Prior to COVID we had a hypothesis that many, if not most, businesses had been surviving on cash flows. And with the cash flows coming to sudden halt, most of the businesses had to undergo a litmus test of profitability. When the businesses survive on cash flows, which is merely moving cash without generating margins, they lack cash reserves.
The difference was apparent in the immediate times following the lock-down. Profitable and cash rich companies not only paid for all their operational expenses but also opened up their coffers to help. Whereas the unicorn start-ups, which made revenue leaps, struggled to pay for salaries.
Although the current situation can be a once in a century event, uncertainties today are far higher compared to previous century. Hence it is important for businesses to understand the difference between operating cash, on the income statement; and cash equivalents, on the balance sheet.
This understanding is crucial to avoid any delusions regarding their financial position.
Cash or cash equivalents on the balance sheet indicate the liquidity available in the company at any given point of time. This figure is derived after considering the effect of liquidating stock, adjusting receivable and playable, balancing borrowings and investments.
While operating cash indicates the cash margins generated from the company operations. This income statement (profit and loss) item appears before EBT (Earnings Before Tax), which is derived by deducting depreciation and interest expense from the operating cash.
Cash on hand may be more or less than operating cash depending on how a particular business manages its assets and liabilities. Hence, the amount in the cash drawer and bank at the end of the month should not be construed as profits.
For instance, if a business receives payments immediately upon sale while takes credit from suppliers, their cash on hand would be higher than operating cash. Hence, this may give an illusion of higher profitability from operations. While a company that pays suppliers immediately but gives credit to buyers may be cash strapped and develop an illusion of losses.
But in an usual scenario, a company that pays cash to suppliers and gives credit to buyers, should calculate their working capital requirement to avoid being cash deficit. Whereas, a company that collects immediate payment from buyers and take credit from suppliers should keep a check on profitability to avoid any dreamy delusions.
Understanding these two terms help business owners plan to mitigate the uncertainties.
During the post COVID recovery if one can project cash levels and operating cash, decisions can be made strategically. If a business is going to accrue losses, operating cash will be negative, someone has to pay for those losses. Projections will help understand the magnitude to decide whether the losses can be recovered in future and over what time horizon.
Once the magnitude is understood, it is passed upon to the ability of the company to manage assets and liabilities. The entire loss does not need to be supported by the business owners, some portions are shouldered through external stakeholders. It can be through borrowings, such as loans or debt bonds; credit from suppliers in form of extended payment period or outstanding payment threshold; and even equity investment in lieu of future profits.
Clear understanding and strategic management of these two items can be the difference between survival and closure in tough times.
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Photo by Erik Mclean on Unsplash
Savvy Munshi 