Have you ever wondered what to do with your money?
We recently ran a survey asking our users about their most significant financial challenges in business, and many of the responses surprised us. A common theme emerged in the form of a shared sense of uncertainty about what to do with cash.
Business is all about setting up systems, and this post is an attempt to help people figure out what to do with their money through a simple framework I'm calling the Cash Flywheel.
The Flywheel is based on the idea that money consists of two components: cash flow and cash balances.
As we dive deeper into cash flow and cash balances, we'll divide them into six subcomponents, which represent the individual areas we'll choose financial ratios and other metrics to monitor our Flywheel.
In a perfect world, we would choose one metric for each subcomponent, but reality tends to be more complicated, which is why your company's strategy should inform which areas require additional attention.
Before we can decide what to do with cash, it's a good practice to identify how much money we have. A novel concept, I know.
However, in a business setting, cash balances tend to be more complicated than simply looking at our bank account. After all, our personal finances don't often include things like inventory.
Luckily, companies have a document called the "Balance Sheet," which tells us where all of our cash currently resides.
In a way, the balance sheet provides a 360-degree view of our "balances" by tracking assets we don't typically think of as cash, like inventory, and converting them into cash balances.
We'll start building the Flywheel by describing the three main categories of cash on the Balance Sheet: Available cash, Deployed cash, and Anticipated cash.
Available cash is our first building block and represents the money we have available to spend. This money can be in the form of a bank balance, but also includes highly liquid investments, like stocks, or lines of credit.
We'll monitor the first component of the Flywheel by choosing at least one metric to represent our Available cash balance. It's often useful to select a metric that ties the balance of Available cash to the status of the greater system.
Potential metrics include:
The purpose of any chosen metric is to illustrate the health of the cash we have available.
Our metric(s) should help answer questions like: How much money do we have? Can we cover the cash needs of the business? How much can we afford to invest?
Deployed cash is our next metric, and it represents money we no longer have in the bank, but we instead have invested in equipment, inventory, prepaid expenses, or some other useful asset. In essence, it's money we've already used to buy things for the business. We can sell these things and convert them back into cash, but that's not a very sustainable activity.
The metric(s) for Deployed cash should often reflect how efficiently assets are utilized to generate money for the business.
Potential metrics include:
Some questions we might consider answering: Where does the business need to invest? How efficiently are we using assets to generate cash? When should we make additional investments?
Anticipated cash is our last area of focus for measuring cash balances. It represents money the business expects to receive or pay out in the future. The common theme here is that the money hasn't yet had an impact on Available cash. Anticipated cash comes in the form of accounts receivable, accounts payable, debt obligations, and other balance sheet accounts indicating future payments or deposits.
These accounts typically make managing money more complicated, because they require us to balance Available cash against the expected timing of future deposits and payments.
Potential metrics include:
Questions to consider: How long does cash sit in Anticipated accounts? Are we collecting Anticipated deposits faster than we disburse Anticipated payments?
All three cash balance categories illustrate where cash is, and when considered as a whole they provide the complete picture of your money.
As cash balances increase or decrease between the different categories, it has proportional effects on the other balances. We'll get a better understanding of these cash balance fluctuations by taking a look at the second core component of the Flywheel.
Cash flow tells us how money is moving through the business.
Unlike Cash Balances, which primarily focus on the Balance Sheet, Cash Flow considers the movement of money no matter where in the business it takes place. Consequently, cash flow originates from two primary locations: operating activities (Income Statement) or changes in cash balances (Balance Sheet).
We'll analyze cash flow by first taking a look at total cash flow and then breaking it down into subcategories. Focusing on cash flow from a higher-level can provide valuable insights into the health of the company's economic engine. In summary, Total Cash Flow is the speed at which we are adding to or subtracting from Available cash.
Potential metrics you may want to consider include:
Questions to answer: Are we generating cash or using it? How long can we sustain current levels of cash flow? How do decisions regarding cash balances affect cash flow?
To get a sense of why cash flow is behaving as it is, we'll have to investigate its subcomponents: the Sources and Uses of cash.
