Optimizing your cash flow during the downturn Alan Miltz Founding Director Inmatrix

Objectives How to conduct a financial health check How the banks would review your performance Techniques used by the best global companies to measure financial performance

Who am I? 12 years ago I co-founded Inmatrix. We developed Optimist as a standard communication between Accountants, Banks & Companies. Optimist A C B 3

A C B Optimist 22 Countries +1500 Accountants ‘000s of Companies +200 Banks

Gary’s Furniture We are going to use a case study based on a company Gary’s Furniture. Gary’s Furniture was founded in 2001 Gary is a furniture importer and manufacturer and distributes to 500 stores including majors and independents Gary believes he is doing fantastically B-91

Gary’s Furniture

Gary’s Furniture On a scale of 1 to 10 how would you rate Gary's Furniture’s financial performance? On a Scale of 1 to 10 how do you think the Bank rates Gary's Furniture’s financial performance? What is Gary's cash flow for 2009?

The funnel analogy

Your company’s strategy Does your strategy give you a sustainable competitive advantage? (SCA) Your SCA should be a filtering mechanism when considering new opportunities. ( i.e. Will the new opportunity add value to your SCA?)

How does finance measure your SCA? Profit? Revenue Growth? Cash Flow? Market Share? Return? Dividends?

How does finance measure your SCA? Profit Revenue Growth Cash Flow Market Share Return Dividends

How do your accounts enable you to calculate these measures? Profit Revenue Growth Cash Flow Market Share Return Dividends

The accounting equation – the balance sheet

The management accounting equation – the balance sheet All funding is moved to the left hand side of the equation

The management accounting equation – the balance sheet

The balance sheet Funding (E +ND) Operations NOA

The balance sheet Rearrange the accounts of Gary’s Furniture.

Gary’s Furniture

Gary’s Furniture

The management accounting equation – the balance sheet

(The Dupont Theory of Financial Analysis) Why go into business? R eturn On Capital Employed (ROCE) OR Return On Net Assets (RONA) ROCE = RONA (The Dupont Theory of Financial Analysis)

Financial analysis – the theory Return on Capital Employed or Return on Net Assets or ROCE = EBIT/Net Operating Assets OR X EBIT Revenue Net Operating Assets

EBIT NOA The ROCE equation As management it is mission critical that over time we ensure that our EBIT is growing at a faster rate than our investment in our Net Operating Assets. EBIT NOA

Optimizing Growth B C A D EBIT E NET ASSETS KEY POINTS Clear understanding of what the business is doing Which quadrant is the business in now, where is it heading and why? What are the opportunities for the business? What will the outcomes be for the business There are options and the answer is ‘it depends’ This provides a powerful partnership tool B Optimising growth? C Fast growth? A Declining Growth? D EBIT E Corporate stress? Re-engineering Working Investment? 24m 25m 26m 27m 28m 29m NET ASSETS

Business Positioning

What return should we be getting? D + E = NOA What is the cost of debt = after tax cost of borrowing What is the cost of equity = Rf + (Beta x Mp) What is the weighted average cost of capital (WACC)

Equity is the most expensive source of funding Have you ever tried to get equity funding? Approx 2 to 5% of companies are successful in attaining equity finance What does an investor look for?

Obtaining Equity Finance A Prospective Investor will look at: Management Opportunities Valuation Exit Strategy ROI Is your Company a MOVER?

How do I understand my SCA? Marketing Operations Innovation HR Finance What are the 3 critical success factors for each of the above?

Does your business have an SCA?

Take my business I founded 11 years ago

Plotting your Critical Success Factors

Plotting your Critical Success Factors

Plotting your Critical Success Factors

Techniques to improve your ROCE and Cash Flow Marketing Operations Innovation HR

Marketing – understanding your customers Most companies operate under the 80/20 rule – 80% of their customers account for 20% of the revenue.

