Lesson for the silent killers of cash flow. Here are the three things we'll cover in this lesson. First, well identify the things that you're doing that might be robbing your business of cash to understand the difference between short and long term debt, and when each should be used. And three will learn how managing the critical drivers of cash flow puts more money in your pocket. So take a minute, gather the supplemental materials, and then let's get started. lesson four, the silent killer is a cash flow.

More specifically, we're going to talk about these five things Miss financing, inventory management, expense control, your accounts receivable and your accounts payable. Believe it or not, these are the types of things that actually suck cash out of your company because you're too busy. A lot of times like I was to just realize what's happening, right? It's one of those things where as you're in your business, and you're working on it, and you're doing all the tasks that you do on a normal basis, working with customers on your products on your good, these little little things you don't pay attention to, but they sit there, and they robbed your business of cash. So let's talk about how that happens. First of all we're talking about is Miss financing.

Miss financing? Probably don't haven't heard that term a lot. You probably don't know what it is. But 60% of small businesses right now are Miss financed. And here's what I mean. You had bought an asset, a product that you can depreciate, it has a useful life.

So usually what happens is you've used the long wrong home product to buy this asset, such as buying a house with a credit card. Yeah, we wouldn't do that, would we? No, of course not. Unless you want the miles super great miles. It'd be great miles if you bought a house for the credit card. But one of the reasons why we don't buy assets that we can depreciate with a short term loan product is that the entity Interest rates are higher.

We're thinking about credit cards right now about 1314 15% when the average mortgage is around four or 5%. So when that's happening, you're actually robbing the company of cash, you're making the payments, you don't really realize it, but more interest is coming out, it takes cash away from you. So here's the rule with financing an asset, the length of the loan should match the life of the asset. That's right, the length of the loan should match the life of the asset. So if you can depreciate something for five to seven years, then your term loan should match it should be a five or seven year term loan. So remember that and keep out of trouble.

And it happens a lot. Believe it or not, like I said, 60% of small businesses that even happened to me. Here's how it happened. I had a restaurant where we had one of the 12 foot coolers 12 foot long, two foot wide. It was older starting to rust out on the bottom, and I knew it was going to go out and it did one morning. There was brown goo coming out from underneath the cooler so the compressor went out and if you know anything about those large commercial coolers, when the compressor goes up, it's time to buy a new one.

So I went down to the restaurant supply store, plop down the credit card at $500 for new cooler, put in the back of the truck went back saved the day. I also miss financed my company, because they used a credit card which have to pay off in one year on an asset I can depreciate for three years. So in that case, I had well actually miss finance my company. And nobody ever walks out of the house and says I am going to miss finance my company today. That's not how it happens. It happens just by routine transactions, where you use your line of credit or you use your credit card when you actually should have purchased it on a term loan or use cash.

So be mindful that the length of the loan should match the life of the asset. So let's look at a company. How do you find it? How do you know if you've already done this? So here's a balance sheet of a company we've been using through all these lessons. It's spectrum manufacturer a trained di is going to look at replaces on balance sheet, this is how you find it, you're going to look at the change in gross fixed assets, you're going to look at the change in long term debt and the change in retained earnings.

So basically the equation is the change in gross fixed assets should equal the change in long term debt plus retained earnings. Here's what we're saying. We bought something the change in gross fixed assets, and we either use long term debt or cash or a combination of both. You notice that we left out short term debt. That means if it doesn't equal, chances are high that we used a credit card or line of credit or some other short term product. So that's how you find it.

The change in long term debt plus the change in retained earnings as long term debt and cash should equal the change in gross fixed assets or what you bought. So looking at spectrum manufacturing, we can see that their change in gross fixed assets was about a million dollars over five years they invested a million dollars in equipment and land and buildings. They did stuff to improve their business. So how do they pay for it? Well, when we look at the long term debt line change, the long term debt actually went down by $200,000. They paid down long term debt.

