7

The operating cash cycle

This chapter reviews:

• The concept of corporate liquidity
• The cash cycle
• Matching short-term and long-term liquidity

Corporate liquidity

A company must maintain sufficient cash resources to pay all legitimate bills as they arise. A company that cannot do so has run out of liquidity and is in a very serious financial condition. Ironically, this is so even if it is currently generating good profits.

Cash in this case can be a bank account with a positive balance, or it can be a loan facility that the company has authority to draw down.

When cash runs out, the company’s management has lost the power to make independent decisions. An outside agency, such as an unpaid creditor or a bank whose loan is in default, will often decide the fate of the company.

That fate could be insolvency, a forced reconstruction, an involuntary takeover, or the company could be allowed to continue in some altered form. The reality is that management has lost its authority. It is also likely that the owners have lost their entire investment.

One may well ask, ‘How can this happen if profits are good?’ The answer is that it does happen and for reasons that will become clearer later.

Loss of profits is often the immediate cause of the disaster, but, as we have said, it can happen even when companies are making good profits. Indeed, profitable and rapidly growing small companies very often run out of cash. They then pass out of the hands of the original owner or entrepreneur, who is left with nothing while others reap the benefits of his enterprise.

This chapter will examine corporate liquidity and the factors that drive it. It will look at how we can measure a company’s liquid health. It will identify the forces that bring benefit or harm to it.

The cash cycle

The flow of cash through an organisation can be compared with the flow of blood around the body. When we look at the cash flow diagram in Figure 7.1, the reason for this is obvious. Cash is in continuous circulation through the ‘arteries’ of the business carrying value to its various ‘organs’. If this flow is stopped, or even severely reduced for a time, then serious consequences result.

This diagram shows part of the total cash cycle, the part that we refer to as the working capital cash flow. Central to the system is a cash tank, or reservoir, through which cash flows constantly.

It is crucial to the independent survival of the business that this tank does not run dry.

Supporting the cash tank is a supplementary supply, representing unused short-term loan facilities. These provide a first line of defence against a cash shortage. Day-to-day liquidity consists of these two separate cash reservoirs :

The main flow of cash into the reservoir comes from ‘accounts receivable’. These are the customers who pay for the goods or services received from the company.

The main cash outflows can be identified under two headings:

• payments to ‘accounts payable’, that is the suppliers of raw materials and services
• payments of staff salaries/wages, and payments of all other operating expenses.

We can trace the steps in the cycle. ‘Accounts payable’ supply ‘raw materials’. In time these pass through ‘work in process’ into the ‘finished goods’ category. During this conversion, cash is absorbed in the form of labour and expenses and payments to suppliers.

In due course, these ‘finished goods’ are sold. Value passes down the artery into the ‘accounts receivable’ box, from which it flows back into the ‘cash’ reservoir to complete the cycle.

Cash flow – the role of profit and depreciation

In Figure 7.2, two further input values are shown that produce an increase in the cash in circulation:

• profit
• depreciation.

The input from profit is easy to understand. Normally goods are sold at a price that exceeds total cost. For instance if goods that cost $100 are sold at a price of $125, the $25 profit will quickly flow into the business in the form of cash. It is a little more difficult to understand the input from ‘depreciation’. But depreciation is often quoted as a source of funds and we may have seen the definition:

operating cash flow = operating profit + depreciation

It is not easy to see why this should be. What is so special about depreciation? The answer is that, for most companies, depreciation is the only cost item in the profit and loss account that does not have a cash outflow attached to it. Although we just referred to depreciation as a source of cash, it is really the avoidance of a cash outflow. This point is more fully developed in the following section.

It must be emphasised that, even though depreciation does not have a related cash outflow, it is a true cost nevertheless. The relevant cash outflow has simply taken place at an earlier time when the associated fixed asset was purchased. When the fixed asset was purchased, the cash cost was not charged against profits. It was, instead, added to the balance sheet. As the asset is used up, an appropriate amount of cost is released into the profit and loss account. This is what depreciation is all about.

What Figure 7.2 shows is that, with every full cycle, the amount of cash in circulation is increased by the profit earned plus the depreciation charged.

Depreciation and cash flow

The example in Figure 7.3 illustrates the relationship between depreciation and cash flow. This relationship gives rise to much confusion, so we will take the time to explain it here.

Please note that the diagram refers to ‘Trading/profit and loss account’. This is because we are simply looking at operating profit (or EBIT) here as opposed to the ‘full’ profit and loss account.

The example uses the illustration of a very small haulage business. It has one single asset, namely a vehicle valued at $20,000 that the owner uses to transport goods on a job-by-job basis. The business has no inventories or accounts receivable. It has no bank or other loans and all its transactions are carried out for cash.

The opening balance sheet is simple. It shows a single asset of $20,000 that is represented by capital of the same amount.

The profit and loss account highlights are:

• sales of $30,000
• total costs of $27,000
• profit of $3,000.

