Transcript: Unlocking cash flow — The lifeblood of small business success
Welcome to Financial Toolbox, a podcast series sponsored by CIBC Bank USA that understands that financial wellness is not innate. It's learned whether you're a member of the next generation wanting to start your financial journey out strong or you're a lifelong learner looking to improve your financial standing moving forward. Our team of experts are here to equip you with the information you need to help make your ambitions a reality. And now for this week's episode.
>> Kevin Kehoe: Hello and welcome to Financial Toolbox. My name is Kevin Kehoe and I lead the business banking group for CIBC Bank USA. I'm pleased to be your host today where we will discuss cashflow for small businesses. For this episode, we will discuss the effects of cashflow. And joining me today is Todd Gordon, who manages our business banking credit team here at CIBC Bank USA. Thanks for joining me, Todd.
>> Todd Gordon: Thanks, Kevin. Happy to be here.
>> Kevin Kehoe: Alright, let's get started with you telling the audience a little bit about yourself and how long you've been in banking.
>> Todd Gordon: Yeah, so I've been in banking for close to 25 years, and so I've worked at a few different banks, seen financial statements of thousands of different companies and different industries. I’ve pretty much always in the small business and business banking space, but it's given me an opportunity to review many different financials and really understand a variety of industries and companies and see how they work. So I've seen what works and what doesn't, and I've seen successful companies fail and then I've seen failing companies actually turn it around and succeed. So there's definitely some common themes of why and what parts of the credit side that drove that.
>> Kevin Kehoe :As a bank, we probably look at small businesses up to $30 million in revenue. When people mention cashflow, what does that mean to you?
>> Todd Gordon: Yeah, that's a good question. So cashflows can be a confusing topic. A lot of people confuse profitability with true cashflow. Cash and profitability is only good if you can turn those profits into cash because you're not going to be able to pay bills or buy inventory or pay expenses with IOUs, right? So to me, cashflow relates to the entire operating cycle. It's the money coming in, it's the money going out and just making sure that you have enough cash to pay all of your bills.
>> Kevin Kehoe: Can we talk a little bit more about one of the points you just made? Walk us through why profits don't always mean cashflow?
>> Todd Gordon: Yeah, I mean it's definitely all connected, but there's a lot of different layers to it. So profits are mainly the income statement and they show you what you should make and what you should have based on your sales. But to really understand cash and cashflow, you have to go an extra step and look at the balance sheet also. And so there's really three main components I would say on a balance sheet, right? There's the accounts receivable, there's the inventory and accounts payable, and they really all work together. So starting with accounts receivable, for an example, if I sold a hundred pencils at a dollar each and they cost me 50 cents each, that would be a hundred dollars in revenue, $50 in the cost of those pencils. And so it would look like I made $50 profit. But then if you go with that extra step further, what if the people who bought the pencils can't pay me for 30 days, that makes an accounts receivable for the a hundred dollars. So my income statement would show that I made $50, but in actuality, because there's that accounts receivable, I have $0 right now, meaning as expenses come up. So those salaries, rent, things like that, I need to be able to collect that receivable to create cashflow so that I can pay my bills.
>> Kevin Kehoe: Can you explain how that would tie into inventory and accounts payable also?
>> Todd Gordon: Yeah, of course. So in that same scenario, right, if I had a hundred pencils and sold them, now I need to buy more pencils so that I can sell more. But if I haven't collected those accounts receivable or those payments, I don't have any money to buy any more, so I don't have any more inventory to sell. So then if some suppliers were selling me those pencils, and they might offer what's called terms, so they may give me a hundred pencils and say “you don't have to pay me for 30 days.” That payment, what I owe those suppliers creates an accounts receivable, but I still need to be able to collect the profits that I made and the payments from those customers that I sold to in order to make the payments on those payables. So when companies get into trouble is when their payments are due before they get paid, so they really don't have any cash to make their payments.
>> Kevin Kehoe: Got it. So everything is all connected and really everything you do in business drives cashflow. But let's talk a little bit more about the balance sheet. So is there a specific way a balance sheet should look?
>> Todd Gordon: There is and there isn't. There really isn't a one size fits all, and so a balance sheet is really just a snapshot in time, so it can change on a daily basis. If you think about it, an income is more like a movie. It compounds over the course of a year. So it's January 1st plus January 2nd, plus January 3rd plus January 4th, whereas a balance sheet is more of a picture. So you will see a balance sheet as of January 4th or as of January 8th or as of March 18th or whatever the date is, right? So income statements will tell you the full story over a period of time, but a balance sheet is only going to show you what it looks like as of that day, which could change from day to day.
>> Kevin Kehoe: I think that's a very good point about balance sheets as a point in time and income statements or over a period of time that things can change on a day-to-day basis. But let's go back to the beginning that you've seen a lot of companies that were succeeding that have failed and a lot of failing companies succeed. Maybe you can walk through some pitfalls of companies or some decisions that caused the company to fail.
>> Todd Gordon: Yeah, sure. So again, if we talk about accounts receivable and inventory that we just went through, there's definitely some common pitfalls, as you said, right? So from inventory, we once had a high-end restaurant that did very well, and they sold steak and shrimp and they got a great deal on the steak and shrimp, and I don't remember the exact numbers, but let's say that they sold a thousand steaks per month. Well, they were offered a great deal if they bought 5,000 also, as you know, and the meat industry and shrimp and seafood and stuff like that, it spoiled. And so they weren't able to sell that. So they ended up paying a lot more for this inventory. They got a better deal per steak, but they ended up having to throw away a whole bunch of it because it's spoiled and they weren't able to sell it.
