Cash Flow: Essential, powerful and devastating

We would like to start with a statement that we never tire of using, and which is often repeated by colleagues involved in corporate finance: Companies are born and die by the cash register. The meaning of this phrase is clear, but the most important thing is that it shows us the importance of cash flow and its impact (essential, powerful and devastating) for any company.

For example, at the time of valuing a company, an important fact to take into account regardless of its willingness, becomes as a main point the company’s cash generation capacity. It should be noted that a company with a negative EBITDA and a negative cash position might have a high value because of its future cash generation potential (in addition to other variables that also affect the value of a company such as the team, the product, the potential of the project, etc.).

EBITDA (acronym for Earnings Before Interest Taxes Depreciation and Amortization) is a financial indicator that shows the company’s profit before subtracting interest payable on debt incurred, business taxes, depreciation due to impairment and amortization of investments made. The purpose of EBITDA is to get a true picture of what the company is earning or losing at the core of the business. Although it is not part of a company’s income statement, EBITDA is a ratio that lets you know quickly and easily whether your business is profitable or not, as it represents the gross operating profit calculated before the deduction of financial expenses.

In general, and taking into account that companies always go through different moments in terms of financing and business projects, the objective should be to achieve positive and sustained cash generation.

To achieve this objective, or at least get close to it, we have to apply measures and compare different ratios, since it is important to have a scorecard that allows us to optimize decision making. Despite this fact, it is always necessary to analyze other factors, since the result of certain ratios alone can lead us to errors, being fundamental to take into account the type of business, the seasonality and the sector in which the company is located. As we have discussed in previous content, the times in which the company is located play an important role. There are times of growth when working capital needs increase and are very important, since the increase in purchases, stocks, production and subcontracts derived from the increase in sales must be prefinanced; and times of contraction, when the reduction in business volume leads to lower sales, which implies less availability to finance a business that requires longer financing terms.

Therefore, the most relevant factor in cash generation is working capital. This is what some banking institutions want to cover when they offer products whose objective is to « provide solutions for anticipating collections, overcoming unforeseen events, purchasing inventory, matching cash flows and any other short-term financing requirements».

To understand how a company’s working capital works, the following chart from Jonathan Berk’s Fundamentals of Corporate Finance provides a complete representation of the cash cycle:

As the example shows (in this case in an industrial-based company), the flow of the operating cycle begins when the company purchases the product (“inventory” in the example in the graph) and ends when payment is received from the end customer.

The objective of any company is to minimize as much as possible the period between the purchase of raw materials (or operating expenses also in the case of services) and the moment of final payment.

To minimize this period there are two basic concepts that we must master:

• Payable days (“accounts payable” in the chart): Days elapsed between the time we purchase the material and the time we pay the material supplier.
• Receivable days (“accounts receivable” in the chart): Days that elapse between the time we sell a product and the time we actually are paid by the end customer.

Here are some real examples that always help us to contextualize situations such as the one we are describing.

As has been confirmed by several newspapers in the country, large companies in our environment have exceeded for several years (continuously) the limits established at a legal level with respect to the days of payment to their suppliers. This fact causes that, companies like these, can be self-financing because they have a very long payment period and a collection period of 0 days, since the clients pay instantly in the establishment. In other words, and following the graph, in the case of the examples, they reach the point of being paid before the final customers than paying their suppliers for the same product; therefore, they have a very important advantage in terms of cash generation.

At the other extreme (in terms of negativity) are the suppliers to these companies, who spend heavily on materials and personnel to produce the products they sell to these companies and do not get paid for several months. Since this cash conversion cycle is too long, it often results in these companies (even if they generate a high volume of sales) having to close, because they cannot withstand the financing period between the time they generate the expense and the time they receive the income. The longer these periods are, the more financing (via loans or credit facilities) the company will need.

It could be said that the optimum point would be to extend as much as possible the payment days and minimize the collection days, since in this way we would be stretching the payment to our suppliers and anticipating the collection by our customers.

From ST strategy, as we advise our clients, we recommend not stretching the payment period too much, since we have to maintain a good relationship with our suppliers, regardless of the strength or negotiating capacity we have over them, because in a time of crisis like the current one we will need them by our side. (As stated in the blog above).

The aforementioned periods refer to the payment and collection relationship with external agents in our operating cycle (suppliers and customers), but we also have to fight the flow with ourselves, since the greater the company’s volume, the greater the need for financing will be if we do not change the aforementioned periods. This temporary fight with ourselves is what we know as change in working capital (change in working capital).

We always recommend that the company analyze the difference between collection days and payment days on a daily, monthly or annual basis, since the change from one moment to another is what really tells us what our cash generation capacity or financing needs are. This temporal analysis is very relevant to know in what situation the company is in at any given moment, but also to analyze the seasonal periods when the need for financing is higher.

The mastery of periods and technical concepts are basic to understand the dynamics and analyze situations with the necessary knowledge to find the right solutions, but the human factor is also important in all business decisions.

The focus on people is paramount in our team, but also with the relationship, we have with our suppliers and customers, since, in crisis situations, the most fragile and smallest companies have only been able to survive by helping each other based on the relationships established over the years. Therefore, we would like to emphasize that the best asset of the company is the team that makes it up and the way it relates to its agents.