A key solvency metric: Free cash flow

In the short term, businesses need liquidity to pay their bills to keep vendors and employees happy. But what about the long term? Businesses need to money to expand operations (and sometimes to pay more dividends to keep shareholders happy). Without free cash flow, a business runs on a treadmill, taking in money and giving it back out again. For a business to grow, they need free cash flow.

MEASURE YOUR SOLVENCY WITH FREE CASH FLOW

There are other ways to measure solvency but I like free cash flow as one of the key metrics to use because it reveals that all-important cash flow number.

So here is how to calculate the free cash flow metric:

Cash from operating activities – capital expenditures – Dividends paid

Here’s how to understand this metric:

  • Cash from operating activities is the money taken in from doing whatever it is your business does — selling your products and services to your customers. (Businesses can also bring money in from investing or financing, so cash from operations measures only the money brought in from the actual selling of whatever it is your business sells; it doesn’t include that “one-off” money you bring in from selling a factory or taking out a loan).
  • Capital expenditures is the money spent to buy the big stuff — often summarized as “property, plant, and equipment” — that a business needs to run its operations. The actual definition is a little fuzzy (it depends on the business; we don’t all need a factory) but in general it’s the stuff that you have to spend a lot of money on, and then amortize and depreciate over more than a one-month period.
  • Dividends paid is money that you pay to shareholders in the company.

You just take the money you get from operations and you subtract the money you spend on property, plant, and equipment, and you also subtract the money you spend on dividends. What’s left over is the money you use to grow your business.

In general, you can use the money in the following two ways:

  • Expansion: Businesses can use free cash flow on more marketing to increase their marketshare or they can use it to enter new markets. They can use the money for research and development to innovate new products and services.
  • Additional shareholder rewards: Businesses can use free cash flow to provide additional dividend payments to shareholders, rewarding those shareholders with more money. As a stockholder and as a business owner, additional dividends are welcome!

So let’s look at some examples:

You’ve got a lemonade stand.

You netted $10.00 in cash from operations. But you spent $5.00 to rent the lawn and a table from your cranky old neighbor, Mr. Farley, whose lawn is way better for a lemonade stand than your home’s lawn. And you also had to pay your mom $1.00 in shareholder dividends because she was kind enough to lend you the lemonade in exchange for for a 10% daily dividend.

So let’s plug the numbers into the calculation:

Here’s the calculation again…

Cash from operating activities – capital expenditures – Dividends paid

We’ll plug in the numbers…

Cash from operating activities: $10.00 – capital expenditures: $5.00 – Dividends paid: $1.00

So the equation looks like this…

$10.00 – $5.00 – $1.00

Which leaves $4.00 as free cash flow. You can use that money to buy higher-end lemonade, to innovate new lemonade recipes, to pay for a wider marketing effort, or to pay your mom a higher dividend.

Let’s look at a real life example of free cash flow. We’ll use an insanely cash-rich company — Apple (APPL) — and we’re using the information from their quarterly cash flow statement (the most recent statement available at the time of this writing), published June 30, 2012.

Again, here is the equation…

Cash from operating activities – capital expenditures – Dividends paid

And we plug in the numbers…

Cash from operating activities: – capital expenditures – Dividends paid

Cash from operating activities: 10,189,000,000 – capital expenditures: 2,056,000,000 – Dividends paid: 0 (they don’t pay dividends)

Cleaning it up a bit…

10,189,000,000 – 2,056,000,000 – 0

So Apple’s free cash flow is: 8,133,000,000. Nice!

Who wouldn’t love to have 8.133 billion to use for expansion???

3 reasons why I didn’t like “Rich Dad” Robert Kiyosaki… until now

I have a confession to make. There were many years when I didn’t like “Rich Dad” Robert Kiyosaki. Only recently have I become a fan but it’s taken me a while to come around.

Robert Kiyosaki is the creator of the Rich Dad brand, and author of a bazillion books like Rick Dad, Poor Dad and Cash Flow Quadrant. Kiyosaki’s message is: Poor people work for their money while rich people have their money work for them. And he uses a quadrant to illustrate his message, showing how poor or middle-class people are either employees or self-employed people who trade their hours for pay while rich people are business owners and investors who use their money to make more money.

