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How to Flatten the Slippery Slope of Poor Cash Management

Updated: Sep 27, 2021

A profitable business must generate cash to survive. But what is the difference between operating profit and operating cash and why are some businesses unable to convert profit into cash?

Good v Poor Cash Management

Firstly, let’s look at two waterfall charts that step through how operating profit converts to operating cash.

The first chart represents the slippery slope of poor cash management. The business has made an operating profit of $1,000 yet has only managed to convert this profit to $390 of operating cash.

The second chart demonstrates how good cash management practices can deliver $1,030 of operating cash from the same $1,000 operating profit.

There are four ways in which cash has been better managed in the second chart compared to the first. We shall consider other strategies later.

  1. receivables have been collected quicker

  2. suppliers have been paid later

  3. non-essential fixed asset purchases have been avoided

  4. tax instalments have been reduced in line with an updated forecast

Operating Profit v Operating Cash

The difference between operating profit and operating cash is one of timing and over a longer period the two metrics should converge. But the timing of cashflows is important, and if not managed well, can be the difference between survival and insolvency. If a business is unable to meet its liabilities as they fall due, it is not a going concern and eventually must cease to trade.

Timing differences generally arise where accounting principles require income and expenses to be recognized in the profit and loss statement before they are realized as cash.

The accruals basis of accounting is the principle which explains most timing differences. It requires revenue to be recognized in operating profit once a product or service has been delivered rather than paid. In other words, reported revenue includes both paid and unpaid sales. By contrast, operating cash only includes paid sales.

As receivables are collected in the normal course of business, unpaid sales are converted to cash meaning reported revenue and cash inflows should converge over a longer timeframe. Though poor credit control could cause receivables continue to grow at a faster rate than sales creating a wider unfavourable divergence between profit and cash.

The accruals basis of accounting also requires expenses be recognized in the profit and loss account when a product or service has been consumed rather than when it is paid. Leveraging supplier credit terms gives rise to a positive cashflow impact by deferring the outflow of cash.

Depreciation Is a Non-Cash Item

Depreciation is another accounting concept that gives rise to a timing difference between operating profit and operating cash. When a business buys a fixed asset e.g. computer hardware, there is an upfront cash outflow. However, for accounting purposes, the cost is expensed to operating profit incrementally over the life of the asset which is usually at least three years. This expense is called depreciation and is a non-cash charge because it does not result in a cash outflow.

To see the true cash picture, depreciation is added back and thereby removed from operating profit and is replaced by the cash outflow arising from fixed assets purchased in the year. Both waterfall charts above include a depreciation add-back and a cash outflow for fixed asset purchases.

Consider an example of an asset purchased for $10,000 on 1st January, Year 1 and depreciated over its useful life of four years. Over the four year period, the impact on operating profit and operating cash is the same although timing differences arise in each of the four years.

Working Capital and the Cash Cycle Timeline

Receivables and payables are two components of working capital. Another is inventory. Effective working capital management is a critical tool for improving operating cash flows. A business needs to minimize cash trapped in receivables and inventory. It should negotiate favourable payment terms with suppliers to reduce the time lag between paying a supplier and collecting from a customer.

In the following example of a typical cash cycle timeline, there is a 65-day lag between paying for the purchase of goods and collecting the subsequent sale proceeds from a customer. That’s two monthly payrolls that need to be funded in the interim period.

Effective Strategies to Improve Cash Management

Management should build a cash management strategy based on the most effective levers for their business. The following table includes some common levers, though every business is different.

The Final Word

To summarize, operating profit and operating cash are calculated according to different principles but should converge over a longer timeframe.

There are a variety of levers which can drastically improve operating cash and these include effective working capital management, a robust capex approval policy and embedding rigorous profit and cash flow forecasting.

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