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  • Writer's pictureRamin Zacharia

A Primer on Operating Cash Flow

Years ago, one of my earliest memories of first learning about business finance and accounting is the oft-used phrase “cash is king.” At the time, it was an adage that lent itself nicely to be repeated by our high school teacher as he stood in front of the class, to be plastered on posters across the classroom, and to be printed on the back of $20 t-shirts for the students that took the class. First and foremast, if I truly understood why “cash is king,” I probably would not have spent $20 for a cheap t-shirt just to look cool. But more importantly, what I also did not fully appreciate at the time was how apt the statement was for every type of business. Whether it is an early-stage startup company monitoring cash burn over the next 18 months of operations to understand if a capital infusion is needed or a multi-billion-dollar international public company reporting on its latest financial quarter to investors, cash is definitely king.

There are a variety of methods of monitoring cash flow within a business environment. Although each have their own nuances, merits and considerations, all help inform business owners and investors of a company’s cash generation profile. Operating cash flow as I will describe it in this article focuses on a very simple subset of items that are critical to monitor – profitability (EBITDA), operating assets and liabilities (working capital) and capital spending (capital expenditures and capitalized software costs). This article will also focus on operating cash flow for software and SaaS companies specifically, but it is worth noting that it is certainly an applicable metric for all other companies across industries and vertical end markets.

What is Operating Cash Flow?

Within a cash flow statement, cash flow from operations / operating cash flow is typically the summation of net income, non-cash items such as depreciation & amortization and stock-based compensation, and period-over-period changes in working capital accounts such as current assets and current liabilities (excluding cash and cash equivalents). In the simplest of terms, operating cash flow is the amount of money generated (or lost) from normal course business activities.

In this article, I will define operating cash flow with a slightly different approach than what is seen in a cash flow statement with these two primary differences in mind:

1) I will look at operating cash from an unlevered perspective and without the impact of taxes - thus I will use EBITDA as the starting profitability metric vs. net income (net income considers interest paid on debt and taxes, which lowers a company’s profitability and cash flow);

2) I will include the impact of both capital expenditures and capitalized software costs, which typically are considered in the investing cash flow / cash flow from investments portion of a typical cash flow statement

On the first point here, my rationale for starting with EBITDA is that I want to attempt to strip out the potential effect of debt and taxes on a company’s cash flow. This is due to the fact that both leverage and taxes will skew the operating cash flow metric downwards. Also, debt levels and effective tax rates are variable and unique to individual companies, and should be assessed and analyzed more thoroughly with other metrics (e.g. levered free cash flow). With this point, I am by no means stating that debt and taxes are not critical to include in cash flow calculations - they are indeed very critical to understand a company’s true cash balance and cash generation profile because remember, cash is king.

As it relates to the second point above on capital spending, my rationale is two-fold:

1) Typical capital expenditures for software and SaaS companies (such as office space, computers / technology hardware for employees, IT infrastructure and data center fees) are critical items for daily operations. Additionally, these items tend to be at their highest levels when companies are growing aggressively – companies must make the necessary investments to support data consumption / hosting and employee growth, which have a significant impact on cash available for normal course operating activities;

2) Select software and SaaS companies capitalize software development costs, which removes their impact on the company’s income statement (and “artificially” increases the company’s profitability). These software development costs are generally research & development expenses that have been capitalized and amortized over time vs. expensed and included in the income statement. Thus, by including these within operating cash flow, we can provide a pro forma view of the company’s operating efficiency and effectiveness.

Overall, my hope with this metric is to isolate the true operating items that business owners and investors should consider when evaluating performance.

The definition I will be using throughout this article for operating cash flow is as follows:

EBITDA less capital expenditures less capitalized software development costs less the period-over-period change in net working capital (net working capital is defined as current assets (excluding cash) minus current liabilities)

Companies have a variety of business and financial model nuances that affect each of the components of the operating cash calculation. Possessing an understanding of these nuances and the effect each has on the metric is important, as it provides a more detailed picture of operations and how varying business practices can impact financial performance.

Understanding the Key Nuances of Operating Cash Flow

Incorporating operating cash into a company’s KPIs is quite easy and simple. Each of the components within the operating cash calculation I provided above are items that companies already monitor separately. However, in order to expand the metric’s usefulness and applicability, one must consider and fully understand how different nuances impact operating cash flow. There are five specific items I have chosen to cover here as integral components in a company’s operating cash flow, and will provide examples on an illustrative company to highlight how each nuance can affect operating cash flow, and its utility as a KPI.

1. Profitability

One must understand a company’s profitability on an EBITDA basis before digging deeper into the other components of the operating cash calculation. There are many factors that contribute to a subject company’s profitability: whether its revenue growth / revenue trends, cost of revenue / gross margin dynamics or operating expenses such as sales & marketing, research & development and general & administrative spending, developing a fundamental grasp of these components and how each affect profitability is essential.