I first read one of Kiyosaki’s books back in 2000 (I think it was his Cash Flow Quadrant book, although I can’t remember). The book was okay but I confess I didn’t love it and it took me years before I came around to appreciate and admire Kiyosaki.

Here are the reasons that I wasn’t a fan:

1. KIYOSAKI IS ALL SIZZLE AND NO STEAK

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His ideas about why someone should own a business or invest in real estate were good. But I felt that he lacked the “how-to-do-it” that I was looking for. He is the master of packaging ideas but they didn’t always fulfill a value quotient, in my opinion.

What changed for me recently was a book I picked up called The Real Book of Real Estate in which Kiyosaki’s name is splashed prominently on the front but he has 22 other people write the book… and their insights are really quite valuable. While reading the book, I realized that Kiyosaki doesn’t have to provide the steak. He provides the sizzle and other people can provide the steak.

2. KIYOSAKI’S IDEAS CONFLICTED WITH MY ASPIRATIONS

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I have always aspired to be a writer. That’s all I ever wanted to do. There are parts of being a writer that are “B” (Business owner) qualities, such as writing a book, and Kiyosaki’s advice would be to focus there. But there are parts of being a writer that are “S” (Self-employed), which Kiyosaki says are part of a less-than-ideal business model. The problem was, I really liked being a writer and enjoyed the “B” part of the business as well as the “S” part of the business. (Note: If you’re unfamiliar with Kiyosaki, he makes a distinction between being self-employed, where the business is entire dependent on you, and being a business-owner, where you grow a business that doesn’t require your input). It felt like Kiyosaki was discounting my aspirations.

What changed for me recently was re-reading Kiyosaki’s Rich Dad, Poor Dad book (as part of a project for a client). In that book, Kiyosaki makes the excellent point that people should work to learn rather than work for money, then they can use their education to build businesses and invest. I can live with that because it helps me to see that there is a legitimate balance between what I do on the freelancing side of my business and what I do on the book/e-book writing side of my business.

3. KIYOSAKI’S DISCIPLES DROVE ME CRAZY

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Yeah, that might sound harsh but in the past 12 years that I’ve been familiar with Kiyosaki’s ideas and worked with entrepreneurs and real estate investors, many of the biggest Kiyosaki disciples drove me crazy. I can’t tell you how many times I sat down with a prospective client who was stuck in a dead-end job and up to their nose in debt (while I ran my decently successful, debt-free business) only to have them lecture me about why my business needed to be a “B” business instead of an “S” business. And I’ve seen a bunch of aspiring real estate investors regurgitate the words “I want a cash flow positive property” without really understanding what it means, and while turning down potentially lucrative short-term deals because they didn’t meet their idea of a Kiyosaki-quality investment. And Kiyosaki’s emphasis on network marketing has created an army of pro-network-marketers who continue to make the same mistakes that lead to failure in their MLM businesses.

What changed for me was a client I’ve been working with who had me dig back into Kiyosaki’s work for some of his projects. He is an extremely successful real estate investor and lives out many of Kiyosaki’s principles in a way that most aspiring investors only dream of. I started to see Kiyosaki’s principles in action (something I hadn’t seen in the first decade of my familiarity with Kiyosaki’s work).

I’M TURNING INTO A KIYOSAKI FAN… SLOWLY

I’m not yet ready to go out and buy all of Kiyosaki’s books or get a Rich Dad tattoo or attend his seminars (PLEASE don’t invite me) but I have gained a new appreciation for Kiyosaki and I see the value that his platform can provide. I’m not quitting my “S” business just yet but (to use Kiyosaki’s own terminology), I’m building assets in the “B” and “I” categories of his quadrant. And I’m learning to respect his audience.

If you are a Kiyosaki disciple, here are some of my own thoughts for you:

  1. Kiyosaki has a good platform but he lacks step-by-step methodology and that might be holding you back. There are other resources out there that might be able to help you. Use Rich Dad as a springboard to do other research from other experts and don’t be afraid to move outside of the Rich Dad boundaries to see how other people are applying Kiyosaki’s ideas.
  2. If you’re an employee right now and you want to become rich, it can be hard to go from “E” to “I” in one step. Instead, make a plan to go from “E” to “S” to “B” to “I”. The steps are smaller and you can learn a lot along the way.
  3. Not every person aspires to be a real estate investor. There are other kinds of investments out there. You might be suprised.
  4. Remember that all of Kiyosaki’s ideas are only good if you actually act on them. If at this time next year you are still an employee and haven’t done anything else to move beyond that, then Kiyosaki’s ideas have no value for you. Action gets results. Figure out what is holding you back and address that.

