Cash flow: management pointers.

Managers often fool themselves when it comes to cash-flow management. Cash flow is not depreciation added to the bottom line of an income statement. Nor is cash-flow management looking at the balance of cash in the bank and developing a picture of how much cash will be there next month based on net income this month.

Surprisingly, an FMI survey of 50 Florida contractors indicated that only 43% forecast cash. That should not shock anyone because only 41% of those same managers said owners of their companies think that forecasting cash is important.

Seventy percent of companies with revenues greater than $50 million forecast cash. The percentage declines as companies become smaller, to the point where only 25% of companies with revenues of $10 million or less forecast cash.

Consequences of not forecasting cash

Management looks to income statements as barometers of a company's financial well-being. Additionally, an income statement budget for the next year sets goals for revenue and profitability by providing a benchmark for performance. However, income statements and budgets do not provide management with information on issues that affect cash flows, such as the collection of receivables or the adequacy of cash flows to cover debt repayments or equipment purchases. These issues can sometimes translate into dramatic differences between profits and cash flows.

Managing a company by looking at past profitability is reactive; managers can be proactive if they look at what lies ahead. One item that can help them is a cash forecast.

The term "cash flow from operations" is the cash flow generated by the business before asset purchases (e.g., equipment and vehicles) and debt repayment. After five or more years, cash flows from operations should generally approximate net income before depreciation, if the company accurately reports financial data. This does not hold true if a company uses aggressive accounting policies to inflate profits. Likewise, a company that is unable to collect its accounts receivable will report higher profits than cash flows. In most cases where construction companies are involved in a turnaround, net income has been much greater than cash flows for several years. Most companies that end up in financial trouble displayed warning signs years ago with trends in declining cash flows and its growing dissimilarity to net income.

Cash flows as an indicator of financial well-being

For a company in decline, cash flows lead profits. That means management of a construction company can manipulate the numbers on an income statement to get a figure that pleases banks and sureties. Arthur Levitt, the chairman of the Securities and Exchange Commission, referred to it as "earnings management" in a recent speech. "Earnings management" occurs when "earnings reports reflect the desires of management rather than the underlying financial performance of the company."

Studies have shown that cash flows from operations are a better predictor of financial well-being than income statements because it is much harder to manipulate cash flows. In fact, when comparing healthy companies to those involved in a turnaround, financially sound companies tend to have a ratio of net income (excluding depreciation) to cash flows from operations that are very close to 1 to 1 over a five-year time period. Companies in financial trouble tend to have a high ratio of net income (excluding depreciation) to cash flows from operations. One possible explanation is that they use aggressive accounting policies to inflate net income to attempt to hide their problems.

For example, one company reported net income over a five-year period of several million dollars. Yet, cash flow over that period was less than $9,000. The ratio of net income (before depreciation) to cash flows from operations over a five-year period was 293 to i instead of i to 1. A recent turnaround client had a ratio as low as 2.7 to 1. This simple ratio was an indicator warning management of financial trouble for years. However, no one at the company noticed this because they focused on net income as a barometer of financial well-being.

With most companies that inflate performance on jobs for their income statement, cash flows decline before a corresponding decline in net income [ILLUSTRATION FOR FIGURE 1 OMITTED].

Anyone can manipulate an income statement. In tough times, controllers and chief financial officers are told to "pull out all the stops" to raise net income on the financial statements. Estimates of the potential collection of unapproved change orders or optimistic forecasts of final job costs are two examples. Cash flows are more difficult to manipulate.

Do's and Don'ts

There are many simple things contractors can do to impact cash flow. FMI frequently recommends clients use a report card. The report card helps them focus on important issues that increase cash flow by setting standards or targets. Without a mechanism to tell management how well they are performing in areas that affect cash flow, some areas tend to be overlooked.

The following are some "do's" and "don'ts" you can use to manage your company effectively. Cash flow in the definitions below is cash generated by company operations before debt repayment and capital item purchases, such as equipment and vehicles.

Do's

1. Calculate actual cash flows monthly. Report cash flows on a complete basis by month for the past 12 months and by year for the past five years to show cash-flow trends.

2. Set goals for areas that affect improving cash flow. Examples are:

A. Receivables should average fewer than 40 days old. (A focused effort on reducing receivables helps cash flow.)

B. Costs plus margin in excess of billings (also known as underbillings) should be no greater than $x,xxx,xxx. (Underbillings are similar to receivables.)

3. Develop and monitor your financial statistics that help you determine the adequacy and efficiency of cash flow. Examples, in addition to the average age of receivables described above, include:

A. Cash Flow Return on Assets: [Cash Flow/Total Assets = Cash Return on Assets Employed].

B. Cash Flow Adequacy: [Cash Flow/{Debt Paid + Asset Purchases + Dividends Paid} = A

Measurement of the Ability of the Company to Generate Cash Sufficient to Pay Debts and Reinvest in its Operations]. A value of 1 or greater shows an ability to cover these cash requirements.

C. Free Cash Flow: [Cash Flow - Purchase of Equipment and Other Fixed Assets = The Cash Flow Available to Pay Debts and Dividends].

D. Reinvestment: [Purchase of Fixed Assets/Cash Flow = The Percent of Cash Flow Used to Acquire Equipment, Vehicles and Other Such Assets].

E. Financial Statement Accuracy: [Net Income After Taxes + Depreciation + Amortization}/Cash Flow = A Ratio That Should Average About 1 to 1 Over a Period of Five Years or More].

Note: There may be other issues similar to depreciation that have no cash influence and should be added to net income.

4. Invest excess cash. The easiest way to make money is to take a little time to invest cash you do not need right now. Talk to your banker, who is more than happy to take cash off your hands.

5. Look into cash-management programs your bank offers, such as lock boxes and zero-balance accounts. Activities that speed up cash collections or that automatically invest idle cash are easy ways to improve cash flow.

Don'ts

1. Don't take net income and add depreciation thinking you have the answer about cash flow. Most likely, you will be wrong.

2. Don't think you don't need goals. When you establish goals, you provide focus to problem resolution. Otherwise, less-than-adequate attention is devoted to supporting a tremendously important function within the company.

3. Don't leave excess cash sitting on the balance sheet. This is the easiest way to make money in the whole contracting business.