Mastering Business Finances and Reserve Cash Flow

28:04So basically, if you've got a day's inventory outstanding of 70 days and the days that your sales are outstanding is 30, you're going to add those together and then you're going to, which would be a hundred, you're going to subtract the days your payables are outstanding, which let's say is 45. And then that would give you a cash conversion cycle of 55 days. So that's basically every 55 days you're turning those assets into cash. You would rather it be shorter than that. But again, tying back to the other things that we were talking about earlier, because a lot of times people are like, I don't know, there's 10 different things I should use.

28:39Well, they're actually all very related and it makes sense to look at them. So if your cash conversion cycle is 55 days, then it makes sense that you're going to have at least two months of reserves to cover the time that it takes to convert the assets that you've got into actual cash, which goes back to our two plus one, goes back to our current ratio of two, back to our asset ratio of one, right? All of them are interrelating and there are different ways for us to look at what's going on. But now if you found that, like, if we say general rule of thumb, two plus one, but your cash conversion cycle is 180 days, then you might actually need to have six months of cash.

29:20Or a line of credit. Yeah. Or a heck of a line of credit. I mean, I think that's an important aspect. And that is the kind of thing, if you're interested in getting a line of credit from a bank, which is harder to do now, having some of these ratios to take to them and to say, look, here's how much we have on deposit with your bank. So, you know, we're pretty good there. The reason we need a line of credit is because we need to close the gap between these two areas. That's what bankers need to see, right? And entrepreneurs typically don't have these. They want to try to tell a banker a story like they're talking to an investor or VC or an angel.

29:54Bankers need these kind of ratios. I also like that particular ratio that you talked about because more I've seen more and more businesses, us included, to maintain sales volume, we've had to increase the installment period. So like payment plans, which is a form of receivables. Fast forward back, you know, 18 to 24 months ago, and everybody was happy to pay in full. Even the request for installment payments and payment plans and those kinds of things was fairly low and the number of people who took us up on them was even lower. And so it was, you know, everybody was flush with cash. They were happy to do it to save a little bit.

30:35That is completely inverted in terms of the number of sales that we get pay in full versus the number of sales who want installments. So while at the same sales numbers in the past, you felt like you were crushing it. Now today you feel like you're struggling and you don't know why and you're blaming inflation, oftentimes it's more of a cashflow issue. So running that ratio and realizing, holy crap, we're at 88 days. That's why. What can we do to pull some of this forward? Might be a problem. And I remember even when we changed the product type, this was five or eight years ago, maybe even longer, but we changed the product type from a one-time payment of, I think it was$3 ,000 to a monthly payment of$500.

31:22And because of the change in product, our cash conversion cycle basically 6X, right? Because it was six months of$500 to get to the$3 ,000 that we were getting before. We gave up the$2 ,500 cash that we would have gotten in exchange for a stream of cash flow of 500 a month, which we hoped would exceed the 3000. But even if it had, and we found, you know, sometimes it did and sometimes it didn't, but even if everything was perfectly as we assumed it would be, we forgot, Hey, we're losing five months of cashflow right off the bat, but our expenses didn't change and it almost killed us. Right. And that's, we're going back to what we talked about before with the, um, with those, those additional funds.

32:10So sometimes you need to set aside some money to make a major investment. Sometimes you need to set aside money to test a major new initiative. And so to say, hey, we're going to be doing this. This is the impact that we believe it's going to make from a cash flow perspective. This is what we're going to go backwards in terms of cash. It's okay. We've set aside X amount so that we can fund this. And we would expect by the six month mark, we're no longer having to fund into it. Now we've got a surplus. Now everybody's happy. We can distribute out the rest, right? That is the more professional way of doing that.

32:43And frankly, not greenlighting some of these tests until you know that you can sustain a failure or in some cases, sustain a win. Which goes back to cash planning, right? That's why it's so important to be thinking about this, to have a clear picture of what your cash flow actually is. And then you think about the strategic initiatives that you've got, and then how will they impact cash flow. Great question to ask. And then now the sixth strategy is a contingency fund, which we kind of touched on for certainties. The contingency fund based on risk assessments and anticipated cash needs. So there are risks.

