What is good operating cashflow what why is operating cashflow important?

Why operating cashflow is important when you grow your business

Operating cashflow is important to fast growing businesses. In fact, operating cashflow is way more important than being profitable.

These are the 5 reasons why operating cashflow is important:

  1. Cash pay for bills, investments and dividends, not profits.
  2. Profit is an indicator for a stable business but miss to include the change in demand for working capital.
  3. Money out, money in spending and cash income is balanced only in stable, moderately growing businesses.
  4. Fast growing companies increases their spending for new customers faster than old customers make their cash payments, at any given period.
  5. You can only finance so long. At some point you need to start generate operating cash.

Profitable companies do go bankrupt because they run out of liquidity not understanding a good operating cashflow. Keep track on your liquidity, how it’s generated, where you spend it, tie it to work in progress and generate enough to finance growth.

You can invest, make dividends and grow your cash at account for bad times when you have a good operating cashflow.

Understanding operating cashflow

You will understand why operating cashflow is important if you learn how your business consumes money, and when. In fact, operating cash flow is critical and profitable companies has gone bankrupt not managing their operating cashflow.

(+) Gross cashflowMoney in, money out from your P/L
(-) Change in working capitalChanges in accounts receivables, payables and stock
(=) Operating cashflowMoney for investments, dividends or accumulated wealth

This is gross operating cashflow

What is good operating cashflow what why is operating cashflow important?

Money in less money out is your gross cashflow for the period. A simple concept easy to understand.

Your accountant will explain gross cashflow as your profit after tax, less depreciations and any year-end provisions. Another way to explain gross cashflow in financial terms can be EBITDA + net financial expenses + taxes paid.

Most people understand that customer payments need to be larger that expenses to make a viable business. Profit however is not the same thing since as cashflow since it includes non-cash depreciations and possible year-end accounting provisions.

More importantly, you also need to deduct your change in working capital from your gross operating cashflow to understand your true operating cashflow. Complicated? Maybe, so let me explain:

What is working capital?

The more your business grow the more working capital you need. Working capital growing out of control is a common reason why operating cashflow may not growth with your sales growth.

“You have expenses, you tie money in materials, work in progress, and stock before invoices get paid by your customer. That is working capital.”

In most situations, your business has expenses to make before you have cash at your account paid by your customers. These advance expenses and customer invoices not yet paid are called working capital.

Your working capital level will not change if your business would have the same sales and expenses all the time. Your use of advance cash is constant relative your sales.

A business that grows have an increasing need for working capital. You pay more salaries, and you purchase more components. The change in working capital is what you need to keep an eye on. A growing working capital can drain your account before related revenue has been received.

“Your working capital need increases when new sales are secured while previous sales have not yet been fully paid. This is the dilemma to fast growing businesses.”

You will run into liquidity problem if you grow your business too fast, relative how you manage your working capital.

Financing solutions are only a temporarily solutions. At some point you need to catch up on your working capital challenge, which is working capital management. We’ll talk about that further down in this blog article.

It’s not unheard of that great companies that grow fast fail because they run into liquidity problem. That is almost always because their change in working capital has grown too fast and out of control.

What is a good operating cashflow?

The amount of expenses and working capital needed is dependent on your industry and how you operate your business.

These practices require high gross margin in your sales to get you to a good operating cashflow:

  • Long lead times leads to high expenses (sales, engineering, manufacturing, sourcing).
  • Retaining stock is a major working capital consumer where finished goods tie money spent and not yet paid for.
  • Late payment terms, like limited upfront and milestone payments gives less cash at account each period and requires stronger cashflow for you to survive.
  • Fast supplier payments, slow customer payments drains you cash at account and requires stronger cashflow to survive.

Remember, it’s cash profits and the need for more working capital as you grow, that effect your operating cashflow for a certain period.

“A good operating cashflow allows for investments, dividends and a growing cash account for bad times.”

Limiting your need for working capital means you have greater financial resources to invest, make dividends and set aside cash at account for bad times. A good operating cashflow is important, so let’s now talk about what you can do to improve your operating cashflow:

What you can do to make cashflow improvements

First, it needs to be clear that it is the entire organization’s duty to produce cashflow and to manage working capital. Your finance head provides financial data, trend and source analysis, but the organization controls how cashflow is generated.

Assigning the task to improve cashflow to the finance team seldom works very well, except for minor short-term improvements. To improve operating cashflow is not something you can delegate to the finance people.

Top-4 tips for your salespeople toolbox:

  1. As short sales lead times as possible improves your operating margin and gross operating cashflow. Prioritize, be efficient, semi-automat where possible, design sales and prospecting processes that are supportive.
  2. Payment terms that are front loaded can be more important than a high margin, if your business is fast growing. Cash at account will be needed if your business grow fast.
  3. Avoid promises that result in stock, i.e. avoid to tie capital to goods not yet billed for.
  4. Be cautious about spare part promises and sales since spare parts tend to lead to stock or expensive low series production.

Top-4 tips for your engineering toolbox:

  1. Design an engineering process and platform to shorten your engineering lead-times.
  2. Limit complexed designs since they lead to increased number of production hours.
  3. Use standard components to the extent possible, limiting sourcing and manufacturing hours.
  4. Assent to lean design principles and prioritize constant design process development.

Top-4 tips for your manufacturing toolbox:

  1. Make manufacturing and assembly simple and fast with tools, fixtures, instructions, and training.
  2. Design your workspace to limit lead times. Think about production flow, how and where your store and make things. Limited time needed to walk around and collect materials.
  3. Make sure that you stock, yes, essential low-cost items such as screws, nuts, washers, welding wire, etc. Halting production because of lack of inexpensive items is extremely costly and bad for customer relationship.
  4. Assent to lean production principles and award workflow improvements.

The finance team provides operating cashflow information while your entire organization is responsible their part of your operating cashflow.

How to calculate your operating cashflow

There are plenty of blog posts how to calculate operating cashflow and the change in working capital using accounting terminology. Simply put there are 3 principles:

  1. Your cash profit is your gross cashflow, i.e.  your profit less your depreciation (add them back).
  2. It’s the change in demand in working capital that leads to more or less cashflow for a certain period.
  3. Find out the net operational change from your balance sheet for the period. How much accounts payable, accounts receivable and your stock has changed compared with the previous period.

In accounting terms these 3 principles may look like this:

EBITDA – financial net- tax paidGross operating cashflow
Change in accounts receivablePart of change in working capital
Change in accounts payablePart of change in working capital
Change in stockPart of change in working capital
=Change in working capital 

Many businesses, small as well as large businesses, are steered in profit terms, margins or maybe with cashflow proxy’s like EBITDA (operating profit excluding non-cash dividends).

For fast growing businesses it’s absolutely essential to instead steer on operating cashflow. Profitable companies do go bankrupt because they run out of liquidity not understanding a good operating cashflow

You can invest, make dividends and grow your cash at account for bad times when you have a good operating cashflow.

The best of luck growing your business, and do not forget to manage your operating cashflow to propel that growth.

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