How to Use Your Balance Sheet and Cash Flow Statement to Strengthen Your Business's Health

So let's talk about what we're going to cover today.

0:17 Stephen Brown

I am Stephen Brown. I am your instructor. I'm also the COO and co-owner of LedgerGurus. I also am a CFO of some of our customers. I also co-own Solé Toscana, a direct to consumer Italian organic skincare. I bring that up because we are going to be using data from Solé Toscana.

I have a bachelor's in engineering and an MBA, and have been in LedgerGurus for 10 years, and we've owned Solé for over two years.

0:48 Stephen Brown

All right, like I said, this is part three of our workshop series. If you were not able to attend part one or two, they are available on demand, and Kelley can drop you the link to where you can go to see those workshops.

The idea of this workshop is to help you better understand your financial statements. Part one was basically an understanding of accrual accounting, for those who needed a little refresher or some education. Part two, which we did a few weeks ago, was on how to use your profit and loss statement. And today we're going to talk about the balance sheet and cash flow statements.

1:25 Stephen Brown

Obviously, we're LedgerGurus. We help with a lot of different aspects of accounting for consumer products businesses, everything from monthly accounting, bills, payroll, inventory accounting, sales tax. I work on more of the bullets on the bottom. And so if you want to nerd out with me, I'm the person you can talk to. Just reach out and you can connect with us and we can see if there's some way we can help you.

For those of you that are our current customers, love to have you here, hopeful to help you get a better understanding of the things that we're producing for you.

2:09 Stephen Brown

All right, the goals for today's workshop. Understand balance sheet concepts, analyse your financial health, interpret a cash flow statement, learn how to use QuickBooks more effectively. And I'm going to show you as we go how visualising this data is more interesting.

This is something we're getting to roll out to our current customers who are doing monthly accounting with us, and I'm going to show you visualised versions of this data.

2:26 Stephen Brown

This is going to be a hands-on activity, so if you have QuickBooks Online, you can use it. If you're on a different accounting software, obviously the reports are different, but the concepts are the same. So if you want to run your reports from your business side by side and have a second screen, please do. When we go in, I'll show you how I run some of these reports.

2:58 Stephen Brown

All right, Kelley, why don't you close the current poll and just launch the other one. We will run this second poll for a minute.

And basically I want to know how comfortable you are reading a balance sheet and a cash flow statement. I'm going to ask you the same question at the end of the workshop, and hopefully we've made some progress in your understanding.

One would be, what's a balance sheet? Barely know anything. Ten, you're a pro, time to promote you to a CFO. Or maybe you are a CFO, in which case I would say, hmm, maybe you should be teaching this with me. But if you're here and you're a pro, I appreciate you joining us.

3:40 Stephen Brown

All right. Like I said, we're going to be using real data from a brand that I co-own called Solé Toscana. We bought this two and a half years ago. It is Italian organic skincare.

And part of the reason that my business partner at LedgerGurus and I decided to buy a brand with a third partner is we wanted to have a laboratory, so to speak, to better understand how our customers are going about their business. And so I have some real data that I'm going to show you from that business. So it'll be a lot more interesting.

4:24 Stephen Brown

Okay. I talked last month, if you joined me last month, about my continuous financial performance process. And that's where we would take our profit and loss, we would analyse it, we would use that to do budgeting, and then we used operational analytics to make decisions.

So on the top one we'd say, how did the business do versus budget? And validating our operational analytics, we are making projections against a business plan and we are measuring daily activities. So we use an analytics tool in that case to make decisions.

5:02 Stephen Brown

I have a similar process that really deals with cash and inventory, which are the two key things on the balance sheet that we're dealing with the most. And actually your payables and loans.

So I'm analysing my balance sheet and statement of cash flows, I am forecasting, and we're making operational decisions.

5:24 Stephen Brown

So usually we're analysing, we're trying to figure out what our resources are, where did my cash go. On the forecast we're particularly looking at cash balances and usage, and inventory purchases. Those are the key things. Also with the cash usage, that gets into debt and other things.

And then operational decisions. Me and my operational partner at Solé Toscana, or if I'm doing this with other customers, we're really usually making a couple of key decisions. How much inventory do we buy and when, and how do I fund purchases or paybacks?

6:09 Assets on the balance sheet

Stephen Brown

So let's talk about how we do this analysis. There's a very simple equation. You learn this in accounting 101. Assets equal liabilities plus equity.

So it's called a balance sheet because you'll see the total amount of assets will equal the total amount of liabilities and equity. It just has to.

6:28 Stephen Brown

Let's talk about what's in each one of these components. And I'm going to talk specifically about a consumer products business. Different industries might measure things slightly differently, but there'll be some things that are universal.