33:26We just set aside$3 million in one of our other businesses as a reserve for special situation that we had with a vendor that we had paid that didn't perform. And so that created a potential risk exposure of, we determined$3 million. And so we actually had to put that money aside as a contingency fund in case things went, went poorly. Now we'll know in about six months, what percentage of that will have to be used. I'm very, very certain it won't be all 3 million, but it could very easily be 700 ,000 to a million five. And that, you know, like that, that's another thing. Do you want to take the, your decision there is, do I pay all that profit out?

34:10And now potentially I'm called on to write a check. Let's say that you're a single shareholder to write a check for 700 ,000 to a million, you know, into the company. Well, now you personally need a contingency fund, right? So, so I like that. Now there are contingency fund formulas based on percentages of revenue. I feel like that's one of the worst least in connection with the company kinds of ways you can do it. If you are going to do that, then I think you go back to what's the profit margin that I've got and your profit margin against your expected or historical profit margin against your projected 100, close to certain revenue will give you an idea of the profit or cash that you'll have to work with.

34:57And then you're looking at what's the cash cycle to get the profit. To me, it gets too complicated. So I like a contingency fund for we know this is going to happen. We're testing this initiative and we're certain it's going to change things. But hopefully in the long run, it will be better. And we're long run people. So that's OK. But how do we stay in business and pay the bills in the meantime? We forgot to think about that way back when. And that was painful. I remember that really, really well. It was terrifying. And it's one thing to be panicking when you lose because something goes poorly.

35:31You don't want to be put in the situation where you're panicking because the thing that you wanted to happen happened, but you didn't prepare for some of the second order consequences of that. And that was exactly the situation we were in. The pivot from one-off to MRR and subscription was the right decision long-term. It created more value, created more revenue long-term. We just were not prepared for it from a cash flow perspective. Big mistake, big lesson learned. Hopefully people don't make that one at least. Learn from us, not from you. the next thing is kind of a supplement I don't think it's a replacement but it's a supplement and that's a line of credit which you touched on earlier as well your business if it doesn't have one should have a line of credit not just for whatever you've got it for now but also for contingencies so a line of credit is a really really great resource for allowing you to distribute money out to yourself or invest money in the company that will receive a significantly higher return than the cost of the money that you'll have to pay on the line of credit.

36:40So if you can get a line of credit at six to 10 % and in your company, you're operating at a, you know, at a 50 % profit, well, then you're getting a 5X on the money that you reinvest in your company over and above the, well, if it was 10%, you're getting a 5X because you're getting 50. And maybe you're getting 50 on multiple terms. So maybe you're getting 50 and you're turning your cashflow four times a year, right? Now you start to really think about that's significantly more. Same thing in your personal life. Now, if you're taking your money, you're going to distribute it out and put it in a 3 % fund, then the 6 % that you're going to pay interest to a bank on a line of credit is double what your costs, it's double the cost of capital that you're getting on return.

37:31You should take that money and put it back in the company. But you should for sure, those are all finance decisions. But in terms of a contingency optionality play, having this line of credit that you can draw on that should be at least equal to the reserve that you think you need. Let's say that you have a two plus one reserve. And so you've effectively got, let's just call it three, three months of expenses that you've got reserved that you're holding in the company. Now you go get a line of credit for that three months as well. You've effectively doubled your carry time. And now you've got three plus three or two plus one plus three, right?

38:11That gives you a lot of flexibility. Now you can draw on your internal cash reserves. You can say, I don't know. I want to keep that just in case. Let's tap the line for this downturn we've got right now. And you're covered, right? So a line of credit, like how much line of credit do I need can tie into the, or at least as a minimum can tie into all those other things that we're saying so that all these things harmonize and come together. Thoughts? Yeah. And that, that is, you're dead on. Couldn't agree more. And I think that's how you, cause people talk about three to six months. I think the way that you get to six months, it's not just having cash, it's having access to cash is kind of the same.

38:53And so I don't love having six months just sitting there. It can make you feel warm and fuzzy, but talked about it before, cause you to take the foot off the gas, cause you to make stupid investments that you shouldn't be making. So how do we mitigate against that? You go two plus one. And then in addition to that, to kind of close the gap between the three and the six month. Yeah. See if you can get you a line of credit. Most banks, if you can show that you've got X amount on deposit, they will give you an equivalent amount in a line of credit. Once you have some reputation with the bank, they won't even require you to necessarily guarantee that much.