There are countless permutations of how each of the aforementioned areas can impact profitability. I will provide four broad examples to illustrate the nuances of profitability, and how each influence operating cash flow.

On the left in the graphic below, I have provided a base view of Company ABC, where the company is profitable on both an EBITDA and operating cash basis. On the right, I have taken Company ABC and discounted the revenue by 25% while maintaining the same revenue growth, gross margins and operating expenses (full disclosure: I have discounted G&A and working capital by 25% as well to reflect the company’s overall smaller scale). This example shows how revenue scale can clearly impact profitability:

In this second view, I have taken the base view for Company ABC and reduced revenue growth in FY 2 by 15% to show how a reduction / slowdown in revenue growth can decrease profitability, and therefore lower operating cash.

Moving from revenue to the cost of revenue, it is important to also assess the impact of how gross margins can impact overall profitability. In the base view, Company ABC has steadily increased both its subscription and PS gross margins. Company ABC’s gross margin profile is very solid, with subscription margins in the high 70s and PS margins approaching 30%. However, what if we were to take gross margins for both subscription and professional services revenue down? Let’s explore the effect of this on Company ABC below:

As expected, lower and/or stable gross margins vs. higher and/or growing gross margins contribute to lower overall profitability (of course, while holding other variables constant) on an EBITDA and operating cash basis.

The fourth and final profitability consideration is the assessment of a company’s operating expenses, and how the spend in each bucket impacts operating cash. In the case of Company ABC, the absolute value of each operating expense item increases quarter-over-quarter, but the expenses as a % of total revenue remain stable or decline over time. However, in the operating expense constant ratio view, I have kept the % of revenue ratios for each of the three operating expense buckets the same over time. This results in an even larger base of operating expenses, and as a result, an overall lower profitability profile and decline in operating cash (again, holding everything else constant).

Each of the four illustrative cases on Company ABC above provide a look on how varying business levers impact EBITDA profitability, which in turn impacts operating cash. Being in tune with a company’s profitability profile (especially by digging in to understand its scale, revenue growth rates, gross margin profile or operating expense trends) help inform business owners and investors on the fundamental effect each of these considerations has on operating cash flow.

2. Capital Spending

Capital spending, which consists of capital expenditures and capitalized software development costs, provide a view into where a company may be in its growth lifecycle. In a software / SaaS company’s expansion phase, more capital investment is typically made to support continued scale. These investments from a capital expenditure standpoint include spend for datacenters, IT infrastructure, hosting, office space, computer equipment, telecommunications equipment and other fixed assets. Early on in a company’s lifecycle, substantial growth capital expenditures are made to support increased data consumption, new customer onboarding, rapid employee hires and other expansion activities. Over time, the company must make maintenance capital expenditures to support continued operations and stable growth. These maintenance items include incremental office space, infrastructure growth and new computer equipment / telecommunications items for new and existing employees.

To illustrate how a company’s operating cash flow varies with different levels of capital expenditure spend, let’s continue the example for Company ABC. In the base view, the company is spending a maintenance amount of 5.5% of revenue in each period. In the growth capex view, Company ABC is making substantial growth capital expenditure investment in the first and third quarters of each year on top of the maintenance spend. With this increased level of capital spending, Company ABC’s operating cash is lower in the first and third quarters of each year in the right-hand side of the graphic below:

When looking at capitalized software development costs, this capital spend category is typically inclusive of coding, development and testing costs for specific projects that meet GAAP capitalization guidelines. One common example of capitalized software development costs are the salaries for development employees allocated to specific capitalizable projects. When a company is in its expansion phase and constantly developing new solutions / technology, there is an opportunity for companies to capitalize software development costs vs. expense the costs as incurred. This moves these costs from research & development expenses on the income statement to the balance sheet and cash flow statement in the form of capitalized software development costs. To show the effect of this, here is Company ABC in a base view (where the company capitalizes software development costs at 4.5% of revenue in each period) and a view where there are no capitalized software development costs.

Analyzing a company’s capital spending profile can identify where the entity is in its growth lifecycle. By and large, capital spending is higher for early-stage companies that are expanding rapidly, as these investments are made to support future scale. Whether it is looking at an early-stage company or a mature growth company, these capital investments are meaningful to monitor and consider, as they reduce the operating cash available for other business activities.

3. Billings and Cash Collection

Changes in periodic values of working capital accounts can significantly impact operating cash flow. These fluctuations can be a product of accounting policies, seasonality or when a company bills customers and collects invoices. With respect to billings and cash collection, the key working capital accounts that are affected are accounts receivable and short-term deferred revenue.