So we know they don't use long term debt to finance their equipment, buildings, they didn't do it. They actually paid it down. So when we look at the change of retained earnings, that's cash because remember, net profit comes over to the balance sheet in the form of retained earnings, which goes into your accounts receivable or into your cash accounts. They actually increase retained earnings by $87,000. So there's 1 million equal 120,000. No, it doesn't.

Yep, you guessed it, this company's Miss financed, chances are high that they use one of their short term products like a line of credit, to improve their business to buy their land to buy their equipment. And when we look at notes payable on the balance sheet, you can see the increase in your notes payable. That's your line of credit. So that's how you find it. The change in gross fixed assets should equal the change in long term debt. And the change in retained earnings.

That's long term debt or cash. That's how you find it. Go look at your company and see if you are. So how should you structure debt? Since I told you about what not to do? How should it be?

Well, there's three different ways to structure debt and small business. And this is how they should go. On the first level is your gross fixed assets. That's your equipment. That's the stuff that you can touching, put your hands on it, your vehicles, your your shelving, your office equipment, things that you have to run your business. When we purchases and we don't use cash, we should use long term debt.

And that's basically a term well, so that's what you finance gross fixed assets with is a term loan. Where does the money come from, to make that payment? Well, it comes directly out of your net profit or your retained earnings, whichever you want to call it. So when a banker looks at your loan application you're looking to see Do you generate enough cash and your net profit tax Make the loan payment because that's where the cash is going to come from, for that product. So that's level number one, the second level and if you do this one, right, you really only have to buy your inventory one time. Other than that your customers are buying the replacements.

But you buy your first inventory, your base level inventory, your par inventory, whatever it is that you have on a weekly basis where you never run out, you can always satisfy your customers needs. That's your base level. If you go into a grocery store and you look at we'll say the bare shelves, there's always nicely facing every spots filled, it's always there. So that's the base level. So when you have that, a lot of times companies will buy that with another term loan, five to seven year term loan and then just make payments on their first set. So if they need 100 of an item, they use a five or seven year term loan buy the first hundred as people buy it.

And it whittles down from 100. To we'll say 50 or 40 or 30. They take the customers money from those purchases. And replace it back up to the hundred that's setting back to par part, it looks like golf or whatever, it's just a middle. This is what you want as a minimum where you never run out. That's your base level inventory.

Now on occasion, we need more, right, going back to the grocery store, where it's always neatly faced and there's always enough exactly right inside the containers or inside the coolers. There's a couple times a year where they need more and you'll see structures built to have n caps of cases of beer, they'll have large tents and coolers and everything else out into the owl's. That's because on things like Fourth of July or St. Patrick's Day, or, well, heck, I don't know Cinco de Mayo, they'll sell more beer so they bring more in, instead of the hundred that they always have. They might bring in 200. That way they satisfy a bigger demand during those seasonal times. That's where you use your line of credit.

You already have your base level inventory that your customers are replacing on a weekly basis. Now you Is your line of credit to buy the next hundred. So I use my line of credit I buy the next hundred already have the first hundred, my base level inventory, the second hundred making it 200 cases of beer is bought with my line of credit from there, as the customers buy it, I take the customers money again and I pay down the line of credit. That's the perfect way to use it, which is as soon as you use your line of credit to buy extra inventory. You go back and take the customer's money when they pay you you pay down your line of credit. If you do that, it's showing that you're exercising it properly and you'll be in a better position to let it rest at least one time a year.

That means paying it down to zero and not drawing on it for 30 days. That's one of the rules. So use your line of credit to buy your seasonal inventory. Now you might say Mike, I don't have any inventory. I'm in the service business. What do I do there?

Well, this is your payroll. Use your line of credit to meet your payroll needs and as your customers pay your invoices paid out. In your line of credit first and then use a remainder of the money for operating expenses and profit. So let's say you structure debt and a small business and how you use it. You get your term loans for your gross fixed asset. You got a term loan, for your base level inventory, you got a line of credit for your seasonal needs.

Those are the three levels. Do that and you're going to be in great shape with Mike. So let's talk about inventory management. I just told you to buy inventory with a term loan, replace it with the customers money. How do I know if I have too much, this is another way where cash leaks out of your company. It gets sucked out in the form of just sitting on the shelf.

