How to ensure that you, and your bank manager, sleep well at night

A good night's sleep

How to measure cash flow with CFADS, to ensure your business has enough cash for the coming year.

They say that ‘cash is King’ - so it’s surprising how often profitable companies can come close to running out of it.  As we emerge from the recession, cash will be tighter for many businesses as they begin to experience growth.  

So how can you – and your bank manager – be sure that you’ll have enough cash to sustain your business in the coming year?  Measuring your cash flow is a good place to start, but the bigger question is ‘how?’.

Cash flow measurements: from none, to some, to smart

None

A lot of businesses measure their progress by assessing growth or activity levels, using indicators such as sale volumes, marketing leads, work in progress or even just how busy the office is.  But these KPIs don’t measure cash generation.

This can be particularly problematic for businesses where strong growth means more stock and debtors to fund ahead of cash being generated by trade.  Furthermore if your business is looking for funding, banks will need to see a lot more evidence of cash generation.

Some

Many business use EBITDA as a proxy for cash generation when looking at forecasts. While this isn’t a bad proxy, there are still good companies with plenty of EBITDA that seem to run out of cash.  Why? Because EBITDA doesn’t take account of changes in the amount invested in working capital, asset investment, dividends and tax payments.    

Smart

Arguably the best measure of cash flow is CFADS (Cash Flow Available for Debt Service).  We frequently see this used when raising finance for deals such as management buy-outs.  Banks often lend based on the strength – or covenant – of the business, and are particularly focussed on cash generation as they hope to be repaid. Thus, before lending they will think about five things:

  1. Financial Risk – how leveraged is the business?
  2. Business Risk – how sustainable is the cash generation? Is there any seasonality? Is there bad debt history?
  3. USP – what’s special about the business that will help to protect its trading and its cash generation?
  4. Risk Management Plan – does the company have a Plan B for managing cash if things go wrong?
  5. CFADS  - If ‘cash is King’ then CFADS is the heir to the throne in the eyes of a banker. Banks will measure this against the businesses debt servicing obligations.

It’s worth taking a leaf from the bankers’ book and using some of their assessment techniques on your own business.  

Measuring CFADS

CFADS is quite simple to calculate and is defined as:

EBITDA  +/-  changes in working capital  +/-  corporation tax  +/-  capex  +/-  dividends.   

You should compare this to your debt service obligations (i.e. the total of all of your bank and asset finance repayment commitments, plus all your interest obligations).  If CFADS is 1.5 to 2.0 times greater than your debt obligations, then you’re in for a good night’s sleep. 

Weak CFADS

Reasons why you might have weak CFADS include sales growth (cash sucked into funding debtors), poor debtor collection, rising stock balances (does that mean there’s some slow moving items in there?), uncontrolled WIP, or you might operate in an industry where your creditors need paying quickly but you have slow paying debtors.

Overly strong CFADS

If your CFADS is more than 2 times your debt obligations then you should be thinking about investment plans. You might like to talk to us about making an acquisition, or planning tax strategies to extract cash from the business.    

Many business owners with strong CFADS simply leave the cash to build up on their balance sheet. This reduces financial risk of course, but you should bear in mind that over large cash flow balances can make it difficult to secure entrepreneurs’ relief upon a sale of the business. So if you are planning an exit strategy you should reflect on an appropriate level of cash to hold.

 

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Lake Falconer

Corporate Finance Partner
Lake leads the PEM Corporate Finance team on MBO, acquisition, disposal, succession and strategic planning. He also heads up PEM’s valuation team providing business valuations for shareholder exits, disputes, business planning and regulation. Lake has over 30 years' senior level experience as a business adviser and as a manager in industry. He holds the ICAEW corporate finance qualification.

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