This is a Forbes.com article written by Matt Garrett
We have all heard that statement, and it is true…sort of.
In a business, you cannot do anything without cash, well at least not for very long. However, the truth is that cash follows profits. Cash can be put in a company through a loan, investment, deposit on a sale or contribution by the owner. However, all of these types of cash inflows are dangerous. That’s because they come with strings attached and represent money that is eventually going back to the bank, investor, owner or customer.
The only cash that you can use without strings attached – meaning one where the source will not want it back plus more – comes from profits. As part of my Triple Bottom Line, this type of money is determined by calculating yourNet Cash from Operations. The figure measures your company’s ability to generate cash from profits, and, when paired with the other components of the Triple Bottom Line – Net Operating Income and Net Equity –will tell you everything you need to know to operate a business with health and efficiency.
The formula for calculating Net Cash from Operations is relatively simple. Take your Net Income and subtract out cash you did not collect from customers during that period of time. Add back the cash you were able to keep by pushing out scheduled payments to vendors and suppliers during that same period of time. Because cash comes in from collections and cash goes down when you pay people, net cash from operations measures how effective a business is at making a profit, collecting from customers, and pushing out vendors and suppliers.
= Net Cash from Operations
Take ABC Electric as an example. In month one of operations ABC makes a profit, but it does not collect from its customers for 30 days; pretty typical of this kind of business. ABC incurred expenses for wiring and tools. Also, in performing its work, it received invoices from other vendors. In month one, although ABC made a profit, it did not collect any cash, but didn’t spend any cash either.
In month two, ABC should collect the cash from the work, and pay the vendors and suppliers. Because it made a profit in month one, the amount it collects will be greater than the amount it spends.
This is positive Net Cash from Operations, and it’s a good thing. It shows that ABC worked for good customers and paid its vendors on a reasonable schedule.
But what happens if it does not collect all of the money? What happens if the amount of cash it pays out to vendors and suppliers is greater than the amount of cash it collects?
In that case, Net Cash from Operations will be negative. This is a bad thing and clearly means one of two things. The worse possible answer is that ABC worked for a bad customer and is not getting paid. The other possible answer is that ABC has not been diligent about getting paid and is inefficient in its operations.
Either way, if Net Cash from Operations is positive, we are doing well. If, however; net cash from operations is negative, we have to look closely at our operations and our customers. But unlike traditional statement of cash flows, this calculation can help you pinpoint where the fault lies so it can be fixed. And knowing the problem is half the battle.
This article originally ran on Entrepreneur.com on 08/14/2013: http://www.forbes.com/sites/matthewgarrett/2013/08/14/cash-is-king-sort-of/ For more Forbes.com articles written by Matt Garrett, visit this link: http://www.forbes.com/sites/matthewgarrett/