The more you have, the longer it tends to sit. So you want to make sure that you're meeting the customers needs, but not having too much where it never moves. That's just dead money. So here's what you have to do. You have to look at what your weekly averages are. And we'll go back to the beer store.

If you're selling 100 cases of beer on average. That's what you should carry. You want to plus it up when you know seasonal needs are coming. So you should have some historical data. If you're a new business, there's a little bit of guesswork that has to happen. But you want to make sure you have just enough and not enough.

Not too much. How do I know where to start? You're going to look at the industry averages, that's a great place to start. So when you, you go to your bank, you can ask them what the industry averages are for your business. Or you can ask your SBDC advisor for the industry averages for your industry. And whatever they have as an inventory level, that's a great place for you to start.

So if they have $500,000 with inventory, that's probably where you should be as well. At least that's the average and then you can make adjustments up or down from there. So let me tell you some stories about inventory. Because people love to see it. When I talk to business owners. They just, they want to take me on a tour.

They come here to look at this warehouse. So I go out and I see the warehouse and it's just beautiful. It just looks wonderful. You can see all the nice shells. But that's not where it's supposed to be. It's supposed to be in a customer's house or the customer's garage, or somewhere else besides your warehouse.

You want that to move. You don't want to just be sitting. So I went to tire drillship one time, and I saw these huge tires. I mean, absolutely. I mean, they were bigger than I am, taller than I am and wider than I am. They're probably for one of the larger trackers or row graders or something like that.

And I saw 16. I'm just counting them up, and they were 16. And I asked him, so how much are those? He says, Well, they're 30 $500 apiece. Well, quick math told me that was about $50,000. Just in tires.

So well. Wow. So you must go through a lot of those. If you get 1516. I'm sitting on the shelf. He goes off, we sell two or three a year.

Well, why are we carrying 15 if you're only selling two or three, and he says he wanted to be the guy that always had it in stock levels should probably be for them. know if he had four that might be Oh, a better level for that, but try to meet your need, rather than just having it just a habit. Because tires tend to go bad, right? So not exercised and not used properly and not used in a good time. They'll tend to go bad. And then you have inventory that you have to dispose of.

Speaking of disposing of it, I worked with a computer repair company, and I went to the shelf and there were three large boxes. Right about so high, and about so wide, three boxes. We open them up, guess what was in there? This was last year 2018. Yeah, large floppy disks that the government used to use. I mean, the large ones, the ones that are about as wide as your body, yet nobody's using those anymore.

So how do you do I mean, he's carrying in an inventory. It's sitting on the shelf, nobody's going to buy it. Nobody's going to use it. It's obsolete. So what do you do? Well, what we did was we donated it, right.

We donated it to the Civic Art Center, and kids were using it for mobiles and mosaics and things like that. It just became more of an art project. Rather than actual thing and he was able to take the write off because he donated it. So there's ways to get rid of your inventory that way. How do you know if inventory is too old? I mean, you know, we just talked about something being obsolete where nobody would buy it anymore.

How do you know if it's too old? Hey, just blow on it right? When you blow on it, dust comes off, that means it's not moving. So you don't want inventory that collects dust. That's just a quick way to do it. Of course, I'm trying to be funny.

But if your inventory has dust on it, that's a good indication it's not moving fast enough. And you need to do something with it. So how do you get rid of obsolete or old inventory? You can clearance it, you can discount it, you can give it away. You know, you can just throw it away if you have to. But in any case, it's not doing you any good sitting on the shelf.

Because especially if it's on the balance sheet, because it looks like you have an asset that you really don't you can't convert that to cash. So you don't want it to be there and, you know, jive with your ratio. So the banker looks like you're no you haven't More assets you really do, when in reality, you want to have the exact right amount. So that's inventory management. How do I know how much to have? Right?

