During our last time together, in my column “Cash Is King” in the September 2020 issue, we learned that the cash flow statement serves as a bridge between the balance sheet and the income statement. We also learned best practices to follow over the short term as they relate to the operating section of the cash flow statement. We then followed a fictional brewery as they focused their attention on short-term planning while optimizing their accounts receivable, accounts payable, and inventory. In this column we turn our attention to the investing and financing sections of the cash flow statement. These are our areas of focus over the longer term.
The cash flow from our investing activities involves the purchase and sale of fixed assets; assets whose useful lives extend past one fiscal year. It is through this section we plan the purchases of additional fermentation capacity, upgrade to a more robust canning solution, or sell that hand bottler we’re no longer using.
The cash flow from our financing activities is where we find our payments for our long-term loans, our dividends or profit-sharing payouts, and any sort of short-term line of credit borrowing we may need. It is important to note that repayment of debt is not reflected on the income statement, but rather on the cash flow statement and balance sheet. Therefore, it can be easily missed when one is creating a budget to plan for purchases of new assets over the upcoming year or having a valuation completed as a part of selling shares of the business.
When I took several nanobreweries’ financials to the bank to help them apply for a bridge loan this past summer of COVID-19 while waiting for Economic Injury Disaster Loan or Payroll Protection Plan funds to roll in, I noted the banker’s first area of focus for viability was the nano’s current debt state. Before looking at any sort of projections or planned use of funds, as reflected within the income statement, the banker calculated the nano’s debt service coverage ratio. This ratio, also known as the debt coverage ratio, is a critical benchmark used in the measurement of a nano’s ability to produce enough cash to cover its debt payments. To calculate it, divide the net operating income (obtained from your income statement) by the annual debt, both principal and interest (obtained from the financing section of your cash flow). If that figure is 1.25 or higher, the banker will then move forward with their analysis. However, it doesn’t matter how rosy your projections look if that figure is less than 1. That’s been a hard stop for most this past year. Therefore, calculate your debt coverage ratio and spend some time improving it before approaching a bank if that figure isn’t where you expected it to be.
We explored some best practices for cash flow management over the short term in my previous article. Now let’s look at some best practices for cash flow management over the long term, the actions we can take to positively impact the investing and financing sections of our cash flow statement:
- Align overhead spend with future demand. Overhead costs are the ongoing costs of running your nano that exclude direct materials (hops, malt, adjuncts) and direct labor (both brewing and packaging) to create each batch of beer. Overhead includes such items as your monthly lease payment, utilities, dues and subscriptions, and insurance. Sum your overhead costs for a particular time period (I suggest annually first, then quarterly as you refine your operating model), then choose your activity driver as the divisor. I typically recommend using barrels or gallons produced. That pool of costs divided by gallons (or hectoliters) produced will give you an overhead rate per gallon (or hectoliter). Once you have that overhead rate, use that to help with your future cash flow forecasting needs. If you plan to produce 150 more barrels of beer over the course of 2021, and your overhead rate is $3.42 per gallon (x 31 = $106.02 per barrel), be sure to plan for 150 x $106.02 = $15,903 more in cash outflow, whether in brand building and overall marketing or an increase with indirect labor to help support the additional production. While lease rate, insurance rate, and dues may not increase by any material amount, failing to account for the support it takes to sell that additional beer, especially when we may not have a dedicated sales staff, is often a pitfall nanos experience that puts them in a deficient cash flow position.
- Review contracts. Take some time to periodically review all your contracts, as often vendors will build in small increases over time once they feel they have earned your loyalty through the perception of a high switching cost. This equates to small amounts of cash per transaction, but could add up significantly over time. Look at hops contracts, mobile canning contract, your merchant services fees contract tied to your point-of-sale, and even your solid waste removal contract. Ensure the service being provided is aligned with your future needs in such a way you can begin recognizing efficiencies of scale. In some cases you will have to pay more per transaction based on the total volume of transactions incurred, so be prepared to pay or ditch that contract.
- Eliminate, automate, and consolidate. Review your processes regularly to eliminate unnecessary steps. How many of your tasks truly need to be done? Do they have to be done in the same way that you’ve always done them? Automate your systems as much as possible to minimize the potential for human error, and consolidate your data repositories for accuracy and efficiency. Can your inventory management system integrate with your financial management system? Can your point of sale integrate with your financial management system? Working more won’t necessarily coincide with more results; it does you no good to be efficient in tasks that are not effective. Never automate something that can be eliminated, and never delegate something that can be automated. The more efficient you become, the more cash you’ll save over the longer term.
- Evaluate all capital projects and purchases from the cash flow perspective versus the income statement. When faced with making an either/or decision based on limited funds, such as purchasing additional fermentation capacity versus expanding the taproom space, analyze the certainty of the return you will receive from additional cash inflows over a defined period of time (say 3–5 years; with how rapidly our industry evolves, I rarely assign a life cycle of any initiative greater than 5 years). If we purchase additional tanks, let’s look at the contribution margin received from each additional pint sold or keg filled each year over a period of the next three years. If we choose to invest in additional taproom space, let’s look at contribution margin received from each additional seat we haven’t been able to serve in the past that now we’ll be able to serve over the next three years. It’s not sufficient to simply look at additional revenue we expect to receive; we must understand the margin per unit brought in as it relates to our cash flow. We can then take things a step further by weighting each outcome by probability. For example, if we can’t keep up with demand of our beers and are constantly running out, we can attach a certainty of 85–100% when analyzing the contribution margin we expect to receive from that additional tank. It’s extremely likely we will sell all the additional beer we produce. On the other hand, if we live in a rural town and want to expand our taproom, we may be trying to cater to too small a demographic to create an impactful change on our cash flow by investing in a larger space. In that case, we could attach a 40–65% certainty when analyzing the contribution margin we expect to receive from each additional seat we’d be able to fill by adding new seats. If the contribution margin is the same from each, we’d choose the one with the higher degree of certainty. If the amount of incremental cash we expect to receive is relatively small, we can use the net present value (NPV) function in Excel to calculate total cash inflow expected over a three-year time period and compare it to project cost to ensure we don’t generate less cash over that three-year time period than we would spend on that initial capital outlay.
- Minimize pricing erosion. Price erosion occurs when you lower your price, and thereby, the perceived value of your product, for the sake of increasing volume sold. While it may be tempting to permanently lower your pint price from $6 to $5 with the hope of selling more beer, usually the increase in volume sold doesn’t make up for that loss in price realization. It is often more challenging to increase that price later down the road without some degree of pushback versus keeping your price on the higher end out of the gate and steady. If your beers are good, the consumer will pay for it. Don’t undervalue the work you’ve put in and the results you’ve achieved for the sake of potentially wrangling a few more dollars. Keep your pricing in line with the brand value you’d like your consumer to perceive.
Aside from these best practices, remember to use divisional accounting to track profitability by each arm of business of the nano, periodically review and revise your chart of accounts to ensure it still lines up with your business model’s success metrics, review your point-of-sale entry (or mapping from your point-of-sale to your financial management system if they are integrated) as it relates to the accounts in the master chart of accounts, and embrace a holistic view of the enterprise when it comes to decisions affecting your cash flow.
When we control the peaks and valleys of our short-term cash flow, we have a longer line of sight and can plan our expansion and owner distributions with greater confidence.