For example, every business is going to measure cash, or the bank accounts. And in the case of a consumer products business, you're also going to be looking at holding accounts such as PayPal, Shopify, Amazon, because they hold cash.

6:56 Stephen Brown

One of the things that's always fun is when we get a new customer and we find, oh, you've got all this cash that's parked in there that hasn't been deposited. And it can just happen.

Accounts receivable, less common in a consumer products business, but if you're selling to retail or wholesale partners, you're more likely invoicing them and potentially have accounts receivable.

7:17 Stephen Brown

Obviously, one of the biggest things on the asset part of the balance sheet is inventory. Ideally it's just the perfect size. Goldilocks. Easier said than done.

Sometimes if you're buying things in advance, a good example would be annual software subscriptions, you might be tracking those as prepaid expenses that you want to expense onto the profit and loss over time.

7:45 Stephen Brown

I will refer to some of these concepts that are in workshop one, but I'm not going to go into them.

You may have fixed assets. Those are things like a building, a forklift, et cetera. And there are other things known as intangible assets, like goodwill. Or let's say you bought a trademark, you bought a domain name. Those are intangible assets, because you can't really hold them, but you can buy them.

8:13 Stephen Brown

So let's just take a look real quick. I was going to do this after we go through each section, but I think I'm going to do it a little differently. Let's look at each section side by side. And this is a good point where you could go into your QuickBooks Online and do the same thing.

So I am going to run the balance sheet report by going into reports, balance sheet. If this is not one of your favourites, it should be.

8:39 Stephen Brown

Okay, so I've got my balance sheet here. The key thing of the balance sheet is you're looking at it over a time period. I'm looking at August because we haven't quite wrapped up our September. So this one is a closed period.

8:54 Stephen Brown

And so you'll see here some of the concepts that I talked about. At the very top is my assets, and I've got all my bank accounts. Now, this is one of my favourite assets, because this is essentially your cash.

And you'll see that we have a bunch of bank accounts because we do Profit First. So we do that little game. And for people that do Profit First, they may have a few more bank accounts.

9:17 Stephen Brown

But then we also have these holding accounts, which I love to see being very low. It means that we've pulled cash. I've got my PayPal holding account, we hold cash out of that twice a week. And Shopify, depending on the payout schedule, there can be a decent amount of cash in there.

9:40 Stephen Brown

We don't have any AR. We do occasionally do some AR, being accounts receivable. We occasionally do invoicing, but not very often.

We have some other assets. So the big one I mentioned is my inventory. I kind of wish that QuickBooks didn't treat inventory as another asset, because for a consumer products business, you can see that I have a lot of inventory, because this is the time of year we're ramping up for the holiday season. So I have pushed a lot of cash into inventory.

10:13 Stephen Brown

And then I want to talk about one of these goofy other assets, the intangibles that QuickBooks calls an other asset, goodwill. Why do I have goodwill?

Well, when you buy a business, you pay a price. There are things that are valued, the assets. So we bought a certain amount of inventory. In this case it was a very simple business, and the rest of the value shows up as goodwill.

10:32 Stephen Brown

So you'll see that we have this goodwill asset that we have been depreciating. It's a lovely little tax technique that makes my cash flowing business otherwise show a loss, because I am using tax treatment to expense goodwill.

10:59 Stephen Brown

So those are my assets, and then those get added up. The ones that I look at very closely with my businesses and my customers are my bank accounts and my inventory. I look at those very regularly. The others I look at less regularly.

Okay, so that is your asset portion. Obviously if you have questions, shoot them my way.

11:25 Liabilities and equity

Stephen Brown

We're going to go to the next section. Then you get into your liabilities.

So the most common liabilities you see in a consumer products business, and some of these are in every business. Accounts payable, aka the bills. Credit cards, so when you're doing transactions, those are usually building up a liability. I've got to pay off that credit card.

11:46 Stephen Brown

One that we see a lot of is gift cards. Most consumer product businesses sell gift cards. Gift cards are actually a liability until they are redeemed. They are unearned revenue.

This is a concept that you'll see in a lot of businesses. Some businesses will have these huge amounts of gift cards, and sometimes there's different treatment for when you should, you know, you get really old gift cards, can I apply them as revenue? But essentially I received the cash as an asset, and a liability of a gift card in the form of unearned revenue. So that's a funky accounting concept.

12:24 Stephen Brown

Mark asked me a question about, I'll come back to that, Mark. Let me go back to the QuickBooks and all that.

I'll show you loans, short and long term. And then sales tax collected.

12:44 Stephen Brown

And I'm actually going to bounce, I had this later, but I want to show you this. I've shown this in the last two workshops.

Do not believe Shopify. Shopify does not understand accounting. So when they show you this as total sales, it's a lie.