We'll talk about the industry average. But here's a quick calculation on setting your par level, what you're gonna do is you're gonna look back at the weekly average. And we'll go back to the beer we've got, we normally sell about 100 per week, you're going to add in just a little bit of safety, right, because you never want to run out. So add in five or 10 more cases, and then divide it by the number of deliveries you can get in a week. So if you get one delivery, now I have 110 is my weekly average plus my safety stock, I'm going to divide that by one delivery per week, I'm going to buy 110 and that means when I reorder, I'm only going to reorder to the hundred and 10 level that's setting par, you come right back to the minimum. So that's what you should be doing ordering par setting par for each product and make sure you have The exact right amount.

And you'll notice that might change throughout the year. So be mindful of that. Next one's expense control. And I harp on this one a lot, because this is the one we control expenses don't change, unless a manager makes a decision. They can increase or not increased. And we tend to be more or more like Santa Claus when we're having good times.

And it's harder to bring it back now when we're having bad times. So especially true, the rule is this. The change in operating expense should mirror the change in gross profit. That's right, the change in operating expense should mirror the change in gross profit. And what we're saying there is gross profit is the money I have to spend operating expenses the way I spend it. When I have less money to spend, I should spend less money.

So that's how much you should cut as well. Most people don't know Hi, I need I need to cut expenses, but I don't know how much to cut. Well if gross profit is down by $50,000 you should cut $50,000 in expenses, that way, you're maintaining your profitability levels and you're not going upside down, which means starting to lose money. Now, cutting expenses is an art. It really is. I mean, you could cut the wrong expenses.

It happened to my next door neighbor, meaning that I had a bar restaurant. And so did he right next door. And during the downturn in 2008, we both cut expenses. I chose to cut labor that was my largest expenses. And so as people are treated out or as a left, we actually replaced them with part timers, or not at all. We actually tried to maintain staffing levels a little bit lower during that time to keep labor expense down.

What he cut was one of the drivers of his revenue. in this industry in the bar restaurant industry, you have to make some investment in entertainment, such as direct tv or live bands or karaoke or UFC fights. But they all have a cost associated with them. But they also are the reason why people come they come to see the UFC fight, or Sunday ticket on on Sundays for the football games. With that in mind when you cut that you're also cutting people's reasons to come. So you got to be careful not to do that.

Because when you take away the reason to come, they stop coming. So you don't want to be the type of business owner that's taking away people's reasons to come. So marketing advertising the things that you do today, to drive revenue to your business, don't cut those. Instead, you're gonna look for things that you're not using or underutilized or it's nice to have, you know, you might look at, you know, your personnel, you know, like I did, or you can look at your suppliers, hey, maybe it's time to shop for different suppliers, maybe you can get things a little bit cheaper for somebody else. Maybe that's a way you can cut expenses or cash coming out. You can look for, you know, unnecessary you know, nice to have frills, maybe there's a laundry service that you have, or maybe there's, you know, a cleaning service that you use.

Where you can actually take that in house rather than paying an outsourced firm. The other thing is understanding and being able to forecast your expenses. Right? forecasting your expenses is huge. That's one of the reasons why we built cashflow tool is to be able to take that forecast and see how expenses are coming out. And when you can see a downturn in revenue, where you're forecasting out maybe a contracts expiring, or otherwise, make sure you're adjusting your expenses ahead of time ahead of the curve.

When you have seasonality and you know, you have a three month slow season, going right into the slow season, you should have an expense reduction plan to go right along with it. The last one is strategically add expense, and only when capacity is needed, right. You've hit a wall. You can't continue to grow. You can't get to new operate, unless you add a person or unless you add expense. Make sure you're doing it to drive revenue or to drive profit, not just because It's a luxury.

So that's that's a couple things about expense control that I think you can help. The last two is accounts payable and accounts receivable. Remember, these are part of the cash conversion cycle. This is how fast money is moving through your company. And we want it to be fast, right? We want to collect fast and keep money in our company a little bit longer by paying maybe just a little bit slower.

And if you remember, I told you to keep those right around the industry average, because these two are your best tools in combating short term cash flow crisis. Meaning that if you're around the industry average, basically what you can do is collect, make a few phone calls, bring some cash in a little bit faster, or hold on to that bill a couple of weeks longer. If you do that, it keeps cash in your company just a little bit longer or brings it in a little faster. If you're too aggressive with your collections. Customers notice right You got to remember, your customers have a choice, they can go to other vendors have better terms. So if you're collecting too fast or being too aggressive, you might turn customers off and hurt your sales.