Who do we want to work with? They want a relationship They don’t want a relationship 1 2 3 4 We want a relationship We don’t want a relationship

Blind spot? Known by others Unknown by others Common Knowledge Private Known to you Unknown to you

What do we do with the 3 and 4s? They want a relationship They don’t want a relationship 1 2 We want a relationship Increase price Enforce strict terms We don’t want a relationship

What do we do with the 1 and 2s? The goal is to identify your blind spots with your 1 and 2 clients and lock them into your business. Ask these key clients for a wish list (i.e. what do we need to do to at least be equal with your best supplier?) Provide these clients with your wish list (i.e. what we want from them) Document a supply chain agreement.

Operations – where are your overheads? They want a relationship They don’t want a relationship 1 2 3 4 We want a relationship We don’t want a relationship

Who creates innovation? Once a week each staff member should provide one idea in writing on how to improve the business. This is called the 5:15 report.

The role of Finance Finance’s role is to measure your company from a business and banking perspective.

The Financial Health Check

The quality of your cash flow Cash Flow Funding Fixed Assets Working Capital Profit Next Period Weakness Strengths impact on cash flow

For each measure let’s look at… Profitability Ideal Profile G A B Sales 100 GM% 30 >30 28 – 30 <28 OH% 20 < 20 20 – 22 <22 EBIT% 10 >10 8 – 10 <8 Working Capital AR Days 60 <60 60 – 70 >70 Inv/WIP Days 90 <90 90 – 100 >100 AP Days 45 – 60 <45 >70 Working Capital % 22 22 – 25 >25

Gary’s numbers Profitability Ideal Profile G A B Sales 100 GM% 30 31 OH% 20 EBIT% 10 11 Working Capital AR Days 60 75 Inv/WIP Days 90 180 AP Days (70) Working Capital% 22 41

The Power of One It is essential to know the cash flow sensitivities of a 1% or 1 day change in: Price % Volume % COGS % AR INV/WIP AP

The Power of One Why does an increase in sales volume reduce cash flow?

The Power of One - sensitivity Change Effect on Net Cash Flow COGS % - 1% 406,000 Price % +1% 187,000 AR days -1 118,000 INV/WIP days 81,000 AP days +1 Volume % -123,000

Chapter 1 - Profitability Revenue Growth % GM % Overheads % EBIT %

} Chapter 2 – Working Capital Accounts Receivable Inventory/WIP Accounts Payable Working Capital % } Days

Chapter 3 – Net Non Current Assets Growth in Net Non Current Assets Asset Turnover

Chapter 4 – Cash Flow and Returns Net Cash Flow Borrowed Funds Cash After Operations GM% - WC% ROCE%

Bank Measures Interest Cover Debt Service Coverage Leverage Debt Payback

Why is cash flow important? What is profit – an opinion or a fact? What is a balance sheet – an opinion or a fact? What is cash flow – an opinion or a fact? Cash flow is the only fact in the accounts

Cash flow The term ‘cash flow’ is used in so many different forms, that it means something different to each of you. A consistent, meaningful, standardized definition of cash flow would be very helpful.

Net cash flow On the 1st of January 2008 I have $160 in the bank. On the 31st of December 2008 I have $60 in the bank. What is my net cash flow? 100 outflow

Why can’t we apply this logic to the company? Net cash flow Why can’t we apply this logic to the company?

Gary’s net cash flow

Net cash flow Remember, as the providers of your finance, the bank always knows your cash flow. Ask yourself: is the bank providing funds to grow or to fund wastage?

Net cash flow We know that the Net cash flow for Gary's Furniture was -$3,260,073 Is that a good or bad?

Net cash flow We need to know what the money was spent on…. The 4 chapters approach to analysing cash flow will assist…...

The 4 chapters of cash flow

Marginal cash flow The additional cash that will be generated or used up if we sell $1 more of our product or services.