Sources of cash are the avenues available to generate money for the business. Generally, this could refer to sources like investors, lenders, or asset sales, but these events are not often repeatable and predictable, so we're going to focus on sources provided by operations to emphasize the goal of building a perpetual cash machine.
Metrics you may want to consider include:
Questions to answer: Where is cash coming from? What are the metrics telling us about future cash from sources? What sources are the most productive or profitable?
To build a cash flywheel, we at least want to make sure our chosen metrics reflect a favorable outlook for covering uses of cash in the long-term.
Now we reach the topic that plagues so many of the entrepreneurs we've spoken with: Uses of Cash. The number of potential uses is nearly limitless, representing a form of chaos, which is probably the reason so many people struggle with the topic. After all, how do we know what to do with the money?
Well, fundamentally we can only use cash in one of two ways. We can spend money on something we've already done, or we can spend it on something new.
We know how we're currently using cash because it's documented in our financial statements, and we know how we're not using money because it's absent from those same statements. This fundamental difference defines how we should proceed.
Some questions to answer with uses of cash include: what should we do with our money? How can we determine the value of our options?
Investing in current activities is the least risky option. Our choices boil down to the opportunities we have available for increasing scale, whether in volume or efficiency.
Activities related to business operations, like marketing, sales, and product development are on the Income Statement, while assets used for operations, like inventory and manufacturing equipment, reside on the Balance Sheet.
Often, we'll find that investing in one area means investing in the areas that support it.
The secret to intelligent money management is to use cash on things that eventually improve your ability to generate Cash Flow and/or Cash Balances.
use cash on things that eventually improve your ability to generate Cash Flow and/or Cash Balances
For instance, investing more aggressively in sales should positively affect cash sources, while investing in more efficient processes or equipment can improve the business's ability to produce cash flow and cash balances through increased profitability.
Selecting wise metrics for Uses of cash often means measuring the impact our choices have on cash flow and cash balances.
Potential metrics to consider for measuring uses of cash include:
Sometimes we don't have the option to invest in anything other than current activities. There might be room to scale current activities further, leaving little reserves to consider new opportunities. However, once we've exhausted the utility of current activities, or haven't found anything particularly impactful, we look to our second option; investing in activities we haven't done before.
Venturing into uncharted territory represents the pinnacle of chaos, which makes it our riskiest option. If we're just starting a business, this is where we naturally begin the glorious journey.
Investing in the unknown is where frameworks for capital budgeting, business cases, and basic financial projections prove increasingly useful, as they provide standard processes for evaluating the assumptions underpinning whether an investment is worthwhile. Unfortunately, these topics are a bit beyond the scope of this post and warrant their own discussions.
The riskier nature of these investment decisions requires an additional level of scrutiny when compared to investing in current activities. As a result of the increased uncertainty, our choice of metrics tend to focus on expected future benefits.
Some metrics to consider:
Upon further investigation, you might notice that the metrics listed above inherently reflect how an investment will impact the areas we've already discussed, which closes the loop on our cash flywheel.
Once we've chosen a framework for evaluating and measuring new activities, we'll have all the pieces of our Flywheel in place.
Don't feel the need to limit a metric to a single category. What matters is how we shift the lens we use to interpret a metric based on the category we're considering.
When viewing Return on Assets from the perspective of Deployed Cash we're more interested in how effectively we're using an asset to generate a benefit. We're more concerned with the opportunities for spending money on productive business assets when looking at the same metric through the lens of uses.
Including metrics in more than one category can simplify the system, while ensuring we don't overlook opportunities.
Now that we've covered the main components of our cash flywheel, it's time to consider what the system might look like once it's filled in.
Here's a simple example:
Based on the chosen metrics, we can infer a few things about the business. Available cash is primarily deployed in the form of inventory and constrained by the speed of receivables. Additionally, Cash Flow is driven by the company’s ability to create long-term customer value relative to the costs for servicing customers.
The thing to notice is how the six components making up cash balances and cash flow tie together and create a cohesive story.
You may recall how cash flow takes place anywhere in the business, which makes it the glue that holds the story together, so for any important cash balance, it's wise to consider a corresponding cash flow measure.
At this point, we can begin to establish benchmarks for each of our metrics to measure progress as the company executes against its strategy, updating the metrics as the strategy changes.