Tip 2 in “CashChain”… understanding Free Cash Flow vs. Book Income

Posted on January 7, 2015

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Free Cash flow

When running a business and in particular starting a business from little knowledge of the difference between what is cashflow and what is income is critical.

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Free Cashflow loosely defined is the flow of cash after paying expenses into your business on a daily, weekly, month basis.  Formally defined as

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FCF is calculated as:EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital ExpenditureIt can also be calculated by taking operating cash flow and subtracting capital expenditures.

For example you sell 10 items at 10 dollars for 100 dollars of revenue but the payment does not happen immediately but 3 weeks out.  However, you have paid $5 each for said items $50 up front.    In the first 4 weeks you have negative cash flow although your book income is positive.    The lesson here is lead-time and cash flow management could be the difference between great success and total failure.   What if you took order for 10 items at $10 for $100 received said cash and then purchased the supply at $50.   You know have immediate positive free cash flow and almost an infinite rate of return.    This in essence is the wisdom of an intelligent well designed supply chain.   Matching lead times to sales as best as possible and maximizing return and minimizing cash used for working capital.

At the end of said accounting period the profit of $50 will be reported the same and the book accounting perspective potentially identical but in real world operations the design in completely different.   The managing based on yearly average lead times could easily put you out of business and at a minimum dependent on your local bank to fund your accounts receivable ? Note book accounting income statement will just see the $100-$50 and book $50 profit even though during that period you could be “free cashflow” broke for awhile J

Accounting earnings can be opaque due to debt leverage, timing and write off gimmicks but for our example here we are just examining timing of flows.

This concept of free cashflow gets way more complicated when interwoven with many items SKU’s for sale, SKU’s that interrelated such as a bill of material for a finished item or even a kit of itmes,  production of building items and lead times and costs of raw materials and all the inbound and outbound lead times.   This is where S&OP (Sales and Operations Planning) becomes the ultimate free cashflow manager and will cover in detail in later chapters of “CashChain”

So tip of this report is look for an item or group of items you can shorten the lead time between sale and supply or even create negative working capital thus positive cash flow in obtaining cash from a sale before expenditure of inbound supply.   Yes, know this may be impossible for some items or some categories but likely possible in some area of your current or future product portfolio.  Your CFO will thank you !

To be an expert on free cashflow study EVA (Economic Value Add)  form Stern Stewart until you have this time just think like a small business… a very small business trying to get off the ground.  Time your expenditures vs. investments in inventory and / or other operating expenses carefully.

To be an expert in supply chain cashflow or what we call here “cashchain” management begin to study concepts and theories behind S&OP … get started at sopbook.com.  You maybe can start to see from this simple concept how expertise in supply chain timing or “planning” can have a huge impact of positive free cash flow as well as product design.

Next topic understanding “what is supply chain strategy”

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