Marginal cash flow

Marginal cash flow for the next $1 of sales

Marginal cash flow for the next $1 of sales

Marginal cash flow for the next $1 of sales What does this tell us? For each additional $1 of sales the business will require 10.34c of funding If the existing relationships stay the same

Why is marginal cash flow important? Many businesses do not understand why as Sales increase Cash Flow deteriorates Solicitor Sales $ 100 Direct Costs $ 30 Gross Margin $ 70 Working Capital $ 80 Marginal Cash Flow $ -10 The Balance Sheet in effect steals from the Income Statement

Profit vs cash flow Many companies do not understand the relationship between profit and cash flow. High Margin Poor Balance Sheet Management = possibility of poor Cash Flow Solicitor Low Margin Good Balance Sheet Management = possibility of good Cash Flow Construction Company Obtains payments in advance, deposits, bills work in progress frequently, pays creditors slowly

Marginal cash flow Marginal cash flow can be very powerful to analyze components of a business: Products Product groups Customers Distributors State offices Business units

A bank’s view of cash flow The cash flow methodology used by banks is not even the same as the ones used by you!!!!

A bank’s view of cash flow So what is a banker’s cash flow? All major Australian banks and most banks around the world use subtle variations of the same report. Many call it the UCA Cash Flow. No one seems to know what UCA stands for!!!

Banker’s cash flow Focuses on the 7 key items of cash flow: Gross cash profit Cash after operations Net cash after operations Net cash income Cash after debt amortization Net cash after investing Financing surplus/(requirements)

Gross cash profit

Gross cash profit Gross cash profit is in turn made up of cash from customers & cash paid to suppliers. Gross cash profit is equivalent to the cash flow from gross margin. Note: COGS would exclude depreciation.

Cash after operations

Cash after operations Cash after operations is gross cash profits less Overheads and changes to balance sheet items relating to overheads such as provisions, accruals & prepayments. Cash after operations is equivalent to the cash flow from EBITDA Note: Overheads would exclude depreciation and amortization.

Net cash after operations

Net cash after operations Net cash after operations is cash after operations less changes in sundry assets & liabilities and income taxes paid. Income tax paid is not the tax charge per the profit & loss, but is the actual tax paid. Net cash after operations is the operating cash flow from which the providers of funding are paid.

Net cash after operations If you were the banker of Gary's Furniture what does a net cash after operations of negative $895,442 tell you?

Net cash income

Net cash income Net cash income is net cash after operations less interest and dividends paid. Interest and dividends paid are not the charge per the profit & loss, but the actual amounts paid. Net cash income is the cash flow from which the business must pay back debt.

Net cash income Gary's Furniture has a net cash income of negative $2,258m. As their banker how do you feel now?

Cash after debt amortization

Cash after debt amortization Cash after debt amortization is net cash income less commitment to retire debt. The most interesting aspect of cash after debt amortization is to look at what items are yet to be taken into account. Cada is BEFORE the purchase of fixed assets & investments. Is there enough cash flow generated after paying tax, interest, dividends & retiring debt to buy fixed assets or investments?

Cash after debt amortization Gary's Furniture has a cash after debt amortization of negative $2,258m As the banker to Gary's Furniture, how comfortable are you with their 2009 cash flow at this stage? Where is the company going to find the money to purchase the new coffee roaster?

Net cash after investing

Net cash after investing Net cash after investing is cash after debt amortization less net purchases of fixed assets and investments.

Financing / surplus (requirement)

Financing / surplus (requirement) Financing surplus is net cash after investing less extraordinary items.

Financing / surplus (requirement) Is equal to the Net Cash Flow that we calculated already.

How was the $3,260,073 financing requirement funded? $2,260,073 by short term borrowings $1,000,000 by long term debt

Banker’s cash flow A banker’s cash flow treats cash flow as a process rather than a number. The cash flow shows the flow of cash in and out of the business. As we have seen, the banker’s cash flow is a very good way of understanding the flow of money through our business.

Your Credit Officer

Your Credit Officer

Your Credit Officer

Your Credit Officer

Understanding the customer A big picture for credit management Understanding the customer

Key Measures

Profitability

Assets

Working Capital

Cash Wastage

Strategy

RONA %