Cash is king. But, in advanced Sales and Operations Planning (S&OP) or Integrated Business Planning (IBP), this king has lost his crown. Often, there is no cash flow forecasting in S&OP/ IBP.
The same applies to Financial Planning and Analysis (FP&A) where cash flow forecasts are non-existent many times. If cash is the lifeblood of a business, why is it also the missing element in S&OP/ IBP as well as in FP&A?
The integration with Finance has been rough in mature S&OP processes—also known as Integrated Business Planning (IBP).
Unlike generative AI, this is not new. In her most recent study, Supply Chain Analyst Lora Cecere, reveals that the gap between Finance and Operations is coming back to pre-pandemic levels, being 79% of importance and 39% of performance.
Other supply chain leaders have voiced the importance of alignment between finance and operations in a recent Conference from the Institute of Business Forecasting and Planning. However, progress in this area has been limited.
The P&L is Not Enough
Most advanced S&OP/ IBP focus on the Profit and Loss Statement (P&L) at its best and neglect the other two core financial statements that are the Balance Sheet and the Cash Flow Statement.
The three of them are critical to understand business performance. The P&L or Income Statement is a summary of the company’s revenues, expenses, and profit or loss over a period of time.
Knowing whether a company is profitable is important and so is the balance sheet. It conveys the financial performance at a specific point in time, like a snapshot of the business’ finances, displaying assets, liabilities, and shareholder’s equity.
It shows a different angle. For example, the business can be highly profitable when we look at the P&L and be fully financed with debt. What’s worse, even being profitable, the business can go bankrupt if there is no cash.
Here is where the cash flow statement comes into play. I refer to it as the “Show Me The Money Statement” because that is precisely what it does: displaying the in-flows and out-flows of funds in a period of time.
By looking at the statement of cash flows, you can see the sources and uses of cash. It has three different sections:
- Operating activities — these are the ins and outs of cash from the business core activities.
- Investing activities — these are the cash flows coming from and used in non-core business activities.
- Financing activities — as the name denotes, these in-flows and out-flows relate to debt and equity.
Each of the three core financial statements take a different view of the business financial performance. It is vital to consider these three perspectives for a comprehensive assessment.
Profit is not Cash
To show each business’ angle, the P&L and Balance Sheet follow Accrual Accounting while the Cash Flow Statement, naturally, Cash Accounting. The difference between Accrual and Cash Accounting is timing.
Cash Accounting tracks the in-flows and out-flows of funds from revenues and expenses while Accrual Accounting tracks the actions that generate or incur expenses.
Consider a company that sells its products to Walmart. Let’s say that payment terms are net 120 days. If we follow cash Accounting, there is nothing to record until the business receives payment in four months.
With accrual Accounting, we record the sale and the receivables. These receivables will turn into cash when the business receives the payment 120 days later.
Staying with this example, the P&L shows a profit—assuming that price is higher than cost—for about four months, but there is no cash from this sale to Walmart in the cash flow statement.
So, P&L and Cash Flow Statement are different. The P&L takes the profitability angle of the business while the statement of cash flows takes the cash angle. I want both for proper assessment of a company’s financials, wouldn’t you?
What happens is that in S&OP/ IBP many companies have P&L forecasts and use a proxy for the cash flow side.
This proxy is EBITDA, a non-GAAP metric, that stands for earnings before interest, taxes, depreciation, and amortization. In other words, our king has lost its crown because of EBITDA.
EBITDA is not Cash
The EBITDA calculation takes the operating and non-operating income from the P&L and adds back the depreciation and amortization because they are non-cash items.
This means that they do not represent payments at the moment. The idea behind EBITDA is to remove all non-cash items, precisely, to get to cash. Depreciation and amortization are examples of non-cash items.
Depreciation is a reduction in the value of an asset like Property, Plant, and Equipment (PPE), due to wear and tear. Amortization is the same as depreciation but applied to intangible assets.
These assets are included on the balance sheet, the other core financial statement. Remember that the three financial statements—P&L, balance sheet, and cash flow statement—show different angles of the business financial performance? Here is how everything comes together.
EBITDA can be a disastrous proxy for cash if a business is capital-intensive, with a high value of fixed assets on the balance sheet.
This situation happens with growing companies that invest in adding capacity with new equipment or manufacturing facilities, for example. By adding back the depreciation, EBITDA doesn’t consider the required capital expenditures—CapEx.
Initially, CapEx doesn’t show in the P&L, but it can have a massive impact on cash flow. This represents a serious flaw of this metric. In Warren Buffet’s words, “does management think that the tooth fairy pays for capital expenditure?”
EBITDA has other flaws too. Companies may apply different accounting rules. An example is R&D. Per the United States Generally Accepted Accounting Principles (GAAP), companies are required to expense R&D costs in the year they are incurred. This shows in the P&L.
Under the International Financial Reporting Standards (IFRS), companies must also expense research expending but, development costs may be capitalized—asset on the balance sheet—if the asset will become commercially viable.
This implies that the asset in development will generate revenue. EBITDA will be lower for the company that expenses R&D, as R&D goes to the P&L in full.
If the company capitalizes the development part, such a part goes to the balance sheet. Besides this flaw, the non-cash items included in the EBITDA calculation may vary in different reporting periods by creating inconsistency in the measurement system.
Conclusion
The importance of cash is undeniable. Showing profits in the P&L doesn’t preclude a company from bankruptcy when there is no cash. Despite this, even in the most advanced S&OP/ IBP processes and in FP&A, the focus is on the P&L only. Companies are content with using a proxy for cash that is EBITDA.
However, this non-GAAP metric can have perverse effects in capital-intensive companies. Cash is king. Let’s give it back its crown. There are no substitutes for good cash flow forecasts.
