Profits are nice but cash flow is what lenders want

Even profitable companies run into trouble and knowing the ins and outs of your capital stream can help you withstand hard times.

Show me the greenbacks! Proper cash flow forecasting can help a company avoid cash shortages and distress scenarios.

"Show me the money!" shouted Tom Cruise in the film Jerry Maguire. On the other end of the line was a client with just one thing on his mind: cash. It seems everyone is shouting about cash these days. In March 2008, Lehman Brothers announced quarterly profits of US$489 million (Dh1.79 billion). Six months later the Wall Street firm filed for bankruptcy. In spite of four consecutive years of record-breaking profits, the firm ran out of cash. It could no longer do business. The end.

Profits are nice, but cash is what counts. Lenders and investors have seen too many profitable companies face a cash-flow crisis. Apart from Lehman, there were other banks, property developers and many other businesses that reported profits right up until their cash ran out. There are many legitimate ways that companies can report profits that never turn into cash. For example, rules permit "mark to market" accounting of assets such as property, shares, bonds and partnership investments.

Companies invest in assets at one price. At the end of the year, they determine the market price of those assets. If the price has gone up since the purchase date, the increase is considered profit. However, this profit never turns into cash until the asset is sold. There are only two prices that matter: the price you pay when you buy something and the price you accept when you sell it. The rest of the time, the market price only helps you make a decision: sell the asset; buy more; or do nothing. Until you sell, rising prices are just "paper profits". Lehman reported several billion dollars in paper profits over the years. We now know that the only papers that matter are the colourful ones that fit in your wallet.

Companies run out of cash for two basic reasons: In the most common scenario, the business stops generating enough cash to meet its expenses. Quite simply, cash outflow is greater than inflow. The causes may vary. Revenues may decline as customers postpone purchases. Profit margins may shrink as competition increases. Customers may not pay their bills on time, and some may not pay at all. The business may be burdened by the cost of facilities and employees that sit idle. Companies also run out of money when they fail to refinance their outstanding debt. For example, a bank may lend money to a company for a one-year term. The proceeds are then used to buy equipment. At the end of the year, the company must repay the bank, but the company no longer has the cash, it has a piece of equipment instead.

In normal times, banks would make a new loan by accepting the equipment as collateral. In tough times, all banks may refuse to lend. When that happens, the company has a tough choice: default or liquidate assets to raise enough cash to repay the loan. This is precisely what brought down Lehman. While cash flow is important, it is not straightforward. The best companies are not necessarily the ones with the most cash. From a cash flow perspective, the best companies are the ones that generate sustainable cash flows every month. They have enough cash to meet their needs, and they can easily raise more cash if the need arises. They use their cash effectively, investing in projects that will improve future cash flows. They return excess cash to their investors as dividends.

For your company, profit can be easy to figure out. Profit really is the bottom line on the income statement, and bigger is better. When sorting out who is strong and who is not in these times, however, profit is simply looking in the rear-view mirror. In contrast, cash flow forecasting is the key to anticipating the curves in the road ahead. Cash flow forecasting can be tricky. Rising sales, for example, can drain cash reserves. While waiting weeks or months for customer payments, a growing company needs to pay for its additional inventory, a larger sales force and perhaps even new production facilities. In the long run, increasing sales would lead to better cash flow, but in the short term a company can easily grow its way into a liquidity crisis.

There are other potential cash flow issues to consider. Customers may delay payments, and some of them may not pay at all. Suppliers may change your payment terms, requiring upfront payment or even cash in advance. Banks may pull credit lines. Machines and facilities may need to be replaced. These issues may have a minimal impact on profits, but they can make or break a company's cash position. Overconfident chief executives and finance chiefs may fail to realise how inadequate their cash cushion really is.

External stakeholders can use cash flow statements to test the quality of profits reported by management. While it is possible to play tricks to pump up profits, it is much harder to mask weaknesses in cash flow. The easiest game to play involves overstating inventory: add Dh1m in fake profits and show the amount as inventory, leaving the cash balance unchanged. Similar results would be achieved by abusing the mark to market rules to inflate the value of investments on the balance sheet, or by avoiding some necessary provisions and write-downs. Such omissions prevent shareholders from learning about uncollectable receivables, legal suit exposures and evidence that subsidiaries are worth a lot less than the amounts shown in the financial statements. With all of these tricks, exaggerated profits should raise warning flags if accompanied by weak operating cash flows.

Business leaders need to understand their cash flows. Whether you call them plans, budgets, forecasts or projections, executives must be able to predict how much cash they will have each month into the foreseeable future. They need to know where the cash will come from, where it will go, and what factors could impact cash flow. Proper cash flow forecasting has many benefits. At the most basic level, cash flow forecasting helps a company avoid cash shortages and distress scenarios. Without accurate cash flow information, a profits-only forecast will not reveal how much working capital a company needs, when major expenditures will be necessary, and when loans must be repaid.

Cash flow forecasts help executives understand financing needs and develop contingency plans if the company cannot raise outside capital. If a partial asset liquidation is necessary, cash flow analysis should prepare managers with the necessary information: what the assets are worth, which ones are liquid, how they will be sold and what a realistic timeline will be. A keen understanding of cash flow projections prepares management to take advantage of opportunities when they arise. There may be an unexpected chance to acquire a competitor, upgrade equipment, or open a new facility. Companies must be ready to act quickly. If the management team already understands the cash flows of the current business model, they won't be flying blind at these critical junctures.

It will be much easier to raise money if your firm has a detailed and accurate cash forecast. Once you allow prospective lenders to see all of the moving parts in your business model, they will perceive much less risk. Lenders look for capacity to repay. A proper cash forecast will make much more of an impact than vague promises. Lenders also focus on the character of management. Executives can demonstrate such integrity through a willingness to share cash flow forecasts that are transparent, accurate and conservative.

Show them why cash inflows will be more than outflows. Show them how your company will be able to repay its debts. Show them where the cash will come from. Show them why the risks are low. Show them what the backup plans are if the business hits a rough patch. Show them that you are committed to the company's success by risking your own cash alongside theirs. Show them that your management team has the ability to succeed and the integrity to report cash flow honestly, accurately, and completely.

Basically, show them the money. Steve Stanton and Michael Burgess are managing directors at Montgomery Woodrow, a management consulting firm specialising in chief financial officer and governance services, interim management and process improvement