Calculating Cash Flow

On Monday, I defined EBITA and encouraged you to use the term EBITA to replace “Net Profit” which is printed on typical income statements produced by programs like QuickBooks.

Today, I am going to continue discussing the example of the construction subcontractor who was doing everything right. He earned $200,000 in EBITA for 2007, but still was facing a $235,000 cash flow short-fall at year end. This owner was discouraged because he was having a great deal of difficulty paying his trade vendors, employees, and more importantly, himself. He thought the answer to his problem was to work more hours, take on more work and not take any money out of the company to support his family until he could “see” the money in the bank.

In order to explain this better, it is important to understand how cash flow is calculated:

This company had only been in business for a little over one year at the end of 2007. The owner was very good at his construction trade and had no problem taking on new work. He had to pay his employees every week. Some of his trade vendors gave him 30 days terms to pay for his materials, and some required him to pay for materials upon delivery. Working against the company was the average time it took to get paid – 55 days. To make matters a little worse, construction subcontractors often have retainage in jobs. This is usually 10% of every invoice that is held by the general contractor until the entire job is complete. It is not unusual for it to take 180 days or longer to get paid this retainage from the time a subcontractor like the one we are discussing finishes his work on a project.

During the first year in business, this company’s accounts receivable and work in process grew from $0 when the business was started. The business started operations with $0 capital or cash equity. During the year a small front end loader was sold. Here is a chart computing cash flow for the year:

Did this business fail by having a negative cash flow? No!

The company’s EBITA was $200,000, which was approximately 20% of revenues. The earnings were very strong considering most businesses in America operate on less than 10% EBITA.

The problem simply put was that all the EBITA was tied up in financing A/R and WIP.

On Friday, I will discuss how this company solved its cash flow challenges with just a little creativity, some external financing and a cash flow forecast.