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 the cash they have.
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 called the Cash Flywheel.
The Flywheel is based on the idea that money consists of two components: cash flow and cash balances.
We're using the Flywheel framework, because it's impossible to know what to do with cash if we don't understand what money is, and how it behaves within the business.
The first thing we'll need to do is figure out how much money we actually have available to invest, which brings us to our first component.
In a business setting, cash balances tend to be more complicated than simply taking a look 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 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 money, like inventory, and converting them into cash balances.
Let's start building our Flywheel by identifying the three main "states" in which money exists: Available cash, Deployed cash, and Anticipated cash.
Available cash is the most fundamental building block and represents the money we have available for use. This money is often found in the form of a bank balance, but it can also include highly "liquid" investments, like stocks, or lines of credit.
We'll want to choose at least one metric to monitor our Available cash balance. It's often useful to select a measure that ties the balance of Available cash to the status of the greater system.
Potential metrics include:
Any chosen metric should provide useful information about the health of Available cash; answering 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 second category, and it represents money we no longer have in the bank, but we instead have invested in other assets. In essence, it's money we've already used to buy things for the business. We can often sell these things and convert them back into cash, but that doesn't tend to be a very sustainable activity.
The metric(s) we choose for Deployed cash should often reflect how efficiently assets (things) are utilized.
Potential metrics include:
Some questions we might consider answering include: Where does the business need to invest? How efficiently are we utilizing existing assets? When will we need to make additional investments?
Anticipated cash is our last "state" of money, and it represents cash the business can expect 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, 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.
Some metrics we can use to stay on top of these accounts 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 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 need to investigate the two types of cash flow: Sources and Uses.
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 money machine.
Metrics for measuring Sources 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?
We at least want to make sure our chosen metrics reflect a favorable outlook for covering uses of cash in the long-term if we're going to build a cash flywheel.
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.
Fundamentally we can only use cash in one of two ways. We can spend money on something we've done before, or we can spend it on something new. A novel concept, I know.
We know how we've previously used cash because it's documented in our financial statements. Alternatively, we know a potential use is new to the business when it's absent from those same documents. This basic 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 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 things 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, how we actually do each of these activities is beyond the scope of this post and warrants 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 of cash flow and cash balances we've already discussed, which closes the loop on our Flywheel.
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. We're more concerned with the opportunities for spending money on productive business assets when looking at the same metric through the lens of potential 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 of acquiring 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.