12:58 Stephen Brown

And we talked about this in workshop one. Your actual income would be your net sales plus your shipping income, which they do not. Oops, sorry, it's going a little wonky.

What you see here with taxes, that money that you collect actually goes, sorry, my PowerPoint's going crazy, that actually goes onto your balance sheet, not onto your profit and loss.

13:28 Stephen Brown

And so the cash collected from taxes would go into your bank accounts, and you would also have a liability for tax owed. So this is something that gets into the liability section.

And as I said, with double entry accounting, there are always two entries. So when you get some cash, in the case of a balance sheet, some of it goes into asset, and there's usually something in the liabilities as well.

13:57 Stephen Brown

So let's go back to our balance sheet and talk about this. Mark asked me a good question, I want to answer that. He was like, what is this Relay sales tax?

So Relay is the bank that we're using for this business. It's a nice bank, we can recommend it. Also like Mercury, also an awesome bank.

14:19 Stephen Brown

Basically what I do is we put aside the money that we've collected for sales tax into a dedicated account, so we don't mess with that. I also do the same thing for income tax.

Highly recommend that as a technique. Profit First has made those things popular. I did some of those techniques before I read Profit First. And essentially it's like, this is money we don't get to spend on the business. It's reserved for specific purposes.

14:49 Stephen Brown

So if that looks a little bit confusing, all that is is a dedicated bank account for sales tax. And we also have a dedicated bank account for income tax. You'll also see that we have a dedicated bank account for inventory and fulfilment. So we allocate a percentage of sales for inventory and fulfilment purchases.

15:09 Stephen Brown

Well, let's go down to our liabilities. So we see we have our accounts payable, we have our credit card from this time period. And then we have some loans.

Where are my loans at? Oh, these are current. Okay, so we use American Express. We've got a line of credit, and then we lent the business some money early on. We could have done it as a capital investment, but we decided to do that as a loan.

15:43 Stephen Brown

And then our sales tax liability. So you can see that this is what we owe in sales tax that we need to pay out.

Oh, and I have one other line of credit. So I've got a couple of lines of credit on this business.

16:06 Stephen Brown

So that's this business's liability section. Every business is going to be a little bit different, but a consumer products business will typically have those types of accounts. Sometimes a few more.

16:12 Stephen Brown

And then the last part is your equity. So that's the investment into the business, the money I put in. So we actually put money in as debt. We said, hey, we want to get paid back this money. We don't actually want to wait till we sell the business to get the money paid back.

So you'll get your owner's investments. There's also a section called retained earnings. So if you have profits and you roll them into the business, you keep them in the business, those are known as retained earnings. If you are doing stock and some of those things for corporations, you also have a section for that.

16:43 Stephen Brown

This business was really simple, we bought it in cash. And so we just have some partner contributions, we have some retained earnings.

You can see that that's negative, means we have not created profits in the life of this business. Although we have been profitable recently, but we had to, thus the loans.

17:13 Stephen Brown

And over this time period, our net income will also get reflected in there until you apply that as retained earnings. Through this time period, like so many consumer products businesses, we are around a break even business.

17:33 Stephen Brown

All right, so those are the fundamentals of a balance sheet.

Now, what am I looking at when I'm looking at my balance sheet? There are a couple of things that I can look at. I can look at prior periods. So I do like to see changes in balances. Do I have more or less cash in the same period? And yes, I have more cash. Do I have more or less debt? So those are some of the things that I like to look at.

18:11 Stephen Brown

The best way I like to look at that is I like to visualise that.

[unclear] is asking me a question about partner contributions. That's basically the money that I put into the business, the business partner contributions.

So when you saw that down here, that's the money we had to put into the business to buy it.

18:41 Stephen Brown

Owner capital accounts. So Mark asked me a question, how do owner capital accounts work? I didn't notice that you had any.

So sometimes these are named differently. Right now we haven't taken any money out of the business. So capital, partner contributions, owner equity, sometimes that's all the same.

19:11 Stephen Brown

And I'm assuming, Mark, when you're talking about owner capital, I'm assuming that's money in. As we start to do distributions, we could have a separate account that would show that we have taken money out of the business, which we have not. In this case, it's a new business still driving the profitability up.

19:27 Stephen Brown

So oftentimes what you'll see for these accounts is they'll be named differently, which is why it might be confusing. Your particular chart of accounts may have one name, but it's the same concept. It's the money that you as an owner put into the business.

19:47 Visualising the balances

Stephen Brown

All right. What I was going to say is, numbers are nice, but I love visualising the numbers. So this is something that we are starting to do with our customers, which is visualising balances.

For me it's a lot easier to see, okay, what happened.

