Learn how to improve your cash flow and avoid the cash trap

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2 Learn how to improve your cash flow and avoid the cash trap 1 Managing Your Cash Flow A healthy cash flow is an essential part of any successful business. Some business people claim that a healthy cash flow is even more important than your business's ability to deliver its goods or services! That may be placing a bit too much importance on your cash flow, 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! Proper management of your cash flow is a very important step in making your business successful. Understanding cash flow is the first step in effectively managing your cash flow. There's more to it than just a fancy term for the movement of money into, and out of, your business checking account. Understanding How Cash Flow Works In its simplest form, cash flow is the movement of money in and out of your business. It could be described as the process in which your business uses cash to generate goods or services for the sale to your customers, collects the cash from the sales, and then completes this cycle all over again. Inflows. Inflows are the movement of money into your cash flow. Inflows are most likely from the sale of your goods or services to your customers. If you extend credit to your customers and allow them to charge the sale of the goods or services to their account, then an inflow occurs as you collect on the customers' accounts. The proceeds from a bank loan are also a cash inflow. Outflows. Outflows are the movement of money out of your business. Outflows are generally the result of paying expenses. If your business involves reselling goods, then your largest outflow is most likely to be for the purchase of retail inventory. A manufacturing business's largest outflows will mostly likely be for the purchases of raw materials and other

3 2 components needed for the manufacturing of the final product. Purchasing fixed assets, paying back loans, and paying accounts payable are also cash outflows. It is important to manage your cash flow because smart cash flow management is vital to the health of your business. Hopefully, each time through the cycle, a little more money is put back into the cash flow cycle than flows out. Analysing Your Cash Flow To properly manage your business's cash flow, you must first analyse the components that affect the timing of your cash inflows and cash outflows. A good analysis of these components will point out problem areas that lead to cash flow gaps for your business. Narrowing, or even closing, cash flow gaps are the key to cash flow management. Some of the more important components to examine are: Accounts Receivable and Cash Flow Accounts receivable represent sales that have not yet been collected as cash. You sell your merchandise or services in exchange for a customer's promise to pay you at a certain time in the future. If your business normally extends credit to its customers, then the payment of accounts receivable is likely to be the single most important source of cash inflows. In the worst case scenario, unpaid accounts receivable will leave your business without the necessary cash to pay its own bills. More commonly, latepaying or slowpaying customers will create cash shortages, leaving your business without the cash necessary to cover its own cash outflow obligations. Accounts receivable also represent an investment. That is, the money tied up in accounts receivable is not available for paying bills, paying back loans, or expanding your business. The payoff from an investment in accounts receivable doesn't occur until your customers pay their bills. The idea of accounts receivable as an investment is an important concept to understand if you wish to consider the impact of accounts receivable on your cash flow. The following key performance indicators can be used to help determine the effect your business's accounts receivable is having on your cash flow: average collection period in days (Accounts Receivable/(Average Daily Sales *(1+VAT Rate)) overdue accounts receivable in days, amount and as a % of accounts receivable accounts receivable to annual sales(adjusted for VAT) ratio accounts receivable aging schedule showing % and amount of receivables Accounts Payable Using an accounts payable aging schedule can help you determine how well you are (or aren't) paying your accounts payable. If the schedule indicates that you have some bills that are past due, you may be relying a little too heavily on your trade credit. It could also indicate that you aren't managing your cash flow the way a successful business should.

4 3 The accounts payable aging schedule is a useful tool for analysing the makeup of your accounts payable balance. Looking at the schedule allows you to spot problems in the management of payables early enough to protect your business from any major trade credit problems. The schedule can also be used to help manage and improve your business's cash flow, especially when projecting your cash outflows for a cash flow budget. Amounts listed in the current column will need paying sometime in the near future possibly 30 or 60 days. The accounts payable aging schedule gives you a good indication of the amount of cash needed to cover your expenses during the same time period. Improving Your Cash Flow In its simplest form, cash flow is the movement of money in and out of your business. It is most often described as the process in which your business uses cash to generate goods or services for sales to your customers, collects the cash from the sales, and then completes this cycle all over again. The two basic elements of your business's cash flow are the cash inflows and cash outflows. Cash inflows are the movement of money into your business. Examples of cash inflows include cash collected from sales to customers, collections on accounts receivable, and the proceeds from a bank loan or other types of loans. Cash outflows are the movement of money out your business. Examples of cash outflows include paying expenses, purchasing property or equipment, and paying back a bank loan or other types of loans. In addition see the various tips under the heading Cash Trap below. Accelerating Cash Inflows Cash inflows are the movement of money into your business. Inflows are most likely from the sale of your goods or services to your customers. If you extend credit to your customers and allow them to charge their purchases of your goods or services to their account, then an inflow occurs as you collect on the customers' accounts. It should be fairly obvious that accelerating your cash inflows will improve your overall cash flow. The quicker you can collect cash, the faster you can spend it! That may not sound very businesslike, but it's true. Accelerating cash inflows allows your business to pay its own bills and other obligations on time, or even earlier than required. It may allow your business to take advantage of trade discounts offered by some suppliers if you pay them within a certain period of time. And it will certainly make the other aspects of cash flow management easier. Understanding the cash conversion period is the first step in accelerating your cash inflows. Then, you must streamline:

5 Billing the Customer 4 In this step of the cash conversion period, you issue an invoice (bill) to your customers or clients for the completed sale of your products or services. The completion of the invoice is an important step in the cash conversion period. Your lack of attention in this step can unintentionally lengthen the cash conversion period. Your invoice actually begins the cash collection process for your completed sales. You've probably figured out by now that most customers don't pay without first receiving some form of invoice for the goods or services you sold them. Invoices serve as a reminder to your customers that your goods or services have been delivered. Invoices also serve as a reminder to your customers that they have an obligation to pay you. The invoices should include the date they were prepared. These dates are important because they serve as the starting date for your credit terms i.e. the terms you have agreed with your customer for the payment of their account. Customers generally have 30 to 90 days from the date of the invoice to pay the amount listed on their invoice. You can shorten the cash conversion period and improve your overall cash flow by making sure you prepare invoices promptly. If possible, try to prepare invoices immediately after you've delivered your goods or services to each customer. Don't wait until the end of the month to prepare invoices this could add as many as 30 extra days to your cash conversion period! Don't wait until the end of the week to prepare invoices this could as many as 7 extra days to your cash conversion period! Improving Average Collection Period For most businesses, the time it takes to collect on a customer's account is generally the step requiring the most amount of time in the cash conversion period. The time it takes your business to collect your accounts receivable is measured by the average accounts receivable collection period. This average defines the relationship between your accounts receivable and your cash flow. Your credit policy and credit terms play an important role in the amount of time it takes to collect a customer's account. For example, if your credit terms provide your customers with 30 days to pay their bills, then you should expect that your average collection period will be somewhere around 30 days maybe longer. Your credit policy and credit terms can also be used to accelerate and improve your cash inflows. Your efforts to collect on your customers' accounts also have a direct impact on accelerating and improving your cash flows.

6 5 Payment and Deposit Payment and deposit is the final event in the cash conversion period. This step involves looking at the way you receive payments from your customers, and continues through to the deposit of their payments into your business bank account. After the completion of this step, the cash paid to you is finally available for you to use. "The cheque is in the post." Your customers will likely rely on the postal service for sending you their payment. Typically, a customer waits until the payment due date before dropping the cheque in the post. There is nothing wrong with waiting until the last day to send you the cheque, or for using the postal service. In fact, your customer is just taking advantage of a good cash flow management technique. For your business, on the other hand, using the postal service to receive your customers' checks can add one to three days (possibly more) to your cash conversion period. Finding ways to bypass the postal service for receiving your customers' payments is a key factor in accelerating and improving your cash inflows in this step of the cash conversion period. There are a number of techniques you can use to accomplish just that: Collection Tips Here's a series of collection tips that may help you improve your technique: Call a few days after issuing the invoice to check that it has been received and that all is in order Always quote the customers purchase order (if issued) on the invoice Whenever possible, do your debt collecting in person. If that's not possible, do it by phone. Write a letter only if neither of the other two options are available to you. When you contact customers, don't hand them an excuse ("Did you receive your bill?"). It's better to ask them, "When was payment made?" If they tell you it hasn't been made, ask them if they intend to pay it today. If they say "no," ask them when they have scheduled it to be paid. Get a commitment from them. If they haven't scheduled it, ask them if they intend to pay the bill. If they say "no," ask them why. Once you have the reason, hang up or walk away. If you continue the call or visit at this point, you may be crossing over into harassment. You can wait a day or two and call back to confirm the customer's position, but don't call or visit more than twice if they say they don't intend to pay the bill. At this point, it's time to turn to a collection agency or lawyer. If you ask your customers if they intend to pay their bill, and they say "yes," you should continue the discussion. Ask them why they haven't paid it. They'll give you either a reason or an excuse. In either case, get a firm commitment from them for when they can pay you.