The other side, if you're paying too slow on a regular basis, where I said, just do it on a temporary basis, if you're paying too slow on a regular basis, you might make your vendors mad. And when they're mad, they might move you to cash terms, they might stop selling to you altogether. Or you might be missing out on some key discounts or put more cash in your pocket. So maintain the industry average, that's what the market expects. That's what your customers expect and your vendors expect. And if you get into a short term cash crunch, you can collect a little faster for a while, or you can hold on to your bills just a little bit longer.

So let me talk about the working capital cycle. Just one more time. It's that important to me. Remember, the inventory sits on the shelf for a certain number of days and it takes you a certain number of days to collect. That's just how it works. So that's money coming in.

The other side of the coin is money going out how fast you're paying. And the difference between those two is called the financial gap. And we want that gap to be small, we want it to be as small as possible. Because when a financial gap is small, the difference between money coming in and money going out, it takes less money to run your company. You don't need as much You don't need a huge line of credit. You don't need as much cash in a bank.

So manage to your cash gap. Right? That's the financial gap. You want those days to be as small as possible. So let me tell you a story about growing too fast. We always talk about running out of money.

It's also possible to be so successful that you grow broke, yeah, probably didn't know that. It's everyone's dream to put their product in Costco or Target or who knows I owe any of those any of those big bucks. But what could happen is that dream Get quickly turned into a nightmare. How? Because people might like your product. that's a that's a terrible problem to have.

But it happened to a friend of a friend. His name is Alden Mills. And he built a fitness product. And we built this fitness product. I mean, it just didn't go over well. He had 27 friends, families that he raised friends and family that he raised about $1.2 million.

And in no time at all, he was on home shopping network QVC, it doesn't matter. He spent a lot of the money and he was down to $25,000 trying to promote a product that nobody wanted. It's called the body riff. So if you YouTube or Google it, you can see that now the body ref was it was a fitness product that combined kind of aerobic activity and resistance, but nobody bought it. So with his last $25,000, he changed the product. We took one of the components of the body rev and put it into these two paddles, and these two pedals really were just extremely Have your hands and he was former military and one of their favorite exercises is the pushup.

So his whole idea was to as you do a push up to have your hands rotate, it just makes the push up just a little bit more difficult. It actually, you know, put some turn into your arms, and it's successful and he called it the perfect push up. You know, I'm sure you've heard it. In the first year he did $2 million of sales. And it went like hotcakes. Then all sudden he was As Seen on TV.

The second year he went $60 million in sales and almost lost the company. Here's why. It was so successful. I think everybody bought the perfect pushup even I did. But when Costco would sell out, they would reorder. So think about that.

He has 100 units in Costco. They sell in a week. Costco reorders sells another hundred, then another hundred, then another hundred. We'll say that happened five times before he saw the payment for the first hundred. So he had to go to the manufacturer, take cash out of his pocket, build the product, ship it, deliver it, and then wait about 90 to 120 days for the first check to come in for the first order. All the meantime, he has four other orders.

That's his cash sitting on Costco shelf that's growing broke, where you can actually outrun your cash flow by being so successful. Try to maintain your levels and Costco does a good job of that now by by putting limits on how much they'll take from a small business, they never want to be more than 20% of a small businesses, you know, customer base. That's one of the ways that they they try not to put them out of business, but you as an individual, you want to maintain it yourself. From a customer perspective. They say that the perfect mix on customer concentration is not to have a customer that's more than 8% of your total value. So when you look at your current concentration have 8% or less I think you'll be in good shape.

So here's your homework, I want you to go to cash flow tool and add the five silent killers to your dashboard. Now, with Miss financing, you're going to go to the document center and look at your balance sheet. Remember to change the gross fixed assets should match the change in long term debt and the change in retained earnings. The others you can build a dashboard and just check on a regular basis. So there's your homework. That was lesson number four the silent killer cash flow