Cash flow is, quite literally, the flow of money into and out of a business. It's also a measure of a company's financial health or liquidity. If a business spends more than it earns and runs out of cash, it may go bankrupt.
While the concept is straightforward, executing a cash-flow strategy can be difficult. Every business faces its own unique challenges, as cash is needed to pay fixed expenses such as a property lease, bills and salaries, as well as to purchase assets and inventory.
If cash-flow projections aren't made and a six-month cash-flow budget isn't created, you may find yourself facing a cash shortage that can put major stress on your business operations.
It may sound counterintuitive but, just because a company is profitable doesn't mean it can't have a cash-flow problem. After-tax profit equals revenues less expenses and taxes. On paper this can show a profitable enterprise. However, if expenses are due before revenues get collected, how will rent, bills and employees be paid without cash on hand?
While sales may be strong and the profit margin substantial, there can still be a cash-flow issue if revenue is tied up in receivables.
The four areas of business that have the most impact on cash flow are:
- accounts receivable;
- inventory;
- accounts payable; and
- credit.
While this list is only partial, it's worthwhile exploring some ideas about managing each of these four areas:
Receivables are the primary source of incoming cash for many companies and must therefore be well managed. The following can help turn receivables into cash and align cash outlays with inputs:
- invoice clients promptly. The less time between the sale and the invoice, the sooner you will be paid. Contracts should outline payment terms agreed to by both parties;
- when client credit is questionable, or a client is new, obtain a bank confirmation or credit check. You can also ask for cash in advance;
- review aging reports regularly and have your collection department make scheduled calls. Don't procrastinate with delinquent accounts and ensure open communication with clients to find solutions;
- make slow payers pay in advance on future purchases; and
- for older accounts receivable, speak with your legal advisors or hire a collections firm.
Inventory can also be a big drain on cash, though there's often a fine line between buying too much and not having enough to meet demand. The more items you need to have on hand the more likely inventory will impact your cash reserves. To help in this area, you can:
- analyze trends in your inventory, establish forecasts and purchase inventory around these patterns;
- enact "just in time delivery" and buy inventory as close to the sale date as possible. For some this may mean the product sold is "made to order";
- avoid "dead inventory" and sell inventory at a markdown before it becomes outdated. For some businesses "outdated" may be only three to six months old;
- increase your inventory turnover rate. Buying more because it's cheaper may mean cash is tied-up in low-turnover items. Paying a bit more for inventory but buying less can be more efficient;
- negotiate better (read: longer) payment terms with your suppliers and make sure you're getting the best price/terms combination; and
- if possible, arrange for drop-shipment on lower-demand products (where the manufacturer or distributor ships directly to your customers).
Remember, companies experiencing high growth often have to increase inventory that is sold on credit. Cash injection by investors or special financing may be necessary.
A key to managing your accounts payable is to understand and use your payment terms by:
- negotiating terms so that they meet your needs;
- asking creditors for extended payment periods; and
- only paying when payment is due – in other words, don't pay early!
Maintaining working capital and minimizing down payments and monthly payments when purchasing larger assets and equipment are also important considerations. Work with your lender to structure payments so that they meet your needs.
Gary Akali, a business and leasing advisor with BlueShore Financial, suggests business owners consider leasing when acquiring large assets.
"Down payments are typically substantial when it comes to purchasing equipment, which ties up cash," Akali explains. "Leasing is a great option to consider since you can finance 100% of the asset and, in most cases, payment terms can be negotiated."
Keeping your cash and credit available to manage inventory and other revenue-generating sources is a good strategy.
Since most businesses run into cash-flow problems at some point, having sources of credit is essential. Business credit cards will do the trick for smaller purchases; however, just like with personal credit cards, it's important to pay them off every month to avoid building up interest charges.
For large amounts and other types of expenses such as salaries, establishing a line of credit can help your company survive short-term periods when cash is scarce. It's important to remember that borrowing when there is a cash-flow problem can be more difficult than borrowing when your finances are strong. As such, it's best to plan ahead – even if it means paying a little in fees in order to keep an unutilized line of credit available.
Establishing a relationship with a business advisor associated with your financial institution can be extremely beneficial when it comes to cash-flow management. Expert advice can prepare you for future challenges and make your road to success much smoother. If you have any questions, contact us – we can help.