The closing balance sheet shows a cash figure of $8,000. The company started with no cash and ended up with $8,000, but the profit was only $3,000. How can this be?

We run down through the items of cost and find that the depreciation charge is $5,000. No cash was paid out under this heading. The trading cash receipts were $30,000 and the trading cash costs were $22,000. Therefore the net cash from trading was $8,000. However from this net cash we must deduct depreciation to give the profit of $3,000.

Therefore it is simply a convenient shortcut to arrive at cash flow by adding back depreciation to profit.

An interesting aspect of the depreciation effect is that certain types of companies can suffer serious trading losses without suffering from cash shortages. These are companies where depreciation is a big percentage of total cost, e.g. transportation or utility companies. So long as losses are less than the depreciation charged in the accounts, their operations are cash positive.

Non-operating cash outflows

In Figures 7.1 and 7.2 we saw cash flowing round in a closed circuit. If there were no leaks from this circuit, there would be few problems. However, this is not the case and we must now add further sections to the diagram to allow for cash outflows that are not related to day-to-day operations.

In Figure 7.4 the principal additional outflows are shown as:

• interest, tax and dividends
• loan repayments
• capital expenditure.

We will discuss each in turn.

Interest, tax and dividends

Interest, tax and dividends are deducted from EBIT in the ‘profit and loss account’. They represent a distribution of most of the profit earned for the period. Possibly 75% of the profit in any year goes out under these headings, to leave approximately 25% that is permanently retained in the business.

Cash flow should remain positive even after these charges. Furthermore, as regards timing, the profit is usually realised in cash well ahead of these outflows. So this first set of payments should not, of themselves, be a cause of cash embarrassment.

Loan repayments

Loan repayments (as opposed to interest payments on loans) can be substantial in amount. They are also deducted from after-tax income and are in no way connected with the profit for the period. Therefore they can give rise to heavily negative cash positions. However, the amounts required are known well in advance and, in most situations, can be planned and provided for.

Capital expenditure

Capital expenditure is nearly always a matter of policy. It can probably be deferred in unfavourable circumstances. It is subjected to much thought, analysis and planning. Nevertheless heavy expenditure on projects that do not perform to plan is one of the major causes of cash difficulties.

Non-operating cash inflows

In Figure 7.5, the right-hand final branch of the diagram has been completed.

Three sources of cash from external sources are shown feeding into the cash reservoir. These are:

• new equity capital
• new long-term loans
• sale of fixed assets.

In many parts of the world a fourth source of cash is available in the form of grants from government to stimulate investment and employment. This has been ignored here for simplicity.

New equity capital and new long-term loans are the two principal sources of long-term finance to a company. In comparing these sources we must give attention to the following three matters:

• cost
• risk
• control.

New equity capital

It is a function of the stock market (or stock exchange) to raise funds for commercial enterprises. A constant stream of public companies go to the stock market to raise cash from the general public or from financial institutions.

The great advantage of equity capital is that it is permanent and it carries no risk to the company. However, it is high-cost money and expensive in terms of control.

New long-term loans

Companies are continually repaying old debts and raising new ones. They must have long-term loan capital, but banks are structured to provide loans for relatively short fixed periods. Companies draw these down but they rarely eliminate them. They simply replace them with new loans.

However, each time a company goes looking for new funds it must prove itself to be credit worthy; it must show strong evidence that it can service both the interest and principal.

In many ways, debt has features that are the opposite of equity: it is less costly, it does not dilute control, but it brings extra risk.

Sale of fixed assets

This can be a last resort. However, it may be the only way out of a liquidity crisis. Indeed, sometimes it can be a very beneficial move even in a non-crisis situation.

Matching of short-term and long-term liquidity

When we look at a company’s liquidity position we must make a distinction between long-term and short-term sections of the balance sheet. Figure 7.6 shows the five-box balance sheet and highlights this distinction.

‘Current assets’ and ‘current liabilities’ both fall into the short-term area. The remaining three boxes – ‘owners’ funds’, ‘long-term loans’ and ‘fixed assets’ – occupy the long-term area.

A certain balance should exist between the long-term assets and funds on the one hand and the short-term assets and funds on the other. As a general rule, long-term assets in a company should be matched by corresponding long-term liabilities.

Alternative and contrasting positions

A balance sheet with its five boxes drawn to scale can highlight the profile of a company. By profile we mean the shape of the balance sheet in terms of the relative weight of each of the five boxes. These profiles are determined by the operating characteristics of the industrial sector in which a company operates.

Such profiles throw useful light on how a company will respond to certain conditions. Companies that are heavy in current assets will be adversely affected by an increase in the rate of inflation very quickly. Companies that have borrowed heavily are, of course, very responsive to changes in overall levels of interest rates.

Examples of two contrasting companies are shown in Figure 7.7. On the left we see the balance sheet outline of a company from the brewing sector. A very high percentage of the total assets are in the long-term investment area and there is a corresponding reliance on equity and long-term loans.