Accounts receivable for software and SaaS companies is typically composed of contractual amounts that are billed to a particular customer for use of a company’s platform, products and services. When a company begins to conduct business and acquire customers, it can invoice customers on a monthly, quarterly and/or annual basis. The frequency of billings dictates not only how often customers get invoiced for using the company’s platform, but also how quickly the company collects cash. With monthly billings, accounts receivable tends to be more stable period-over-period, and less susceptible to large periodic swings. On the other hand, quarterly and annual billings tend to make accounts receivable balances fluctuate at a larger magnitude based on when a company invoices its largest customers and/or the majority of its customer base.

These variances in accounts receivable balances from one period to the next have an impact on operating cash, as accounts receivable increases (therefore, decreasing operating cash flow) when a company bills its customers, and will correspondingly decrease (increasing operating cash flow) when a company collects on its customer invoices.

Let’s explore how operating cash may vary under different scenarios with Company ABC. In the base view (left-hand side of graphic below), Company ABC employs annual billings on its multi-year engagements, billing the majority of its customers in the second and fourth quarters of each year, and collecting invoices in the first and third quarters. In the monthly billings view (right-hand side of graphic below), the company evenly bills and collects on its customers throughout the year with no evident pattern in accounts receivable fluctuating period-over-period. This results in different working capital dynamics, and thus, different operating cash flow.

Akin to accounts receivable, short-term deferred revenue is also impacted by how frequently a company bills its customers. Deferred revenue represents the amount of unrecognized revenue that needs to be earned by a company over time on a customer’s invoiced contractual amount. If a company bills annually in advance, there will be a larger ST deferred revenue balance in the billing period, representing the amount of revenue that needs to be earned and recognized in subsequent periods. If a company bills monthly on its subscriptions, there is a typically a one-to-one match between revenue recognition and billing, and thus there will be no / limited short-term deferred revenue created.

As highlighted in the example above for Company ABC, short-term deferred revenue is much lower in the monthly billings view - the balance that remained was only applicable to hypothetical professional services unrecognized revenue. Also, with a lower short-term deferred revenue balance, working capital turns positive. For growing software / SaaS companies that bill annually in advance, like we see in Company ABC’s base view above, it is a common trend to see negative working capital. With the change in billing frequency and cash collection, working capital trends vary, and therefore affect operating cash flow in different manners.

4. Accruals and Payables

Other key working capital accounts for many businesses are short-term accruals and payables, both critical components of a business’ daily operations. Accruals are typically representative of payments a company must make in the future for goods / services that the company receives. One common accrual is related to employee compensation, such as bonuses, that are incurred and accrued over a period, but paid out at a later time based on the company’s compensation policies.

On the other hand, payables represent values that a company must pay to a select group of vendors that have invoiced the company for goods / services. An easy way to remember what payables represent is to think of them as the opposite of accounts receivable. One common payable item is the payment a company makes every month to a vendor that provides it with cloud hosting. Payables represent a common method for a company to purchase goods / services without immediately having to pay a vendor in cash for the goods and services. Accruals and payables impact working capital and operating cash flow depending on the policies a company employs, as well as the number and types of vendors it utilizes for operations.

To illustrate the impact that these items have on operating cash, the below represents two views for Company ABC. In the base view, Company ABC receives the majority of its vendor payable invoices in the second and fourth quarters of each year. The company also accrues employee compensation throughout the year, and pays out its accrued bonuses in the first quarter of the following year. Conversely, in the alternate accrual and payables view, Company ABC receives the majority of its invoices for vendor payables in the first quarter of each year and pays out monthly bonuses vs. one lump sum that is accrued over time and paid out at once.

Given all of the moving parts in a company’s working capital, it can be tricky to fully grasp how certain accounts affect a company’s cash profile. Developing a detailed understanding on the nuances of a company’s accrual and payable accounting help inform investing and operating decisions, as well as provide additional insight into key analyses and other KPIs.

5. Deferred Commissions

The final nuance I have chosen to cover on operating cash is deferred commissions. Although deferred commissions are not relevant for all software and SaaS companies, it is still an important item to be aware of, especially given the recent ASC 606 rules that have been implemented.

Deferred commissions represent the amount of commissions a sales person makes on selling a multi-year customer contract that are deferred and then amortized over the life of the customer contract. Prior to ASC 606, software and SaaS companies that sell multi-year contracts could choose whether to expense these sales commissions on multi-year contracts in the periods they were incurred or alternatively, could defer commission amounts and amortize the balances over time. With ASC 606, sales commissions on contracts that are over 12 months in length must be deferred and amortized, creating a corresponding deferred commissions asset line item on the balance sheet.