20:09 Stephen Brown

And what I need to add to this, as we've been doing more debt, is a debt balance. But I can see how I've been doing my inventory. We've been purchasing more inventory, we've had more sales. So that's probably something to look at. Hey, is my inventory growing faster than my sales? If so, why?

There are a variety of reasons why it might grow faster than sales. But it's good if I see, hey, I have more inventory this time versus that time. Why did this big jump up? Well, that was the holiday order. And then we sold a lot of inventory, and you could see our balances went lower.

20:56 Stephen Brown

That's not atypical for a consumer products brand. You're going to see a lot of inventory, so my cash goes down, my inventory goes up. Maybe my cash stays somewhat level because I've got debt. I need to put a debt metric in here as well, so I can keep track of that.

21:17 Stephen Brown

So I like visualising the data. Can I do this in QuickBooks? Sort of. It's not great, which is why we're starting to build this for our customers.

So QuickBooks does have this thing called the Performance Center. I think from previous workshops people were like, we don't see it. It's only available for accountants. So accountants, we can generate some of these reports.

21:41 Stephen Brown

I am underwhelmed, is how I would describe my feelings about this. The options are limited, and how I present that data is also limited.

We have decided to use a more interesting tool, a business intelligence tool, analytics tool. There are a lot of third party reporting tools to create a very specific view of that data.

22:11 Stephen Brown

But the reason I like to visualise that data is it's just a lot easier to interpret it quickly. I can see a story here. I can see inventory is really low and then it went up. Why? Well, because we're ramping up for holiday sales. And you see a parallel in cash. So cash gets really big and then it starts to go down, because we're paying down debt. We quickly pay down a lot of our loans as we have those huge holiday ramp ups, and then we get down to a level set of cash, and then we're back in that game.

22:48 Stephen Brown

So I prefer visualising all financial data, but I still use the reports. If I want to drill into a report and understand what's going on, I can see my total bank balance. But if I want to see, where is my cash? Do I have any cash in holding accounts? Is it building up in holding accounts?

23:03 Stephen Brown

I would say it is not uncommon that we'll go into a customer, in the process of getting access to the information, and we'll find, oh, you have this huge balance in your PayPal account or your Amazon Pay account. And because you don't have auto deposit turned on.

23:36 Stephen Brown

We had an issue recently. We inherited the PayPal, we basically took over the PayPal account from the previous owner, but we were having issues getting the ownership information transferred to us. So we just decided to say, forget it, we're going to spin up a new PayPal account.

We hadn't closed the old account, but we had moved all of the money flow to that new account. And then out of nowhere we had a bunch of deposits. We still haven't been able to figure out what's going on.

24:13 Stephen Brown

But in the process of doing our accounting, our accountant said, you've got a bunch of money, there's something wrong here, you've got money in this account. In the process of closing it out, they said, hey, something's up. We went in, sure enough, there was money in that old account, and so we were able to pull the cash out. Couldn't quite figure out why cash had flown into that account, and to this day we're still scratching our head. And until we figure that out, we're a little bit nervous shutting down that account.

24:44 Stephen Brown

But this is the complexity of an ecommerce business. You have all these payment methods and accounts, and money can go in a lot of places.

So drilling into the data is still super useful. I can see the big picture visualised, but usually at some point I want to drill in. I don't just want to see where the balances are, I want to see what's going on across the balance sheet.

25:10 The ratios worth tracking

Stephen Brown

All right, so that is the basics of a balance sheet. Now I want to move on to more of an advanced concept.

Using this data, looking at balance levels, is helpful. It's useful, you should totally do it. But the real power of a balance sheet is what you can do in some key measurements.

25:27 Stephen Brown

So there are some critical ratios and KPIs that give you really interesting insights. And I'll show you them. They are hard. You have to calculate these, which is anywhere from a little bit of work to a lot of work.

25:46 Stephen Brown

Let me talk about some of my favourite balance sheet ratios. There are two in particular, but I have to talk about one to talk about the other one. There's the current ratio, but my favourite is the quick ratio for consumer products businesses. And then there's the debt to asset ratio.

25:59 Stephen Brown

The current ratio shows the ability to cover short-term liabilities with short-term assets. So if I had to pay all of my bills and credit cards, do I have enough cash to do that?

The one I like even better though is the quick ratio, because the quick ratio will exclude inventory in this calculation. And I like this because, no offence to all of y'all and myself, our inventory is hard. I can't pay bills with inventory. So I like to look at the quick ratio, and that's a little bit more of a brutal measurement.

26:39 Stephen Brown

And the other one I like to look at is debt to assets. So what percentage of assets are financed by debt?

Now let me show you how I calculate these. The current ratio is basically you take all of your current assets divided by your current liabilities. And in general, one to 1.5 to two is considered good for ecommerce. You can be below one and be fine, and I'll show you in the case of our business what below one means. But it just means you're at more risk.

