One of the primary reasons many businesses fail, is their inability to meet financial obligations as they become due, caused by limited cash resources.
No matter how sophisticated your business’ processes, or how wonderful your products and systems are, if your business runs out of cash, it will cease to exist.
Yet surprisingly, many small businesses do not have a cash flow plan, and if they do, it’s often an annual projection done to accompany a bank loan renewal or application.
To know how much financing you really need, or better yet, plan and manage your cash flow so that you don’t incur the costs of financing, you must do cash flow and profit planning.
What is Cash Flow?
Cash that flows into the business from all sources such as cash sales, debtors collected, borrowings, capital introduced, sale of equipment less the cash that flows out of the business such as operating expenses, equipment purchases, repay loans, distribution to owners.
Key Requirements of Your Cash Flow
Successful business owners understand the importance of cash flow. The financial strength of a business depends on if cash flow is positive, available, and timely.
- Positive: Net cash flow should be positive: Cash Inflows – Cash Outflows = +Net Cash Flow.
- Available: A company must be solvent and hold sufficient cash flow in liquid assets so it can access the cash to meet financial obligations.
- Timely: Cash Inflows must be timed to come in before Cash Outflows are due. This doesn’t just happen by accident and takes careful planning; those businesses that do this successfully have cash flow forecasts which they manage (at least) monthly so that they can plan for any cash shortage and put the necessary measures in place to guide the business through those times when cash is thin on the ground.
The Cash Flow Cycle
- The Cash Merry Go-round!
This diagram illustrates a typical cash cycle. It applies to a “generic” business such as a retailer or a wholesaler.
A similar cash cycle would apply to any business—for example, if you were a manufacturing business you would just need to include an extra couple of steps to recognize cash outflows for adding value to the purchased inputs through labour etc.
The cash inflows must be greater than the outflows so that you can use the surplus to pay your operating expenses, repay loans, buy equipment, and make capital contributions.
Cash Flow – more than just profit
It is possible for a business to be making profits yet have a negative cash flow position. This can be caused by large fixed asset purchases, covering large debts etc.
As a general rule, you should try to finance your operations out of working capital.
If your business needs to purchase an expensive machine or other fixed asset, this outlay of capital expenditure should be matched by long term funding such as a term bank loan or a hire purchase agreement over a number of years. That way, the cash outlays are timed to coincide with the expected cash inflows to be derived from the investment in the fixed asset.
For example, if you buy a new property that you expect to use for 10 years, finance it with a 10 year bank loan. If you buy a new machine that will be depreciated over 5 years, finance it over 5 years. This will leave sufficient working capital to cover the short term operating liabilities of the business—assuming the business is profitable, of course!
If you are running short of cash, there is always the option to sell a fixed asset…but normally this is not feasible—presumably you wouldn’t own the asset if you were simply able to sell it if you were short of cash!
In most cases, the business would suffer if a fixed asset were sold and not replaced. You should review the fixed assets to ensure they are all contributing to the profitability of the business. If there are obsolete, rarely used or luxury assets, there could be potential to raise some funds through their sale.
Start up businesses generally have cash flow difficulties early on, due to large outlays building up the balance sheet or asset base.
More mature businesses tend to suffer less from these problems and are generally good cash generators as their outflows are limited to normal operating activities. However, be aware that there are many examples of mature businesses that have run into cash flow difficulties through complacency.
Being mature does not in and of itself guarantee profitability and positive cash flow and the same principles outlined in this presentation apply equally to all businesses.
Methods to improve Cash Flow – cutting costs v increasing turnover
Most business owners when faced with the issue of increasing profits, will immediately look towards cutting costs.
People tend to think of their hard earned money going into the black hole called ‘expenses’ and have traditionally been trained to reduce them at all costs. In 99% of cases, there will be some (sometimes significant) savings to be made through this approach. However, there is a mathematical limit on how far you can cut expenses—to zero!
In fact, it’s less than zero as you need expenses to have a business. In general, cost cutting is a short-term solution that stunts the growth of a business. We should look to rename expenses as ‘The cost of resources used to generate your revenue and gross profit’; by doing that, you change the focus from the perception of expenses as a ‘necessary evil’ to the things that are enabling you to produce the profit you are striving for.
Remember – Nobody ever shrank their way to greatness.
In order to grow a successful business, the owners must be prepared to make an investment, in people, in marketing, in technology etc. I advocate that firms measure everything, systematize their processes and reduce unnecessary operating expenses and duplication of effort through diligent KPI monitoring and effective management.
The key is to look at expenses as the cost of resources used and to make sure that the ROI from those resources is as high as possible – you usually get what you pay for. In other words, if you pay peanuts, you get monkeys. Or if you buy the cheapest inputs, you risk losing customers because of poor quality product, or driving your costs up because of the increased cost of service repair and customer service.
Methods to improve Cash Flow – Cutting costs
A method to address the reduction of unnecessary costs, is to first establish which activity of the business generates those costs. Will changes to that activity affect the business turnover? If no, then is the activity necessary? If yes, the cost reduction techniques may create an adverse affect on the business profitability.
Beware – cost cutting can have a long-term negative impact. Failure to invest in people, marketing and technology can leave you falling behind your competitors. You are increasingly likely to provide a product and service of inferior quality. You will also be likely to experience above-average team turnover. And ultimately, your customers have a choice, and you will cease to be it.
Methods to Improve Cash Flow – Increasing turnover
Increasing turnover is the positive option. Let us review the 4 ways to grow your business:
- Increase the number of customers of the type you want
- Increase the number of times customers come back
- Increase the average value of each sale
- Increase the effectiveness of each process
You’ll note that 3 of the 4 ways relate to increasing the top line, rather than making cuts in overhead. There is no limit to how much you can increase turnover or revenue—except, appropriately enough, cash flow!
“Overtrading” has caused many businesses to fail. This occurs when businesses are so keen to go after the sale that they pay no attention to cash collection. They offer heavy discounts and extended credit, so turnover increases rapidly but little cash comes through the door. Beware of incentivising your salespeople in this manner!
Methods to improve Cash Flow – accelerating Cash Inflow
The majority of cash inflow is generated from your sales of goods and services. Possible ways to accelerate this income are as follows -
- Upfront payments
- Reducing Debtor payment terms, or offering early payment incentives (although beware of scaring good customers away by being too aggressive with your credit terms)
- Setting fixed prices and receiving payment of those by standing orders
- Increase business from cash customers or introduce incentives for cash payment
- Improving invoicing procedures to ensure speedier delivery of invoices (many businesses can benefit from this—this is the 4th way to grow the business…improving the effectiveness of each business process).
Methods to improve Cash Flow – delaying Cash Outflow
Deferring payments to suppliers and service providers helps you keep the cash in your pocket longer.
Pay your bills on time but not before they are due – do however take advantage of discounts offered for payments made before the due date. Better to pay less rather than later.
It is also important to keep your suppliers sweet in case you need them to satisfy a rush job.
If you have a short term cash flow problem, it’s often best to talk with your suppliers and negotiate payment terms, rather than annoying them by simply not paying or fobbing them off with the old “the cheque’s in the post” line.
Make the most of trade credit terms. Business operates on credit and it does not make commercial sense to pay your bills before the due date.
Conclusion
In this article, we have discussed the importance of managing and planning your cash flow in order to grow your business on a sustainable basis.
We have looked at the pros and cons of the various ways in which cash flow can be improved.
In my next article, I will discuss how to plan and forecast your cash flow and how to attach key performance indicators to the critical areas of your business in order to achieve your goals.
Reference:
See ‘Forecasting and Planning Your Cash Flow To Grow Your Business‘
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