17 ways to avoid getting shafted by your customers

In many businesses, you run the risk of getting totally shafted by your customers from time to time — where you deliver a great product or service and then they skip town and they somehow get out of paying (either by ignoring your invoice or doing a credit card chargback).

It sucks. And it happens to a ton of businesses.

I keep a list on my computer of delinquent receivables and every now and then I have to add someone else to it. Just today, I’ve added someone else to that list. I’m not embarrassed to admit it because it happens to most businesses.

Each time I add someone to the list, though, I get a little smarter. I make sure that I learn from the shafting and it keeps me from losing money in the same way again.

Here are seventeen ways that you can avoid getting shafted by your customers. (I realize not all of these will apply to every business but many of them will apply to many businesses so take what you can)…

1. DO YOUR DUE DILIGENCE

Spend a few minutes and research your prospective customer before you sign them as a customer. What are people saying about them? That less cost me $1,000 several years ago. I did a bunch of work for a client and then wondered why he never answered my phone calls or emails. I Googled his name and his company name for additional ways to contact him and what do you know, there was a bunch of info about him not paying his other bills. Customers do due diligence on you; there’s nothing wrong with doing due diligence on your customers.

2. BE WORRIED IF THEY ARE HOUNDING YOU BEFORE BECOMING CUSTOMERS

Before your customers become customers, there is usually some back-and-forth about the project. But the prospective customers you really need to be worried about are the ones who are hounding you a lot. Hey, some hounding is good because maybe it means that they like you and really want to work with you. But in my experience, the customers who hound you the most (before becoming customers) are the ones who wont pay. They desperately want to work with you and will email you every day to find out when they get started.

3. AGREE ON AN OUTCOME

Clearly define the project. Before the project starts, clearly outline what each of you consider to be a successful outcome and what the timeline will be. This will help arguments at the end of a project about what you should be paid for. This was a lesson for me several years ago. I wrote an ebook, delivered it as promised, and the client said “my needs changed and I don’t need the ebook any more. But because you did all that work, I’ve decided to only pay you 50% of what we agreed.” Clearly, I failed to identify the requirement that the completion of the ebook is what will trigger full payment, not concurrent changes to my customer’s business strategy.

4. GET PAID UP FRONT

Receive the cash in hand BEFORE you start work. Yeah, this might seem like a no-brainer to some but not every industry requires it and every entrepreneur needs to find the balance between asking for money up-front and losing customers to those who invoice at the end of a project. I invoice MANY of my customers at the end of the project and my delinquent accounts receivable account for less than less than 1% of my income so that’s a risk I’m willing to take. If my delinquent accounts receivable percentage increased, I would make a change.

5. GET CASH FLOW

If you can’t ask for all of the money up-front, create milestones and get paid on each milestone. This won’t eliminate all shaftings but it will minimize the damage from any one shafting. Plus, you’ll like the cash flow too!

6. WATCH OUT FOR CHANGING TIMELINES

Remember earlier I said prospective customers will hound you? Well my most recent lesson (for the customer I just added to my list today) is one whose timeline that accelerated and decelerated as badly as my father-in-law does when he’s driving. When the project was in my hands, my customer was always hounding me for it. (That’s okay, I don’t mind a little of that). But when the customer was reviewing the project, his timeline went from days to weeks. Then it was back to me for daily hounding and then back to him and I wouldn’t hear from him for a couple of weeks. The same thing seems to have gone on with the invoice. Oh well.

7. BUILD A FILE ON YOUR CUSTOMER

While doing your due diligence, capture all the contact information you can and build a file. The file is a useful tool in general to have. You can get in touch with your customer easily and you might even find additional businesses and websites that you can help your customer with. But when they don’t pay, you also have a useful stack of information to call them with. Way back when I was a sales manager, I did this too. And my delinquent customers became very likely to pay when I knocked on their door. (That makes me sound more intimidating than I meant it to. I just mean that customers can ignore answering your call but they can’t just move their home).