39:28But if they do, that's not, you know, that's not the worst thing in the world to still go out there and get that line of credit. I will simply say, when you get it, use it. We've made the mistake in the past of not using our line of credit because we didn't need it. And then we lost it. The bank came in, re-evalued it. Like, oh, we noticed last year, you only used$50 ,000 in your line of credit. So we're dropping it to 50 grand. Those lines of credit sit on the bank's balance sheet as a liability. Okay. So they sit on their balance sheet as a liability. And if they're not making any money off of that, because you're not using it, then they will absolutely pull that back.

40:03So every now and then you can use it. Pull it back down. Yeah, absolutely. The other thing that we experienced, which was absurd, and so be careful of this, is the line of credit that's not really a line of credit. So if they require, if they give you a million dollar line of credit, but require you to have a million dollars deposited with them, then they're really not giving you a line of credit they're just loaning your money that's 100 secured with them back to you at an interest rate that is far above the interest rate that you're going to earn on the money what we did in that case was we said screw that we're canceling the account and we'll just do our own line of credit there right so your line of credit needs to be a true line of credit not a secured line of credit that you have money that now you can't Because if you thought that if you put three months of expenses in the bank and got them to give you a line of credit, but it was secured by a covenant that you had to keep that money in the bank, then you don't really have that money in the bank because you either take the bank's money and then draw on your money and you're out of covenant and they call their loan due and payable immediately.

41:18Or you spend the money and you're out of covenant immediately before you did the line of credit. the line of credit reduces correspondingly to the amount of money that you took out of the bank and you still don't have anything. So be careful not to fall in that trap. And one of those scenarios, our actual accountant was recommending we do that. And we're just like, this makes no sense. We're paying three times what we're getting on this money. Let's just do it ourselves. It's not a real line of credit. Which should. And I think if you have a windfall, then that does make, so when you go from three months to six months or maybe even longer, if you have a significant windfall, that's a decent use of proceeds is to say, let's essentially be our own bank for this business.

42:00I don't think that's a bad thing. At scale, all businesses become banks. All businesses and executive leadership at a company becomes about capital allocation. So I think making the decision to do it when you have a windfall makes tons of sense. We actually had one bank, I don't know if you remember this, they said, yeah, we'll give you a million dollar line of credit if you buy a million dollar CD. And so it wasn't just have it on deposit with covenant. It was actually lock it up into a certificate of deposit. Why would we do that? It had to be one for one. If that's what you're hearing, either you're just a little too early and that's okay, or you've got the wrong bank and it might be time to shop around.

42:40Before you move though, go to them and say, here's our balance sheet. Here's our P &L. Here's what we currently have on deposit. What could you do for us from, you know, we'd like to get a line of credit for this amount. What, you know, what can you do? Because they also had a line of, in addition to that, not only do we have to have a CD, but they also wanted personal guarantees from all of us. It's like, wait, so you're going to loan me back my money and still make me sign a personal guarantee? absurd but they will they'll they'll frequently ask and you can always say no and then you'll find out how important that personal guarantee is but they pretty much always going to ask for it for sure yeah for sure and you know depending on on the life stage of the business how much you have um it may be what you need to do uh we as a general try to never ever ever ever sign personal guarantees and yet there have been times when it was appropriate and so we did so i don't want anybody to come off saying it's something you should always do or something you should never do it's it's amazing so the next thing that i want to talk about is um the eighth one would be scenario planning and stress testing this is something that is one of my favorite things to do is to create a financial model for your business and your cash flow and that's as simple as an excel spreadsheet or as complicated as pivot tables and a bunch of other things but what you really are looking to do here is say, what happens in if-then scenarios?

44:09If we move from a$3 ,000 sale product to a$500 sale product, what happens to cash flow? If we lose this customer, what happens to cash flow? If this acquisition takes us away, our focus away from the business and causes us to earn 50 % less for the next six months? How does that, you know, how do we, what if we buy this company and our expenses go up or if we take a line of credit and we've got a service of debt, if we buy that, you know, all of that, if we buy a building, it just like that is so important and it goes with cash forecasting, but this is different because it's scenario planning, right?

44:55It's stress testing the business when bad or good things happen that are going to impact cash flow, how do we end up? Having that model, I think, is really, really helpful. Another thing to do is benchmark. So in your industry, there are other people that are in your industry, and they have operating expenses and reserves and all of those things. And we like this from a kind of just checking how are you doing against the rest of the world. Is my pay, like you might have a general rule that payroll should be 20 % of revenue, but maybe in your industry, payroll is 30 % of revenue. So you could beat yourself up because yours is 20 or 22 and really still be significantly ahead of the pack if you're not looking at benchmarking.