27:10 Stephen Brown

If you exclude that inventory, one to 1.5 is considered good. Again, you don't have to be at this level, but these are kind of good targets.

Your debt to asset is basically you're taking your total liabilities divided by your total assets. And so it is basically how leveraged are you against your assets. And 0.4 to 0.6 is considered good.

27:47 Stephen Brown

QuickBooks doesn't calculate these for you. They do, again, the underwhelming Performance Center, which your accountants have access to. We can give you the quick ratio and current ratio, except for some reason I went into it today and it's not there. So again, it's like, hmm, that's cute, QuickBooks, keep trying.

28:14 Stephen Brown

So you can go in and run these calculations, or you can use a reporting tool like I have here.

And here's my quick ratio. Now, before you panic and say, oh, you're in trouble, a lot of this is due to personal loans to the business. So it's kind of all our money. A significant amount of this is a reflection of loans that we made in the first year to the business that we're still paying back.

28:48 Stephen Brown

Probably should have made those long-term loans. They were intended to be short-term loans. They've ended up being much more long-term. We haven't moved them to long-term liabilities. Don't hate me.

But that's why I have a below one quick ratio. The business is still running because what we're doing is we're deferring paybacks in this case.

29:20 Stephen Brown

Debbie, thank you for your comment. This webinar is going to be recorded, so you're welcome to watch the recording for the rest of it.

29:28 Stephen Brown

Okay, so that is one indication. This is a quick ratio and it doesn't look pretty.

Likewise, I have asset to debt, but because we bought the business, my ratios are all messed up with my tangible assets. So I basically did tangible asset to debt ratio, excluding the goodwill. Because goodwill's this squishy, it's a whole different thing that I talked about earlier.

29:56 Stephen Brown

And it's a little bit high. We have 0.4 to 0.6 is usually what you want to be at. You can see that this year we've been rocking around 0.8.

We're slowly paying back those loans. As the personal loans get paid back, that should go down, and then we will get into a good range.

30:27 Stephen Brown

So again, because of the way we're lending to ourselves, it looks worse than it is. Basically what it says is my personal investments in the form of loans have created a less than ideal outcome from a performance management standpoint. But you can see we have brought down that tangible asset to debt ratio over time, and our plan is to continue to drive it down.

30:58 Stephen Brown

Okay. So again, you can calculate these by hand every month, or you can use a reporting tool and see these over time.

And what they tell me is how much leverage am I getting, and how much liquidity do I have? Liquidity being, how easy would it be for me to pay bills if I had to pay bills? And in the case of this particular business, it's not great, but a lot of that is the exposure of personal loans that we're treating as short-term liabilities.

31:33 The cash conversion cycle

Stephen Brown

Okay, let me talk to you about, there are certain metrics that are a combination of data on your profit and loss with your balance sheet.

And my very favourite one, there's a number that you can do, and I'll show you a list of some of the other ones. But this is my very favourite and it is gnarly to calculate. In fact, I did it in MBA school and I thought, I never want to do this again. And then I did it again.

32:10 Stephen Brown

There's this concept of the cash conversion cycle that measures how long it takes to convert investments in inventory into cash flow from sales. And that is made up of three components.

There's a component called days inventory outstanding, which is how long inventory is held before it's sold. Days sales outstanding, how long it takes to collect cash from customers after sale. And days payable outstanding, how long it takes to pay suppliers for inventory or goods.

32:38 Stephen Brown

For most consumer products businesses, the bulk of this measurement, and this is measured in days, the bulk of that is this first one, days inventory outstanding. And these three are sub components of the first one. So let me show you how they're calculated.

32:59 Stephen Brown

Cash conversion cycle is days inventory outstanding plus days sales outstanding minus days payable outstanding. 60 days or less is considered good. I rarely see 60 days or less in a small ecommerce consumer product business.

33:16 Stephen Brown

So if you have less than 60 days, one, you're not going to calculate this here. I'll just tell you this right now, it takes some serious brainpower to do these.

The days inventory outstanding is usually the one that makes it very hard to get to 60 days or less. And the reason why is, as a smaller business, it's very hard to get your inventory sold in 60 days or less.

33:43 Stephen Brown

In the case, and I'll show you this in the example, this is how it's calculated. I'm not going to go through the calculation, because I'd probably mess it up trying to do it live.

But essentially you're taking your cost of goods sold divided by your average inventory over a period. If you're doing it over a year, you would take the total cost of goods sold for a year divided by the average inventory value balance over that same period, and then you times it by 365 to come up with that days inventory outstanding.