A simple example of deferred commissions treatment is as follows: a sales person makes $100K of commission on a three-year customer contract that has a total contract value of $1M. From a payment standpoint, the commissions are to be paid out to the sales rep according to the company’s commission plan structure. From an accounting structure, the company must defer the $100K of commissions, and amortize it over three years to match the periodic revenue recognition. In each month of the three-year contract, the company would recognize ~$28K of revenue and ~$2.8K of commissions expense.

From an operating cash standpoint, multi-year contracts can create fluctuations in working capital due to the creation of a deferred commissions asset account. If the company instead employs monthly billing or customer contracts that are at one year or shorter in length, deferred commissions are not relevant. Here is an example from a prior section above with new commentary for Company ABC to illustrate the impact of deferred commissions.

Why is Operating Cash Flow So Important to Monitor?

Combining an understanding of the nuances that impact operating cash with reasons of why it is such an important metric to monitor is critical. Although this metric is certainly not a veritable panacea for a company’s challenges and pain points, it is certainly a powerful KPI to add to financial and operational reporting, and can be used to inform business and strategic decisions. Here are five reasons on why operating cash is important to monitor:

1. Helps Companies Plan Effectively

Given operating cash can help unpack how billing and cash collection cycles affect a company’s periodic cash flow, management teams can effectively plan major business decisions around cash outflows and inflows. As we saw, companies that are growing must make necessary investments in capital spending and infrastructure to support additional scale. With operating cash flow at a company’s disposal, management teams can plan accordingly and properly time capital spending decisions in periods where the company has cash available for investments. Also, this metric can help inform business decisions that can limit the cash burden on the company at any one point of time.

2. Helps Maintain Cash Flow Discipline

The metric focuses on the most critical operating components of any one business: its profitability, its working capital and its capital spending. Vigilantly monitoring a metric like operating cash helps isolate the impact of these critical business activities, and helps companies develop discipline in cash flow even before considering other items like debt financing. This provides companies with a view into which operating items are absolutely needed to keep the business’ “lights on,” and which items may be worth improving or removing entirely to create incremental operating cash. For early-stage companies, monitoring operating cash flow is even more integral, as they must be constantly informed of cash burn to understand how long they can continue to operate as a going-concern entity. By adding operating cash flow as a KPI, these early-stage companies can make properly informed and timed decisions as it relates to seeking external capital / acquisitions, folding operations or implementing other business enhancements.

3. Helps Identify Outliers and Patterns in Financial Performance

Sometimes business operators and investors are so entrenched in their day-to-day tasks that they forget to take a step back and look at the full analytical picture and how the numbers can help tell the story. With a simple metric like operating cash flow that encompasses many of the key components of a company’s business model, folks can marry their deep knowledge on a company’s daily operations with a KPI that can easily and simply explain outliers and trends in financial performance. As we saw in the numerous examples in this article, operating cash can convey the impact of a variety of factors on a company’s financial performance. Whether it is working capital seasonality, accrual timing throughout a year or one-time growth capital expenditures vs. steady-state maintenance capital spending, operating cash does a great job of providing analytical support to qualitative business items, and serves as a good starting framework to dig into the next level of business data.

4. Helps Companies Construct / Adapt Policies and Reporting Methodologies to Better Suit Performance Goals and Business Needs

Does your company cash collection improve with monthly billings because you serve SMB customers that are sensitive to larger, annual invoices? Do your employees perform at a higher level and remain more motivated with more frequent bonus payments vs. a one-time, annual lump amount? Are your vendors putting you in a cash burden because they are imposing too stringent of payment terms? These, along with many others, are all questions business owners and operators ask and try to understand in more detail every day. With a metric like operating cash that effectively covers many of these critical areas of operations, companies can set or adapt financial and operating policies that best meet its needs and fit its business model.

5. Provides Another Useful Financial Metric in Financial Reporting

If any of the other four reasons do not resonate with you on why operating cash can be important, this reason is a catch-all that hopefully resonates. Much like any other metric that business owners and investors utilize, operating cash is an effective KPI that can extend the understandability and usefulness of financial information. For investors, it can also serve as a helpful tool to see how strong a company’s cash flow dynamics are, which is critical for those seeking a return on their invested capital that meets certain thresholds or requirements.

Concluding Thoughts: Implement Operating Cash as a KPI in Your Business / Portfolio

Although it has specific nuances that may be challenging to isolate or fully understand, operating cash is a valuable metric that can convey a number of key characteristics on a company’s cash generation profile. Whether you are an early-stage entrepreneur seeking external capital or a partner at a private equity fund assessing the viability of a new investment, operating cash can provide extensive insight into a subject company’s operations and business model. Ultimately, implementing operating cash as a KPI improves financial reporting and can also enhance strategic planning and decision-making for companies of all types and sizes.

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