1. cash flow part 1 - income vs cash

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7/30/2019 1. Cash Flow Part 1 - Income vs Cash http://slidepdf.com/reader/full/1-cash-flow-part-1-income-vs-cash 1/3 B AYSHORE  M  A  A  N  N AGE MEN  NT P ARTN  NERS 192 Marina Drive, Long Beach, CA 90803 P: 562-427-4371 F: 562-430-0712 [email protected]  Cash Flow Part 1 – Income vs. Cash By Howard Fletcher January 15, 2007 Why is it important to understand, manage and forecast cash flow? Cash is the facilitator of value. All investment and financing decisions must focus on cash and the future value of cash. If revenue is the food that feeds the company, cash is the lifeblood that keeps the company alive. Cash can be consumed or traded for other assets of productive value. Cash pays the bills. Insufficient cash flow can result in business failure even when sales are increasing and the company is showing a profit. Nowhere is this more relevant than in a startup or small business. Yet many small businesses fail because their owners do not understand the fundamental difference between income and cash flow or the importance of managing and forecasting cash. Let’s start with the basics. Income versus Cash Flow - Income is an accounting measurement of profit. Accountants measure profitability as the difference between revenue and expense, return on assets, return on investment and return on equity. Accountants distinguish between expenditure and expense with the former being cash out the door and the latter being an accounting entry. Expenditures may or may not be expenses at the time they are incurred, and expenses may or may not be expenditures at the time the entries are made. Accountants also measure several kinds of accounting profit. These are: 1) Gross profit – the amount by which revenue exceeds cost of revenue; 2) Operating  profit – the amount by which gross profit exceeds operating expenses; 3) Pre-tax profit – profit  before the accrual for taxes; and 4) Net profit – the amount of revenue left over after all expenses and taxes. Cash Flow is economic income, or sometimes called management income. Managers define economic income as the difference between cash income and all cash outlays whether they are expenditures or expenses. Managers are concerned with free cash flow and measure profitability in terms of the present value of future free cash flow minus the current investment required to  produce it. Managers must quantify risk in their calculation of profitability where accountants do not take risk into consideration when calculating profitability. Managers understand that the bills are paid with cash, not accounting profit. The following exercise illustrates the difference  between income and cash flow. Example John started ABC Big Screen Display Company to sell large screen Plasma and LCD displays in Los Angeles. The initial equity investment was $5,000,000. Surplus cash was invested in short term instruments bearing 2.0% interest. Because ABC was a new business it could not get a credit line to finance its accounts receivable. ABC inventory was carried on consignment by the manufacturers and ABC had to pay for it at the time it was sold. ABC revenue was $2,000,000 in the first year and sales grew by 25% each year. Because retail electronics is a very competitive business the ABC gross margin was only 20%. In order to be competitive with the big retailers ABC offered its customers 60 month financing, 24 months with

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7/30/2019 1. Cash Flow Part 1 - Income vs Cash

http://slidepdf.com/reader/full/1-cash-flow-part-1-income-vs-cash 1/3

BB A  A YYSSHHOOR R EE M  M  A  A  N N A  A GGEE M  M EE N NTT PP A  A R R TT N NEER R SS 

192 Marina Drive, Long Beach, CA 90803P: 562-427-4371 F: 562-430-0712

[email protected] 

Cash Flow Part 1 – Income vs. Cash

By Howard Fletcher January 15, 2007

Why is it important to understand, manage and forecast cash flow? Cash is the facilitator of value. All investment and financing decisions must focus on cash and the future value of cash. If revenue is the food that feeds the company, cash is the lifeblood that keeps the company alive.Cash can be consumed or traded for other assets of productive value. Cash pays the bills.Insufficient cash flow can result in business failure even when sales are increasing and thecompany is showing a profit. Nowhere is this more relevant than in a startup or small business.Yet many small businesses fail because their owners do not understand the fundamentaldifference between income and cash flow or the importance of managing and forecasting cash.Let’s start with the basics.

Income versus Cash Flow - Income is an accounting measurement of profit. Accountantsmeasure profitability as the difference between revenue and expense, return on assets, return oninvestment and return on equity. Accountants distinguish between expenditure and expense withthe former being cash out the door and the latter being an accounting entry. Expenditures may or may not be expenses at the time they are incurred, and expenses may or may not be expendituresat the time the entries are made. Accountants also measure several kinds of accounting profit.These are: 1) Gross profit – the amount by which revenue exceeds cost of revenue; 2) Operating profit – the amount by which gross profit exceeds operating expenses; 3) Pre-tax profit – profit before the accrual for taxes; and 4) Net profit – the amount of revenue left over after all expensesand taxes.

Cash Flow is economic income, or sometimes called management income. Managers defineeconomic income as the difference between cash income and all cash outlays whether they areexpenditures or expenses. Managers are concerned with free cash flow and measure profitabilityin terms of the present value of future free cash flow minus the current investment required to produce it. Managers must quantify risk in their calculation of profitability where accountants donot take risk into consideration when calculating profitability. Managers understand that the billsare paid with cash, not accounting profit. The following exercise illustrates the difference between income and cash flow.