34:21 Stephen Brown

Now, if you're looking at this and thinking, what? Again, I would go back to the definition. It's a financial calculation that tells you how long inventory is held before it's sold.

34:35 Stephen Brown

Let me just show you this and tell you what it tells me. So I could go into QuickBooks, and I'm going to have to pull a bunch of data here. If I was going to do this in QuickBooks, number one it's going to take a while.

34:55 Stephen Brown

But I would probably run a report that looks like this for my average inventory balance. I would get my show up by months, and I would basically go and find, and we have not, I don't know why, but we haven't added prepaid and product inventory. I would take the sum of those two things and I would just average them out.

35:19 Stephen Brown

But I take the total by every month and I'd average them out, and then I would go into my profit and loss. I'd run, what is my cost of goods sold over that same time period? I would do the math, cost of goods divided by the average inventory times 365, and come up with a number.

It's not terribly hard, but it is a pain in the butt. Now, what I love about reporting tools is I don't have to do them. I can do that on the fly.

35:48 Stephen Brown

So I'm actually doing a trailing 12 balance here, and here is my days inventory outstanding.

You'll be like, man, Stephen, your business sucks. Well, it kind of does. It's a small business. It's making less than a million dollars a year. I have no leverage.

36:05 Stephen Brown

My manufacturer's in Italy and I have decent terms with them, but we don't have the leverage to be able to say, I'm not going to pay you right away. So we do have some payment terms with them. This number would be better, but the time it takes me between starting the order to getting the order is about four months.

36:28 Stephen Brown

So four months of this time, and then I've got to sell that inventory. So you'll see this ramp up is an equation of us ramping up our inventory in preparation for the holiday sales.

36:42 Stephen Brown

But this is the biggest challenge that most businesses have, because typically manufacturing overseas takes time to manufacture, takes time to get it. Just getting our inventory from Italy to our warehouse is one to two months.

37:01 Stephen Brown

So this is where a lot of brands struggle, until you get bigger. And by bigger, like significantly bigger, to where you can have terms with your manufacturers that are very beneficial to you. And this is how you drive down your days inventory outstanding, is getting better payment terms where you're like, hey, can you give me 90 days to pay for that inventory? So that you're not actually having to pay anything.

37:29 Stephen Brown

But this is usually what sinks the cash conversion cycle. The other two are less consequential, but I'll talk about them. They're so less consequential in the case of this business that I didn't even build a metric for them, but I can show you those details.

37:49 Stephen Brown

The other one is days sales outstanding. And this is really not going to factor into your cash conversion cycle unless you are invoicing people. So if you're doing wholesale or retail, you're invoicing them, how quickly do you get paid?

With big channels, your Costcos, pick your store, Walmart, Target, if you can actually get your product on a shelf, those numbers can range from 90 days to a lot longer. And so that can really kill you if you're going into wholesale.

38:28 Stephen Brown

The only one that benefits you is how slowly do you pay your vendors. This is tricky. This is a double-edged sword. So the slower you are, the better your cash conversion cycle.

Ideally, you can actually have a negative cash conversion cycle. And there are some noteworthy examples. In business school we studied Dell. Another one that I heard about recently is Costco.

38:58 Stephen Brown

Costco, I want to say, gets 90 day terms with their suppliers, but they will sell all of their inventory in less than a month. And so what happens is their days payable outstanding is probably pushing 90 days, their days inventory outstanding is probably like 30. And so they'll get a negative cash conversion cycle. That is the holy grail of business.

39:29 Stephen Brown

Now what does this mean, and what do I do with this? Well, when I put this into the blender of the cash conversion cycle, what you see here is that calculation.

If I go into the chart data, let me show you the raw data. I have all of those calculations here. So I have my days sales outstanding. You can see it's really small, we've done a little bit of invoicing.

40:06 Stephen Brown

Payables, we have some terms with our supplier that's offset the days inventory outstanding. So we have structured our inventory purchases out so that we pay them over time. And that's why you see longer days payable outstanding, and it grows. That's a good thing. You want that as big as you can without ticking off your vendors or suppliers.

40:25 Stephen Brown

But what do I do with this data? Well, this is telling me roughly how long I've got to finance a dollar, either through profits or through lending. So I've got a dollar that's going to be out there in the wind, being turned into inventory, being shipped to a warehouse, sitting in that warehouse until it's sold. And this is what I've got to do.

41:02 Stephen Brown

I rarely see ecommerce businesses with this below 90 days. If you're doing below 90, I know I said 30 to 60 is good, that's industry best practices. If you get it down to 90, you're doing pretty good. If you get it below 60, I think you're doing really good. If you can get below zero, you are a baller. You should sell your business, because that is highly valuable. It means you don't have to lend very much. You're generating cash before you have to spend it.

