Cash Flow -- The Pulse Of Your Business
There
are frighteningly many small business owners out there who do not understand
their cash flow statement. A shocking fact considering that all businesses
essentially run on cash. And Cash flow is the life-blood of your business. Some
business experts go so far as to say a healthy cash flow is even more important
than your business’s ability to deliver its goods and services! You may find
that perspective hard to swallow, but consider this – if you fail to satisfy a
customer and lose that customer’s business, you can always work harder to
please the next customer. But if you fail to have enough cash to pay your
suppliers, creditors, or your employees, you’re out of business!
What
Is Cash Flow?
Cash
flow, simply defined, is the movement of money in and out of your business;
these movements are called inflow and outflow respectively. Inflows for your
business primarily come from the sale of goods or services to your customers.
The inflow only occurs when you make a cash sale or collect on receivables,
however. Remember, it is the cash that counts! Other examples of cash inflow
are…borrowed funds, income derived from sales of assets, and investment income
from interest.
Outflows
for your business are generally the result of paying expenses. Examples of cash
outflow are…paying employee wages, purchasing inventory or raw materials,
purchasing fixed assets, operating costs, paying back loans, and paying taxes.
Your accountant is the best person to help you learn how your cash flow
statement works. At your annual review or audit, make sure your accountant
explains where the numbers come from in your cash flow statement.
Cash Flow Verses Profit
Profit
and Cash flow are two entirely different concepts, each with entirely different
results. The concept of profit is somewhat broad and only looks at income and
expenses over a certain period of time, say a fiscal quarter. Profit is a useful
figure for calculating your taxes and reporting to the IRS.
Cash
flow, on the other hand, is a more dynamic tool focusing on the day-to-day
operations of a business owner. It is concerned with the movement of money in
and out of a business. But more importantly, it is concerned with the times at
which the movement of the money takes place.
Theoretically
even profitable companies can go bankrupt. It would take a lot of negligence and
total disregard for cash flow, but it is possible. Consider how the difference
between profit and cash flow relate to your business. For example, if your
retail business bought a $1000 item and turned around to sell it for $2000, then
you have made a $1000 profit. But what if the buyer of the item is slow to pay
his or her bill, and six months pass before you collect on the account? Your
retail business may still show a profit, but what about the bills it has to pay
during that six-month period? You may not have the cash to pay the bills despite
the profits you earned on the sale. Furthermore this cash flow gap may cause you
to miss other profit opportunities, damage your credit rating, and force you to
take out loans and create debt. If this mistake is repeated enough times you may
even go bankrupt!
Analyzing Your Cash Flow
The
sooner you learn how to manage your cash flow, the better your chances for
survival will be. Furthermore you will be able to protect your company’s
short-term reputation as well as position it for long-term success.
The
first step towards taking control of, and properly managing your company’s
cash flow is to analyze the components that affect the timing of your cash
inflows and outflows. A thorough analysis of these components will reveal
problem areas that lead to cash flow gaps in your business. Narrowing, or even
closing, these gaps is the key to cash flow management.
Some
of the more important components to examine are:
Accounts
Receivable. Accounts
receivable represent sales that have not yet been collected in the form of cash.
An account receivable is created when you sell something to a customer in return
for his or her promise to pay at a later date. The longer it takes for your
customers to pay on their accounts, the more negative affects there will be on
your cash flow.
Credit
terms.
Credit terms are the time limits you set for your customers' promise to pay for
the merchandise or services purchased from your business. Credit terms affect
the timing of your cash inflows. One of the simplest ways to improve cash flow
is to get customers to pay their bills more quickly.
Credit
policy. A credit policy is
the blueprint you use when deciding to extend credit to a customer. The correct
credit policy is necessary to ensure that your cash flow doesn't fall victim to
a credit policy that is too strict or to one that is too generous.
Inventory.
