 The Four Forces of Cash Flow
How to Manage Your Profit Accordingly
by Greg Crabtree
For small, independently owned AM retailers, the problem with cash flow is that it lags behind profit. Unless your customers pay you and you pay your vendors at exactly the same moment, there will always be a time lag. But, if you understand the correct order of priority for cash flow, you will avoid the disconnect.
If you are profitable, you must understand that there are four forces that demand satisfaction out of your cash flow. Here they are. I assume they are in the opposite order of what you’d prefer.
1. Taxes: You must either set aside money or pay chunks of taxes as you go to avoid the April surprise (or October surprise if you extend how long you stick your head in the sand).
2. Debt: Lines of credit are crack cocaine for entrepreneurs. Get off the drug as soon as you can.
3. Core Capital: Retain after-tax profits until you reach your core capital target, which is generally defined as two months of operating costs in cash with nothing drawn on the line of credit and your anticipated taxes set aside.
4. Distributions: Reap your reward and finally take after-tax profits to diversify your wealth outside of the business.
Taxes
If you did not pay any taxes, you either didn’t make any money or you cheated. Both are bad. The biggest hindrance to paying taxes is the complexity of the tax code; the second-biggest is not planning to set aside cash for paying the taxes. That is why you should monitor your profitability each quarter and determine how much to set aside or pay in, depending on the rules.
Try to pay only what is required at the last possible moment to prevent having to pay a penalty. It means you have to know to set taxes aside as profit is earned. Get your tax advisor to do this for you each quarter – it will be worth it.
Debt
Managing debt poorly has killed many good businesses. Like a drug, it allows you to postpone the hard decisions too long before you are forced to make them. I do not recommend funding losses with line-of-credit financing. It is okay to use lines of credit to fund profitable growth, but the moment you use a line to cover a monthly loss, you have started down a path that too often ends badly. Make the hard decisions sooner.
The other point about debt is knowing that you can only repay it with after-tax profits, with very few exceptions. It comes as a shock to most entrepreneurs who have a great year and think they can use 100 percent of all their pre-tax income to pay off debt.
As for term debt, only use it when you are purchasing a necessary asset and the payments truly reflect the cost of using that asset over its useful life.
Core capital
Your store may be profitable, but if you are pulling all of your cash out of it for the wrong reasons, you will find the cow out of milk when a downturn happens. The deepest down stroke in operating cash flows for most businesses is equal to two months of operating expenses. I recommend setting the core capital “target” at two months of operating expenses in cash, in addition to owing nothing on the line of credit and setting aside any tax amount currently due. You may want to set the target higher, but you would never set it lower.
Distributions
Once you have taken care of the first three cash-flow forces, you get to enjoy the fruits of your labor. To diversify your wealth, you can now use those after-tax profits that the business does not need.
Notice I said diversify, not consume. Unless you have multiple sources of income beyond your needs, the moment you are looking to the profits of your business to meet your consumption needs, you have headed down a slippery slope. This is why it is important to pay yourself a market-based wage for the “job” you do in your business and live off your salary. When your business has profits to distribute, you should first use it to eliminate personal debt and then to build assets outside of the business.
In summary, once you are profitable, it is taxes, debt and core capital before you can have a distribution. It’s a great formula for building lasting wealth from your entrepreneurial efforts, and keeping your cash cow healthy for years to come.
Greg Crabtree, founder of CPA firm Crabtree, Rowe & Berger, PC, has worked in the financial industry for more than 30 years. In addition to serving as the firm’s CEO, Crabtree leads the business consulting team, helping clients align their financial goals with their profit model and their core business values. He is the author of Simple Numbers, Straight Talk, Big Profits! For more information, visit www.seeingbeyondnumbers.com.
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