41:30 Stephen Brown

But it's really hard to accomplish without scale. The two examples I gave you, Dell and Costco, those are enormous businesses that have spent years and years building up a supply chain that's really efficient. This is also a reflection of how efficient your supply chain is.

41:55 Stephen Brown

And so I like to look at it and say, what's it telling me? And you can see again, it's trending up in correlation with my ramp up for holiday season. But if you can drive this down, you're going to be more cash efficient.

So this is a gnarly metric. If you like the explanation, or if you like it as much as I do, send me a comment.

42:15 Stephen Brown

Okay, other metrics I like that I use situationally. Debt to equity ratio, equity ratio, inventory turnover ratio, return on assets.

The first one shows you how much debt a company uses to finance its assets versus equity. The second one shows you the performance of assets that are financed by equity versus debt, kind of the same thing. Inventory turnover, how many times inventory is sold and replaced over a given period. So the idea is, the faster that you're selling inventory, the more efficient you are. Return on assets shows how efficient your business is in generating profit.

42:59 Stephen Brown

And then there are a whole bunch of other things, many of which are related to some of the ones I've talked about. Different ways of looking at these. Accounts receivable turnover, accounts payable turnover, return on equity, and so on.

43:13 Stephen Brown

But like I said, the ones I really like to look at, I like to look at my quick ratio. How much cash do I have against my liabilities? I like to look at my debt to asset, so how leveraged am I with debt? And I like to look at the cash conversion cycle. Those are ones that I like to look at constantly. And then the other ones I like to look at occasionally, depending on the business, depending on a variety of factors.

43:48 The statement of cash flows

Stephen Brown

All right, that's a lot of nerding out. Hopefully you've had a chance to digest it. If you have any questions, hit me up.

Let's turn our attention to the statement of cash flows. So this is a really good one. If you came to workshop one, we talked about accrual accounting. And accrual accounting is really good because it actually tells you how profitable you are, how you're actually performing. But you can have profits but not cash. And the question is, where did my cash go? Well, that's where the statement of cash flows comes in.

44:17 Stephen Brown

The statement of cash flows is this weird creature. Essentially it's going to show you the net cash provided by operating activities. So this is the cash generated or used by the core activities of the business, such as selling products or paying for inventory, salaries, rent, and all that stuff.

Then you have cash provided by investing activities. This could be cash used for long-term investments or received from long-term investments. And then you have financing activities. This is usually your debt or paying back of debt.

44:53 Stephen Brown

You then add those up to come up with your net cash, and then you add your net cash to the beginning cash at the beginning of that period, to come up with your cash at the ending of the period.

45:11 Stephen Brown

Let's take a look at this. If you go into your reports and run your statement of cash flows, which is here. So I've got January through August. I'm actually going to go back a little bit further. Let's go back in the time machine to the beginning of September 2023, so I'm going to see a full year's period and how we did.

45:38 Stephen Brown

So it usually will start with your net income, which is an accrual entry. So it's not actually showing you the flow of cash. What it does is it takes your net income and then it makes all these adjustments based on things that are done on an accrual basis.

So it'll make adjustments to inventory and accounts receivable and accounts payable and lots of stuff, mostly the things that are on your balance sheet, to say, okay, how much cash did I actually generate from my operating activities?

46:09 Stephen Brown

And the answer is, well, in this time period, not a whole lot. Oh boy, $800. That's deliberate. We're in a growth mode.

Then I look at financing activities, which we didn't have. And then, what is the third piece? Drawing a blank. Investing activities. So I don't have those in this particular business, because we haven't done a lot of those.

46:37 Stephen Brown

And you can see that we had a slight net increase in cash. Usually for a lot of businesses, most of the activity is going to happen here in your operations. The others are going to happen as you become bigger and more sophisticated.

47:00 Stephen Brown

So here's how I use these in conjunction. Let's say I've got my profit and loss statement, and I'm just going to use a closed period. So let's use August.

47:23 Stephen Brown

And I said, all right, I made a net income of 2,100 dollars. Yippee. And I'm going to simplify the same timeframe.

So I look at that and I'm like, hey, I made $2,100, I am rolling in the dough. But what happened in my balance sheet?

47:50 Stephen Brown

So if I were to look at my balance sheet, and if I were to look at a month over month, and what we're going to do is previous period, because I just want to compare that. So I say, 2,100 dollars.

48:10 Stephen Brown

Actually let me do one more thing. I'm going to do the dollar change. But I actually increased 10,000. How did that work? And my inventory decreased. So I sold more inventory than I purchased. That probably accounts for some of that.

48:44 Stephen Brown

And then if I want to be like, well, what happened from a cash perspective, let me just go here. Okay, run that report.