Inventory describes the extra merchandise or supplies your business keeps on
hand to meet the demands of customers. An excessive amount of inventory hurts
your cash flow by using up money that could be used for other cash outflows. Too
many business owners buy inventory based on hopes and dreams instead of what
they can realistically sell. Keep your inventory as low as possible.
Accounts
payable and cash flow.
Accounts payable are amounts you owe to your suppliers that are payable sometime
within the near future, "near" meaning 30 to 90 days. Without payables
and trade credit you'd have to pay for all goods and services at the time you
purchase them. For optimum cash flow management, you'll need to examine your
payables schedule.
Some
cash flow gaps are created intentionally. That is, a business will sometimes
purposefully spend more cash to achieve some other financial results. For
example, a business may purchase extra inventory to take advantage of quantity
discounts, accelerate cash outflows to take advantage of significant trade
discounts, or spend extra cash to expand its line of business.
For
other businesses, cash flow gaps are unavoidable. Take, for example, a company
that experiences seasonal fluctuations in its line of business. This business
may normally have cash flow gaps during its slow season and then later fill the
gaps with cash surpluses from the peak part of its season. Cash flow gaps are
often filled by external financing sources. Revolving lines of credit, bank
loans, and trade credit are just a few of the external financing options
available that you may want to discuss with your accountant.
Managing Your Cash Flow
Now
that you have considered how your business practices affect your cash flow, you
are ready to develop some additional strategies for dealing with, narrowing, or
closing cash flow gaps.
Contingency
plans.
You should have a “life is beautiful” plan a “life is life” plan and a
“don’t even talk to me about life” plan. The first plan forecasts high
sales, low expenses and everything going better than expected. The second is
based on realistically achievable sales and honest expenses. The third plan
specifies how to survive if everything goes wrong. The flag for going from the
realistic plan to the survival plan is a sudden or steady decline in sales.
Cash
Forecasting.
The biggest problem for business start-ups is the owner failing to plan for how
much cash the business needs throughout the year. This applies especially to
businesses where payments usually come in over several months or after the work
is complete. Business owners must also forecast expenses that aren’t due each
month, such as annual insurance premiums.
Spending
Controls. Keep
an eye on all spending; try to keep enough money in the company to get through
tough times. New business owners are often tempted to spend too much for
nonessentials. Make sure you carefully negotiate leases and solicit price quotes
from several vendors to find the best value. Also, stop selling products that are losing money and avoid
buying assets that require substantial cash outlays.
Accumulate
Salary.
If necessary to maintain a positive cash flow, you may need to forfeit part of
your own salary. Many entrepreneurs go bankrupt because they don’t pay
attention to the financial state of their business and insist on paying
themselves big salaries no matter what.
Add
Employees cautiously.
Delay hiring workers as long as possible. Instead, look for ways to maximize
your own productivity and that of any existing employees. Also consider
lower-cost alternatives, such as outsourcing work to independent contractors.
What To Do With A Cash Surplus
Managing
and improving your cash flow should result in a cash surplus for your business.
How you handle your cash surplus is just as important as the management of money
into and out of your cash flow cycle.
Paying
down any debt you have is generally the first option you should consider when
deciding what to do with your cash surplus, because a short-term investment is
not likely to yield a return equal to or greater than the rate of interest on
any of your debt. However, the decision to automatically pay down debt may not
be correct in all cases. Your accountant is the best person to help you make
these decisions.
Monitoring
and managing your cash flow is an important task to perform in order to ensure
the vitality of your business. The first signs of financial woe will appear in
your cash flow statement, giving you time to recognize a forthcoming problem and
plan a strategy to deal with it. Furthermore, with periodic cash flow analysis,
you can head off those unpleasant financial glitches by recognizing which
aspects of your business have the potential to cause cash flow gaps. With cash
flow management and analysis, you will be able to plan on how you’re going to
direct your cash surplus with assurance that you will have adequate funds to
cover day-to-day expenses.