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Lake Falconer Partner

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

They say that ‘cash is king’ – so it’s surprising how often profitable companies can come close to running out of it.

By Lake Falconer
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Cash can be particularly tight for businesses experiencing 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

Many businesses measure their sales, leads and other activity, but fail to measure cash generation. This is particularly problematic when your business is growing quickly, since you’ll invest more in stock and labour before you can generate cash. It’s also an issue if you need business finance, since banks will want solid 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 buyouts. Banks often lend based on the strength – or covenant – of the business, and are particularly focused on cash generation as they hope to be repaid. So, before lending they will think about five things:

  1. Financial risk – how leveraged is the business? (In other words, how much capital has it borrowed with the expectation of higher profits?)
  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 debt and interest that the company needs to repay

So, 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. your business’ bank and asset finance repayments, including interest). If CFADS is between one-and-a-half and two 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 (perhaps because of slow moving items)
  • Uncontrolled WIP
  • Your creditors need paying quickly, but you have slow paying debtors

Overly strong CFADS

If your CFADS is more than two times your debt obligations then you should be thinking about investment plans. For example, you could look at buying a business 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 overly large cash flow balances can make it difficult to secure entrepreneurs’ relief upon a sale of the business.

So, it’s important to reflect on an appropriate level of cash to hold if you’re planning an exit strategy.

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