8. BE STRICT ABOUT WHAT YOU GIVE AWAY

It’s good to provide lots of value to your customers… but it’s bad when you do that instead of making money. Chances are, you give lots of stuff away so be careful about how much more you give away to customers. Years ago, I had a customer who I wrote something for and then threw in a quick free project. They were appreciative. Before long, they were only asking for that free project and weren’t sending me any more paid work. They couldn’t quite figure out why I stopped working for them. Just recently, I negotiated a buy-something-get-something-for-free deal with a client who then started demanding the free thing first. Dropped him before I did any work for him.

9. BUILD A RELATIONSHIP WITH YOUR CUSTOMERS

Build a relationship with your customer. Help them to feel like they are not only your customers but also your friends. Sure, friends screw you sometimes, too, but they are less likely to if they know that their delinquency will steal food from your kid’s mouth. Connect with your customer in other places — online and offline — and you’ll dramatically reduce your likelihood of getting shafted.

10. START ON THE NEXT PROJECT BEFORE THE FIRST ONE IS DONE

Customers who don’t pay do so because they hold all the cards: They have your product or deliverable and you can’t get it back. If you start working on their next project, you not only gain extra business for yourself but you also give them a reason to pay you so they can continue on their next project.

11. CUT YOUR LOSSES

While working on a project, you might realize that your customer is not going to pay. For whatever reason, it becomes apparent. (Maybe you do some late-in-the-game due diligence or maybe your gut just tells you or maybe you have a milestone that they haven’t paid yet). Stop the project. Stop working with them. Drop them. Focus your efforts on a different customer.

12. HAVE MULTIPLE EXIT STRATEGIES

Your products and services are an investment of your time and skill and you hope for a return on that investment in the form of payment. Like any good investment, it’s important to have more than one exit strategy… just in case. This won’t be possible all of the time but there will be situations when you can re-sell the product or deliverable you couldn’t collect on, or perhaps you could use it in some other setting (such as a marketing piece).

13. FOLLOW UP ON TIME

Being an entrepreneur is fun and creating and busy! There are always a million things you could be doing and administrative work like sending out invoices is not always fun. But the longer you leave your invoices, the easier it is for your customer to avoid payment. Over time, they forget about the great relationship they have with you and the high value that your product and service gave to them. Weeks later when they get the bill, all they have is a bill… and a distant memory that they interacted with you in some way.

14. BE RELENTLESS

Before the customer became a customer, you might have stayed in touch with them regularly. But afterward, their emails dry up and so do yours. Stay in contact with them because avoiding payment is just another type of sale! It’s you selling the customer on why they should pay and it’s the customer selling you on why you should write that receivable off! Stay in touch. Put a note in your schedule to follow-up regularly and increase the heat as time goes on. Use different methods of contact (in case they filter your email directly to Trash)

15. WATCH FOR WARNING SIGNS

Non-paying customers have warning signs long before they ignore your invoices. I wish I could tell you what all of them are but I think it’s different for everyone and you’ll learn what they are pretty fast. In general these are the warning signs (but this is certainly not an exhaustive list nor are these warning signs exclusive to delinquent customers. These are just my own observations about what a typical non-paying customer is like): Pre-project hype and passion; lots of conversations and email asking you about the project and when you can get started; a lack of detail about the project itself; no established business, website, etc.; a lack of professionalism; a lack of response when they have a specific responsibility to fulfill; cliche excuses; excessive complaining about others; doesn’t flinch at your price. There are probably other signs and certainly one or two of these on their own doesn’t indicate a non-paying customer.

16. TRUST YOUR GUT

You will know ahead of time when someone won’t pay. You’ll know it. You can figure it out over time. Your gut will tell you that you have a problem customer and, if you don’t know what the problem is during delivery, you’ll figure it out soon enough when the invoice goes out. These are difficult customers to cut loose BEFORE they become customers but remember that it’s your business and you don’t have to serve everyone. Find a professional way to tell customers that you aren’t able to serve them.

