conversion cycle. Creating more cash using these levers can reduce reliance on outside financing, reduce the need to sell equity and increase the enterprise value of the business.
Using the knowledge of financial statements, ratios and working capital management, companies can manage their resources more wisely and make better business decisions.
Calculating Primary Working Capital
DSO (in days) = AR / Average Net Revenue Per Day
DII (in days) = Inventory / Average COGS Per Day
DPO (in days) = AP / Average COGS Per Day
Calculating Cash Conversion Cycle
Cash Conversion Cycle (in days): DSO + DII - DPO
This article is the first of several highlighting the 6-4-18 series of Medtrade presentations. The series was designed as six sessions that will provide HME dealers with strategic information for success and survival over the next 18 months.