45:50Now, that doesn't mean that you look at them and go, oh, I'm okay. I don't need to look at mine. But it's good to look. And you can do the same thing with reserves. So look at data that's provided by companies like BVR and other, you know, McKinsey and Bain and all those guys will typically have reports. Your industry or your industry association will also typically have this data. Look at what are the benchmarks for the industry with respect to the different key components of your business and the ratios and percentages of them. You could do that for some of the things that we said. You could do it for reserves, for quick ratio, for acid ratio, for all of these kinds of things.

46:28Cash conversion cycle. These would all be things that you can look and see with the industry. What are my days inventories outstanding? What are my days of accounts receivable are outstanding? What's my cost of gold? cost of goods sold percentage to the rest of the things that I've got. And that will help you see that you are at least in line. And if you're not, then you can figure out what can I do specifically to get there. Can I give everybody a free tool that'll help with that? Yeah. Yeah, if you go to scalable.co, so scalable.co forward slash tools, one of the free tools that we offer is the expense ratio analyzer.

47:04And it will actually allow you make it really, really simple for you to plot in what should it be. So what are your benchmarks? And then you go put in your actuals and it'll tell you, okay, where are you over? Where are you under? And give specific recommendations on what should be increase and decrease. Really simple tool to give you a very, very quick snapshot of where are we overspending? Maybe where are we underspending? But what I like about the expense ratio analyzer is one of the lines in there is profit, right? So you're required to put in how much profit do you want to put in there? So it really does start with this kind of profits first mindset.

47:40And again, scalable.co forward slash tools, scroll down to the expense ratio analyze analyzer can download that totally for free. I love it. And then the last thing is just to be regularly the 10th is just to be regularly looking at your cashflow and analyzing, like just just be sure that you are on a schedule for this. Certainly at least quarterly, you should be taking a look at this. And then you can kind of, maybe you should, you want to look at it more. Or if you find quarterly is too frequent, you might go to six months. But I do think it's really important. And so I'd like to wrap up. And I think because of the time that we've gone on this, Ryan, let's divide this into two podcasts.

48:22We'll do five and five since we've got 10 strategies. So just to wrap up, you know what the strategies are now. How do you actually build your cash flow? How do you create that? Well, the first thing is you have to look at what is our current cash flow. You have to assess. You have to be aware. So going through the exercise of seeing where is cash flow right now, do I actually have a statement of cash flows? And what does my cash flow conversion, my cash conversion cycle look like right now, then use any of the 10 things that we talked about or a combination of that we've been talking about to actually establish and set a reserve target.

49:05This is the target that we want to get. Now, I wouldn't recommend that you immediately say I'm going to pay myself nothing until I hit that target. I would say, what is a reasonable strategy for me to get to that target? Maybe you need to have a million dollars. Do I recommend that you would take a million dollars out instantly? No. Maybe you can take out$100 ,000 a month for 10 months, right? Or maybe you even need longer because you live off of every bit of that million dollars that the business is making right now. Then you might need to make some adjustments. But you want to get there as quickly as you can reasonably get there without adversely impacting your own financial situation.

49:48And I'd love to get your thoughts on that before we go to the next step, right? Yeah. What we've done is say, until you can build up that one month operating, basically, yeah, start to death. I mean, only take out the absolute minimum that you need to live. That is the time, frankly, to be lean because you don't have a lot of options. Once you've built up that kind of one month operating expense fund, everything over and above that, we divide it 50-50. So 50 % gets distributed out to the extent that it is free. The other 50 % gets added into the savings to get up to the additional two months. So that's kind of how we've done it.

50:27Now, I should add, all of this is after pulling out money first into the tax account. So whatever you owe in taxes, that comes out first because the government has missiles and you don't. They can literally take your business. They can take your liberty. So all the things that we're talking about come out after the government gets their share. But yeah, we've simply done a 50-50. If you want to accelerate it, you can do a 70-30. If you need a little bit more, you could change it. But I like going 50-50 until you get the two months operating expense. And 50-50 is what, just to be clear? So of the distributable amount, so everything over and above, you get to the end of the month or whatever, you look and you say, okay, great.