17. FORGIVE BUT DON’T FORGET

It’s frustrating when customers don’t pay. You deserve to be paid and you know that THEY wouldn’t like it if THEY didn’t get paid. It’s really tempting to do something nasty. Write a mean email to them. Maybe post an angry comment on Twitter. Maybe pretend to be a dissatisfied customer on Yelp. Maybe Maybe leave a nasty review on their Amazon account. These things won’t help. They’ll feel cathartic for a season but they’re just bad business and they might come back to haunt you in some way. Forgive them and let karma kick them in the stomach instead of trying to do it. Forgive… but don’t ever forget! Keep a record of your losses and refer to it periodically. You might get some customers paying you back (it happens!). You’ll be reminded of your risk management techniques that it’s easy to become soft on. And you’ll have a handy list when they come calling for more work (it happens… I’m actually surprised at how often it happens).

Most businesses will have customers who don’t pay. It totally sucks. But that shouldn’t stop you from running a business. Follow these 17 ways to avoid getting shafted by your customers and you’ll keep the cash flowing in.

Passive income versus active income

In this blog post, I want to talk about the differences between passive and active income and how they relate to your business.

THE BASIC DIFFERENCE BETWEEN ACTIVE INCOME AND PASSIVE INCOME

Active income is money you earn that requires your effort.

For example, if you sell a service that you must first complete – such as freelance writing, graphic design, etc. – you are being paid for a combination of time, skill, and effort. And if you don’t put in that combination of time, skill, and effort, you don’t get paid. Or if you sell a product that requires some work on your part (i.e. to assemble or customize or ship), that is active income as well.

Passive income is money you earn without any effort on your part.

For example, if you write a book, you can sell it and earn passive income because you only need to write the book once.

UNDERSTANDING ACTIVE INCOME AND PASSIVE INCOME

Active income is commoditized. You get paid proportionate to the amount of time, skill, and effort you put into the product or service you provide. In other words, for every product or “unit of service” you provide, you get paid. If you want to make more money, you have to provide more products or units of service.

Passive income is a bit of a misnomer. It should really be called non-commoditized income. When brand new entrepreneurs hear the words “passive income”, they start to salivate because it sounds like you’re getting a ton of money with no effort at all. Experienced entrepreneurs know that passive income takes some work to set up and run… but it’s non-commoditized because the money you make is not as closely tied to the effort you put in. You can start an ad-based blog and put in hours of time in the beginning to add content and market it, but you can easy up in the future as traffic builds. Eventually, you can run the business with very little effort on your part.

A good example of the difference between active and passive income is to look at two different real estate investors.

  • One real estate investor flips houses. She buys a house, fixes it up and sells it. That’s active income because she gets paid as long as she’s buying, fixing, and selling.
  • A second real estate investor rents houses. She buys a house and rents it out. There is a little effort in the beginning to buy the house and maybe fix it up a bit, and there might be some ongoing effort to maintain the property and collect rent, but ultimately it’s passive income because the second investor gets paid on an ongoing basis for her initial effort even if she doesn’t buy and rent any more houses.

WHICH TYPE OF BUSINESS SHOULD YOU RUN?

Your ultimate business goal should be to build a passive (non-commoditized) business that doesn’t require you to put in an hour of effort to get paid for that hour. But realistically, you need cash flow first and it’s very easy to start up an active income business that produces cash flow. So if you’re just starting out and you need some cash, start with an active business but immediately begin building passive income opportunities (i.e. ebooks, ads, and rental houses) into your business model.

7 critical cash flow questions

Cash flow is the most important thing in business.

Cash flowCash flow brings money in. Cash flow pays the bills. Cash flow keeps your business going after the first month… and the first year.

Without cash flow, you just have a hobby and an expense. And yes, profit is important but a high profit margin from no sales is still a hobby! It’s better to have a little bit of profit from every sale with a big flow of cash.

Here are seven questions you need to ask your self on a regular basis (monthly is good, weekly is better).

  1. How much cash is flowing in?
  2. Where did the cash come from?
  3. How can I get more cash flowing in?
  4. How much cash is flowing out?
  5. Where is the cash going?
  6. How can I reduce the amount of cash flowing out?
  7. How can I use this cash to get more cash flowing in?

Spend time tracking the answers and figuring out how to increase the stuff that needs to increase and decrease that stuff that needs to decrease.