There are hundreds, maybe thousands, of ways to measure the health of your business, but there’s only one way that cuts through the clutter to get to the heart of what is going on: CASH!
I remember one point in my career when I figured out my tough and streetwise client who had built his business from nothing understood this far better than I did. I thought I was a smart CPA, dutifully preparing his balance sheet and income statement each month. Meanwhile, he was looking through the lens of reality, “I’ve got this much coming in and this much going out”, he said. My client was projecting what was going on in cash. His method was better than mine for determining financial health at that moment as well as where they were headed in the short-term. He never called me on it, and I’m not sure whether he realized I missed something. But, I never forgot it and it has since been the most important financial metric I use to evaluate every business.
Here are a couple of terms used to measure businesses that can often distract and confuse if you don’t understand them:
Sales. Sales are not necessarily cash. If you decide to hire me and I complete the work, the “sale” should be booked. But, that doesn’t necessarily mean you paid me—in cash. I worked with a company that continually focused on sales as a measurement of success. What was the problem? They also extended very favorable payment terms to too many of their customers and had high inventory holding costs and slow turnover. This is a combination that can be deadly to a business. You can actually “sell” yourself into bankruptcy if you fail to manage your cash-burning inventory effectively, particularly if you have bank debt payments to make.
EBITDA. For the non-financial gurus reading this, EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. So, what the heck does this mean? This is how I would put it: EBITDA is “Earnings”, which consist of Sales (that are probably not Cash in) less Expenses (that are probably not Cash out) BEFORE (that is, NOT INCLUDING): Interest expense, income Taxes, Depreciation, and Amortization. Banks and Wall Street analysts love EBITDA—a high EBITDA gets them to jump out of their chairs. I don’t know why—it’s WORTHLESS. Why? Interest expense is a huge cash cost for a company carrying debt. Income taxes can run as high as 40% or more for a successful business and must be paid—in cash. Depreciation and Amortization are simply fancy terms for allocating real cash costs of buying equipment, buildings, and even non-tangible items like trademarks. These can be LARGE cash costs, particularly for a capital-intensive company like a manufacturer, builder, and many others. There are also 2 other MAJOR drains on cash not addressed by EBITDA–working capital and debt service principal payments. Working capital is simply the cash your business needs to survive while it waits for inventory to turn over and receivables to be collected. Depending on your type of business, working capital needs can require months of available cash. Debt service principal payments? Yes, the bank wants the interest AND the principal. EBITDA ignores this issue.
And if you don’t want to listen to me about whether EBITDA is an inflated and over-hyped metric, take a look at a quote from Charlie Munger: “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” Forbes Charlie Munger on EBITDA Who is Charlie Munger? He’s the right-hand man to the most successful investor in the history of the planet and world’s 3rd richest person, Warren Buffet. When Warren or Charlie speak, I tend to listen a little harder.
If you are not currently, I’d recommend you make the Cash Flow statement or something similar the most important financial metric you monitor daily, monthly, and yearly. The Cash Flow statement is the undisputed king. You also need to carefully monitor the Balance Sheet and Income Statement (neither discussed today) to help you manage your business’s finances. Don’t know what any of this means? That’s OK but please talk to someone who does. Please don’t be afraid to contact me here or a good CPA in your area.
And, as always, introductory business reviews with me are always free and yield more than enough in Cash and Hours to pay for your time. No obligation to you.
See you again soon,