51:07This is how much we need to have in our operating expense. Maybe you say it's$100 ,000. Every dollar over and above that amount is available for distribution. That is your distributable amount. You want to take 50 % of that and put it into the savings to begin to build that up. And I would go ahead and take the 50 % out as a distribution, unless you need to save for some other planned contingency for some other planned investment. I would go and take it because I do believe you need to develop a practice of distribution early on. Okay. I love it. So step one is assess your current cashflow. Step two is set your reserve target.

51:45Step three is automate savings. So whatever that formula is that you've decided, or maybe step three should be pick the formula, but to me, it's kind of part of it. But you need to get that going and you don't want, you want it to be automatic. You don't want to be thinking about it. So whatever you need to do to set up automated transfers, even if you have to look at it every month and say, okay, it's 50-50 and the amount changes, you can give your CFO or if you are your CFO, you can give yourself the instruction or you can give the bank the instruction. This is what's going to go. And maybe it's to set a minimum and then you can adjust and cap off the minimum if you have excess, but like some base amount, get it in there so that you're building the reserve.

52:34Then you want to invest the excess. So if you get past that cash amount, and even if you've got cash, that cash could be in a money market because money market is as good as cash to tap, right? And you should be earning at least currently about five, 6 % in your money market, that's important. Don't just have the money sitting there doing nothing, have the money actually earning you money. And then the last step would be to monitor this and be sure that you have the right reserve and that you are doing this on a regular basis so that you can adjust it, which is the sixth, the actual, excuse me, fifth step, adjust that the reserve based on the reality of your business.

53:17So that takes you through 10 strategies to set the reserve and five strategies to get your cash reserves established, automated, and actually earning you money. I hope you guys found that helpful. Ryan, anything to say in closing? I would say the ultimate sign of a healthy, valuable, exitable business is not revenue. it's not NPS score. The ultimate sign of a healthy, valuable business is that company's ability to distribute large amounts of cash to its stakeholders on a quarterly or even better monthly basis. That is the ultimate sign of a healthy business. And so to develop a practice of good cashflow management, to develop a practice of distributions is I think incredibly important.

54:07And you should do it earlier than most people think. Do not, do not, do not fall for the line that banks and investors want to feed to entrepreneurs that you need to wait until the end of the sale to get paid. That is complete horse crap. Of course, they tell you that. They are incentivized to tell you that. They want to keep what they perceive as their money in the business so they can get it when they want it. Certainly, if you're bootstrapped, develop a practice of distributions, not only will it make you happier, it will be the ultimate sign that you're running, you're efficiently running your company.

54:42I love it. Well, hope you guys have found this helpful. We are going to divide this into two, two, five strategy, I think, sessions because we went a little bit longer than we want to do, but it's a really important topic. And I think it can be really helpful, particularly as we experience downturns in the economy that we talked about in our episode before this. So hope you guys enjoyed it. If you did, please share it. Let us know if you have any thoughts. If you've got other strategies, tactics, techniques, experiences, war stories, horror stories, great stories, please share them with us. We definitely want to hear them.

55:15And we'll see you next time on Business Lunch. Awesome. My computer mouse thing has frozen, so it's going to continue to record. And my button to stop the recording doesn't seem to be working. So I'll let them do it. Yeah, it froze. That's really weird. Anyway, I'll tell them that it stopped about 50, 54-ish minutes. But that was really great, I thought. I think that's really valuable for people. I agree. I'm trying to see if I can stop the recording from my end. I can't. I'll text my tech team. Cool. That's great, though. Yeah. No, that was a really good... Are you going to record a little thing at one point?

56:06or is somebody going to record a little, you know, Hey, this episode went long. So join us in the next one kind of thing. Yeah, I'll do it. Um, I'll do it now, but let's do it right now real quick. Okay. Recording.

56:27Okay. Hey everybody, this is going to be a two-part business lunch. Ryan and I are talking about how you can establish a reserve for your company so that you've got contingency funds available in the event that good or bad things happen. And we talk about 10 different strategies. We're going to cover five in the first episode and five in the second. And we're also going to give you five. So that's 10 total strategies for setting the reserve amount. And then we're going to give you five, a five-step strategy for actually setting that amount. So look forward to having you there. and that's what this is going to be.

57:04Hope you enjoy it and we'll see you there. Okay, so that's the first one. And then I'll say, so that's it for the first half of the strategies of these two parts or of this two part episode on how you can create a reserve and what are some of the strategies for doing that. The next five we'll do in the next episode.

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