Example

John started ABC Big Screen Display Company to sell large screen Plasma and LCD displays in

Los Angeles. The initial equity investment was $5,000,000. Surplus cash was invested in shortterm instruments bearing 2.0% interest. Because ABC was a new business it could not get acredit line to finance its accounts receivable. ABC inventory was carried on consignment by themanufacturers and ABC had to pay for it at the time it was sold.

ABC revenue was $2,000,000 in the first year and sales grew by 25% each year. Because retailelectronics is a very competitive business the ABC gross margin was only 20%. In order to becompetitive with the big retailers ABC offered its customers 60 month financing, 24 months with

7/30/2019 1. Cash Flow Part 1 - Income vs Cash

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BB A  A YYSSHHOOR R EE M  M  A  A  N N A  A GGEE M  M EE N NTT PP A  A R R TT N NEER R SS 

192 Marina Drive, Long Beach, CA 90803P: 562-427-4371 F: 562-430-0712

[email protected] no interest and no amortization followed by 36 months amortization bearing interest at 10%.Approximately 70% of the company’s sales were on these terms, the remainder being cash or credit card sales. ABC leased its premises, furniture, computers and phone system, so it had nodepreciation expense. Because of heavy sales, marketing and promotional costs ABC’s operating

expenses were 17.5% leaving an operating profit of only 2.5%. The combined profits tax inABC’s jurisdiction was 40%.

The profit and loss statement below show’s that ABC was able to generate a net profit in its firstyear and in each year thereafter. Ignoring whether or not the returns justified the investment, atleast ABC was able to earn a profit and survive. Right? Wrong! As the following two statementsshow, ABC earned a nice accounting profit but ran out of cash in year 4 because it did not earnan economic profit.

Accounting income (profit)ABC Big Screen Display Company

Income Statement

(000)  Year 1 Year 2 Year 3 Year 4 Year 5

Sales 2,000,000$ 2,500,000$ 3,125,000$ 3,906,250$ 4,882,813$

Cost of Sales 1,600,000 2,000,000 2,500,000 3,125,000 3,906,250 

Gross Profit 400,000 500,000 625,000 781,250 976,563 

Net Operating Expenses 350,000 437,500 546,875 683,594 854,492 

Operating Profit 50,000 62,500 78,125 97,656 122,070 

Interest Income/(Expense) 87,000 55,000 116,333 260,667 537,153 

Pre-tax Profit 137,000 117,500 194,458 358,323 659,223 

Tax 54,800 47,000 77,783 143,329 263,689 

Net Profit 82,200$ 70,500$ 116,675$ 214,994$ 395,534$

Ending Accounts Receivable 1,400,000 3,150,000 4,870,833 5,621,875 5,316,233 

If we look at the cash flow statement below we see that ABC had a cash deficit in each year 

 beginning in year 1 due to increased working capital requirements and ran out of cash in year 4. Now this example may be a bit unrealistic in that ABC surely could have found a way to financeits receivables. But it illustrates the point that income is not the same as cash flow.

Economic income (cash flow)

7/30/2019 1. Cash Flow Part 1 - Income vs Cash

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BB A  A YYSSHHOOR R EE M  M  A  A  N N A  A GGEE M  M EE N NTT PP A  A R R TT N NEER R SS 

192 Marina Drive, Long Beach, CA 90803P: 562-427-4371 F: 562-430-0712

[email protected] ABC Big Screen Display Company

Cash Flow Statement

(000)  Year 1 Year 2 Year 3 Year 4 Year 5

Net Profit 82,200$ 70,500$ 116,675$ 214,994$ 395,534$

Increase in Accounts Receivable 1,400,000 1,750,000 1,720,833 751,042 (305,642) 

Net Cash Flow (1,317,800) (1,679,500) (1,604,158) (536,048) 701,176 

Beginning Cash 5,000,000 3,682,200 2,002,700 398,542 (137,506) 

Ending Cash 3,682,200$ 2,002,700$ 398,542$ (137,506)$ 563,670$

The ABC example also shows in a simplified manner why it is important to forecast and manage

cash. It is necessary to ensure adequate cash is available to fund day to day commitments, capitalexpenditures and growth. It also points out that surplus cash earns interest while cash shortfallsmust be met with borrowing that costs interest. The next article will deal with sources and usesof funds and how that impacts cash flow.

Howard Fletcher is the principal owner of Bayshore Management Partners. As an author, speaker,consultant and mentor, Mr. Fletcher has helped many senior executives and business ownersreinvigorate their personal growth, increase their self-satisfaction, improve their quality of life and taketheir businesses to new levels of success. Mr. Fletcher has been CEO of four companies, COO of threeothers, consultant to others and the owner of a small manufacturing company. He has been a senior executive of a major international corporation and non-executive director of numerous for-profit and not-for-profit organizations. He is a founding partner of Stronghold Capital Partners, a private intermediary

based in Scottsdale, Arizona. Mr. Fletcher has lived, worked and traveled extensively overseas as acorporate finance professional and he is a keen observer of global political, economic and financialtrends. Mr. Fletcher has a Masters Degree in International Management and a Bachelors Degree inFinance, both from the University of Southern California. He is also a graduate of the Stanford UniversityExecutive Management Program. He is an Accredited Associate of the Institute for Independent Businessand he holds four active securities licenses.