48:58 Stephen Brown

So I will see the adjustments that were made. Decreased a loan balance, increased inventory, increased my credit card balance. And so that's where my net cash from operations applied.

49:23 Stephen Brown

So that's how I look at those things. The reality of your financial statements is they're best looked at in conjunction.

49:35 Stephen Brown

What questions do you have? Let's open it up to questions. I haven't had a lot of questions. I don't know if I'm melting your minds, but balance sheets are much more complicated than the profit and loss. I think a lot of people understand a profit and loss.

What questions do you have around a balance sheet, and or around a statement of cash flows?

49:59 Stephen Brown

And while you're asking questions, we'd also love feedback on the workshop series that we've done. How helpful was it? This is something that we're testing out. I'd also love, Kelley, if you could run the third poll. Also love to get a sense of how well your knowledge has progressed. Now I'm a little concerned because I haven't had a lot of questions.

50:26 Stephen Brown

Okay, here's a question. Do you find interest from your client as regards, where do you find interest?

Interest usually is going to show up on your profit and loss. So let me just go into my financial statements and this will bring it together.

51:01 Stephen Brown

So where does interest come into play? When I'm paying back a loan, I'm usually paying back some principal and I'm paying back some interest.

The interest is going to show up as an interest expense on the profit and loss. The principal will decrease the amount that's owed on that loan. So I should see my loan balance decrease, and I should also see that reflected in the statement of cash flows as well. Good question.

51:38 Stephen Brown

Oh, good question. I don't like that QuickBooks puts inventory in assets. No, I like it, it is the right place. I don't mean to confuse you. I don't like that it calls it other current assets.

I really wish that they would just pull it out as its own category, which you could do. You could create a custom account under current assets and have it inventory. And actually we could have done this, so I'm just probably ragging on myself or my partner who set it up this way.

52:12 Stephen Brown

So this is just a personal preference. My partner, the CPA, likes to put inventory under other current assets. Me, the MBA, would prefer to see inventory as its own separate current asset by itself. But this is something you can choose to do.

My guess is QuickBooks encourages you to set it up this way, because usually when you go to set up new accounts, you have to choose where they're going to be.

52:42 Stephen Brown

Okay. Change in long-term liability, this is just the change in principal, the interest is in the net income, correct?

So per the previous conversation, the change in your loan liabilities is going to reflect the decrease of your balance. The expense related to those loans will get reflected in the profit and loss.

53:07 Stephen Brown

Oh, and you saw that. So great question. The reality is these don't work in isolation. So I've taught you these somewhat separately, but what I'm hoping that you'll understand is that when accounting happens, those transactions can hit one financial statement. They often hit multiple. In reality, they actually are hitting all the financial statements in different ways.

53:35 Stephen Brown

Are you able to create a 13 week cash flow forecast with Grow? Ooh, that's a great question, Mark. Let me show you. Short answer is, it would be really hard.

There are tools out there to create cash flow forecasts, and I regularly look at the tools and try and decide, are they better?

54:02 Stephen Brown

I rarely am going to say this. In fact, I usually tell my team, quit using spreadsheets, or if I see them doing spreadsheets, quit using spreadsheets. But for forecasting, I still really love spreadsheets. And the reason is it gives me a lot of flexibility.

There are some great tools out there that are not cheap. And my issue with forecasting tools is they are so much work, without the same amount of flexibility. And I've worked in Fortune 500s and they still forecast in spreadsheets.

54:34 Stephen Brown

So I'll show you my 13 week statement of cash flows, which I need to roll over. This is what it looks like. It looks very much like my cash flow statement, where I'm taking my cash beginning, and then I'm looking at projecting my cash from operations, and then I go in and I'm layering in what I'm projecting my cash spend to be, and then any sort of financing operations, and coming up with my cash balance at the end.

55:11 Stephen Brown

It is a fair amount of work to do these. It's super helpful. I am looking at ways to make this more cost affordable, doing a really good cash flow.

And this is a simple business. A more complex business, you're going to have a lot more moving pieces. But this is what my 13 week cash flow looks like. And almost every CFO I've ever worked with also uses spreadsheets. I know there are tools out there, but for their price return ratio, I feel like the spreadsheet is still one of the best tools for the 13 week.

55:45 Stephen Brown

LiveFlow. Okay, I have heard good things about LiveFlow. I need to check out LiveFlow again. Thank you for bringing that up.

So LiveFlow is supposed to be a good tool. I need to look at that again and see how it compares, and see if it's time to invest in LiveFlow. So thank you for that suggestion.

56:10 Stephen Brown

Send us your feedback. And obviously if you would like some follow-up conversations with us, reach out to us here. Happy to talk to you.

But otherwise, thank you for attending this three part workshop, or this one part if you joined here. And we'll see you on the other side.