>> Todd Gordon: So it took them a long time to get back to where they were and they had to cut some staff, make some changes, but they just didn't understand. It seemed like a great deal, but it wasn't because they weren't going to be able to sell it. And the meat and the shrimp actually ended up spoiling. And so they ended up having to throw it away. And then another company from the inventory side was a technology company and they bought and sold computers and phones and things like that. And so they were in business for 12, 15 years and doing very well, and they thought they had a great deal. And so somebody approached them, offered them a whole bunch of computers to buy, and they thought they were getting a great deal on this. And so it was just too many because in the technology world, things changed quickly and they underestimated, and that the computers that they bought were really obsolete in a year.
>> Todd Gordon: There was a new model, there was new technology. So they ended up having a whole bunch of inventory leftover and had to sell them at a discount. So they ended up losing a lot of money and that company actually ended up going out of business. So from the inventory side, you just really need to know what your true inventory levels are. You need to know what you can sell, what is worth money, what changes quickly, know your industry, does it spoil? Does the technology change? Will there always be demand for it? Because inventory is really only as good. It's only a good deal if you can sell that inventory.
>> Kevin Kehoe: I think that's a very good point. I think we also saw some times during COVID where they ramped up their inventory and they weren't able to sell it as quickly as they thought they were. And to your point, the inventory becomes obsolete. So I think those are really good examples on inventory. Do you have an example with accounts receivable?
>> Todd Gordon: Yeah, so one example, I wouldn't say it's a great story, but we had a granite company once that used to supply granite for contractors doing kitchens and home buildings and things like that. And so this company gave one contractor about $400,000 worth of granite that cost them 300,000. So on their balance sheet, it looked like they showed, or their income statement, it looked like they were making a hundred thousand dollars on this. So when the contractor was halfway done, they came back to this company and said, we ran out of money, we need more granite, but we can't pay you yet. We'll pay you after the job is done. So the first 400,000 was still owed to them. It was a receivable that they hadn't collected. And so now they came back to them and said, we need more money, more granite to continue to complete the job.
>> Todd Gordon: And so this company, what they did was they ended up giving them another $200,000 worth of granite, which increased that receivable now to 600,000. So the company, the contractor actually ended up not completing the job, going out of business and filing bankruptcy. So when you look at a borrower's balance sheet, it looked like they were very profitable on this, right? They sold $600,000 worth of granite. They were making about $150,000 on that. But in actuality, they never got paid for any of that because the contractor went out of business and filed bankruptcy. And so they spent a lot of time digging out of that hole. They ended up losing about $150,000 on that because the receivable is only as good as whether or not it's collectible. So again, on paper it may look like you're profitable on that income statement. It looked like they're profitable, but you can't pay expenses and bills with IOUs and you need to be able to collect the receivables. So in that case, not collecting the receivables put them in a very tough position and they ended up losing a lot of money on that deal.
>> Kevin Kehoe: So in those cases where a company can't generate their own cashflow or just need money, what are some options for them? And maybe just touch on some advantages and disadvantages of each.
>> Todd Gordon: So there's a lot of different options out there. It depends on the company and the owners and what they really want it do. They can change the way they operate. They can collect receivables faster. They can pay payables in a different time period or negotiate with their suppliers. They can borrow from funds, they can go to factoring companies, they can get equity investors, but a lot of times we'll see them come to a bank for a loan.
>> Kevin Kehoe: And since we're a bank, can we focus on that one? How does access to a bank loan help a client with cashflow or in our terms, we call it a working capital line of credit.
>> Todd Gordon: Yeah, so the working, that's a good point. So the working capital line of credit is really the main product that's used for cashflow. It's more or less a bridge the gap type product. So in the case we discussed earlier with the pencils, a company can borrow from the bank to buy more inventory to sell if they don't have the cash yet and they have more demand, or they can use the bank's line of credit to make payments on to the suppliers or to pay expenses or things like that while they wait for receivables to come in. So it is really that bridge the gap that in between when they need money and they're waiting to get more working capital coming in. So they sell inventory, they collect the receivables, they pay the line of credit down, they borrow back from the line of credit, and that kind of cycle keeps going. And it really works almost like a very large credit card in a way.
>> Kevin Kehoe: So effectively banks help small businesses without working capital line because of timing and cashflow, right? It's all timing of when you collect on your receivables, maybe when you pay your payables buying inventory. It all intertwines. But it's a timing issue. Just a little bit about how a working capital line of credit is typically secured for a bank.
>> Todd Gordon: So banks like to see collateral coverage on their lines of credit, and usually the collateral on that line of credit will be accounts receivable or inventory. And really banks are going to look and make sure that a company has enough inventory or accounts receivable to kind of be above what that line of credit amount is. And banks usually apply what's called an advance rate against those accounts receivable and inventory because in a liquidation scenario, we're not used to selling the inventory, we don't have the relationships with the customer. So usually those accounts receivable and inventory are discounted a little bit as we give the line of credit.
>> Kevin Kehoe: And how do banks typically underwrite those commercial lines of credit? What kind of financials would we be looking at?
>> Todd Gordon: Sure. So when banks are looking at whether a company is going to get a line of credit, there's a lot of different variables that go into it, but just from the financial standpoint, we're typically looking at the last two to three years of financial statements that we'll collect and we'll look at their ability to pay on an ongoing basis. So we're going to underwrite and do some financial analysis on the historical figures of the company and use that to determine if we think all things equal, if that continued in the future, would they be able to support the line of credit that we give them.
>> Kevin Kehoe: Well, thank you for your perspective on cashflow and working capital lines of credit, balance sheets, income statements, how they're all intertwined. And I want to thank all of our listeners as we discuss cashflow. If you have any additional questions, please reach out to your relationship manager here at CIBC to assist. Thank you.
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