7 6 If they give you an excuse ("I can't pay you until my customer pays me"), don't respond emotionally. Use logic instead. Ask them for a definite commitment and a time frame in which you can expect to receive payment. Make sure that you agree on all the details, including when, how, and where the money will be paid ("I'll deliver a check to your place of business on Monday"). If they give you a reason ("The goods you delivered to me were damaged"), try to remedy the condition, if it's within your control. For example, if you agree that the goods were damaged, see that the customer gets undamaged goods. If they refuse to give you a commitment ("I'll put you on the list to get paid"), you'll have to review your options. In some cases, you can force a commitment by taking away their credit on future purchases. In other cases, your only two options are to turn it over to a lawyer or turn it over to a collection agency. If you deal with large companies, you need to get in tune with how they pay their bills. Find out from them when the last day is for getting an invoice approved to get into this week's (or biweek or months, depending upon how they pay their bills) check run. When you need to collect from them, call a couple of days before that date to make sure that they have all the documentation from you that they need. Delaying Cash Outflows Cash outflows are the movement of money out of your business such as paying wages, expenses, purchasing property or equipment, or paying back a bank loan. The key to improving your cash flow with regard to cash outflows is to delay all outflows of cash as long as you possibly can. However, you still need to meet all your outflow obligations on time. Delaying cash outflows makes it possible for you to maximize the benefits of each in your own cash flow. Seeing the benefit of delaying your cash outflows is the first step in managing them. Managing your cash outflows also requires that you follow one simple, but basic rule: Pay your bills on time, but never pay your bills before they are due. Summary As will be noted below in the section on Cash Trap it is critical that the business manages its cash flow. It also vital that a business not only knows the components of its historical cash flow but also forecasts it s future cash needs. The cash flow forecasts can either be prepared based on balance sheet movements or which is more common for SME businesses on inflows and outflows. Below is an extract of a daily cash flow schedule which compares the forecast with the actual results. Note that the detail of inflows and outflows are not shown.

8 7 Daily Cash Flow Forecast Day 1 Day 2 Day 3 Day 4 00/01/00 01/01/00 02/01/00 03/01/00 Opening Balance Plus Inflow Less Outflow Closing Balance Actual Actual Inflow Actual Outflow Day 1 Day 2 Day 3 Day 4 Updated Forecast Day 1 Day 2 Day 3 Day 4 Opening Balance Plus Inflow Less Outflow Closing Balance Variance Inflow Variance Outflow Variance Cash Trap Many businesses both large and small fall into the Cash Trap during periods of growth. Often this results in the business facing severe financial difficulty, such as inadequate funds to pay suppliers or employees, despite enjoying increasing profits. Terms such as the business grew too quickly are often used to describe this situation. The Cash Trap occurs when cash outflow exceeds cash inflow over a period of time and inadequate funding arrangements are in place.

9 8 This Trap is caused by the following factors: Cash Gap Sales and Costs Control Asset Expenditure Control Funding More detailed analysis is given below including examples of correction strategies. Cash Gap occurs when each new sale creates a cash deficit based on the timing of cash inflows and outflow. This results in an increase in working capital and is illustrated, in a simple form, in the diagram below: Cash Gap Stock Arrives Stock Despatched Days Stock Payables Receivables Cash Gap Cash Paid Cash Received A number of strategies can be employed to manage the Cash Gap. An example of these is noted below: Stock reduction by Payables increase by Forecasting future demand Production scheduling based on forecasts Aged stock records Increasing stock turnover by category Supplier consignment stock Increasing frequency of stock delivery Sell off obsolete or slow moving stock Forecasting future payments Introduction of aged supplier records Records to show correct payment terms Increasing supplier credit taken Renegotiating supplier credit terms Changing suppliers to those with higher credit terms Introducing credit cards for staff expenditure

10 Receivables reduction by 9 Forecasting future sales Introduction of aged receivables records Introduction of credit control KPI Weekly aged reports Stage payments Improve systems for billing and collections. Use more proactive collection techniques. Systems using correct customer terms Root cause analysis of customer non payments Customer discounts for early payment New customer and credit authorisation procedure Factoring Sales and Cost Control is vital for any business but, even more so for those that are growing. An example of these is noted below: Sales Controls Cost Controls Sales forecasting and bottleneck reviews New customer authorisation procedures Product pricing Delivery scheduling Order forecasting Customer delivery commitments Budgets Supplier price tracking Invoice certification procedures Supplier evaluation procedures Expenditure authorisation procedures Renegotiating supplier prices Cost reduction processes Asset expenditure controls are often neglected. They are of course very important and necessary to ensure that the assets are fit for purpose, required by the business and have adequate financial payback. Examples of these are: Capital expenditure evaluation procedures Tougher financial evaluation parameters Depreciation policies Maintenance verses capital procedures Expenditure timing Finance leases Operating leases Sale and lease back Subcontracting Make verses buy evaluation

11 10 Funding for growth is often inadequate. This is mainly due to the lack of or incorrect forecast and inadequate security. All too often business will only realise that they have an increasing cash deficit when it is too late. Often loan agreement conditions are not met. At this point they make urgent representations to the banks for increased loans or overdraft facilities. The banks are of course cautious and will require time to evaluate the request. In addition their confidence in the management s ability is diminished. To make matters worse a business may not have adequate security or cash flow to justify the funding requests. Examples of funding strategies are Forecast financial accounts including cash flow Reporting of actual v budget Regular updates for providers of capital Ensuring that dividend payments can be financed Loan repayment schedules are achievable Early notification of funding problems Use of alternative funding sources e.g. factoring