CASHFLOW MANAGEMENT: THE BASICS

cashflow.jpgCash is the oxygen that enables a business to survive and prosper and is the primary indicator of business health. While a business can survive for a short time without sales or profits, without cash it will die. For this reason the inflow and outflow of cash need careful monitoring and management.

This guide looks at the key elements of cashflow and at how effective cashflow management will help protect the financial security of your business. It outlines the steps that you can take when dealing with your customers, suppliers and stakeholders to improve cashflow. It also highlights common cashflow problems and how to avoid them.

Cash inflows and cash outflows

Ideally, during the business cycle, you will have more money flowing in than flowing out. This will allow you to build up cash balances with which to plug cashflow gaps, seek expansion and reassure lenders and investors about the health of your business.

You should note that income and expenditure cashflows rarely occur together, with inflows often lagging behind. Your aim must be to speed up the inflows and slow down the outflows.

Cash inflows

  • Payment for goods or services from your customers.
  • Receipt of a bank loan.
  • Interest on savings and investments.
  • Shareholder investments.
  • Increased bank overdrafts or loans.

Cash outflows

  • Purchase of stock, raw materials or tools.
  • Wages, rents and daily operating expenses.
  • Purchase of fixed assets - PCs, machinery, office furniture, etc.
  • Loan repayments.
  • Dividend payments.
  • Income tax, corporation tax, VAT and other taxes.
  • Reduced overdraft facilities.

Many of your regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed dates. You must always be in a position to meet these payments in order to avoid large fines or a disgruntled workforce.

To improve everyday cashflow you can:

  • ask your customers to pay sooner
  • chase debts promptly and firmly
  • use factoring
  • ask for extended credit terms with suppliers
  • order less stock but more often
  • lease rather than buy equipment
  • improve profitability

You can also improve cashflow by increasing borrowing, or putting more money into the business. This is suitable for coping with short-term downturns or to fund growth in line with your business plan, but shouldn't form the basis of your cash strategy.

 

The principles of cashflow forecasting

Cashflow forecasting enables you to predict peaks and troughs in your cash balance. It helps you to plan borrowing and tells you how much surplus cash you're likely to have at a given time. Many banks require forecasts before considering a loan.

Elements of a cashflow forecast

The cashflow forecast identifies the sources and amounts of cash coming into your business and the destinations and amounts of cash going out over a given period. There are normally two columns listing forecast and actual amounts respectively.
 
The forecast is usually done for a year or quarter in advance and divided into weeks or months. In extremely difficult cashflow situations a daily cashflow forecast might be helpful. It is best to pick periods during which most of your fixed costs - such as salaries - go out. The forecast lists:

  • receipts
  • payments
  • excess of receipts over payments - with negative figures shown in brackets
  • opening bank balance
  • closing bank balance

It is important to base initial sales forecasts on realistic estimates. If you have an established business, an acceptable method is to combine sales revenues for the same period 12 months earlier with predicted growth.

Download our sample cashflow projection spreadsheet (XLS) - Opens in a new window.

Note that all forecast figures must relate to sums that are due to be collected and paid out, not invoices actually sent and received. The forecast is a live entity. It will need adjusting in line with long-term changes to actual performance or market trends.

Accounting software

Accounting software will help you prepare your cashflow forecast, allowing you to update your projections if there's a change in market trends or your business fortunes. Planning for seasonal peaks and troughs is simplified and you can also make "what if" calculations. Most banks require profit and balance sheet forecasts as well as cashflow. Many accounting packages will assist with preparing these documents.

 

Manage income and expenditure

Effective cashflow management is as critical to business survival as providing services or products. Below are some of the key methods to help reduce the time gap between expenditure and receipt of income.

Customer management

  • Define a credit policy that clearly sets out your standard payment terms.
  • Issue invoices promptly and regularly chase outstanding payments. Use an aged debtor list to keep track of invoices that are overdue and monitor your performance in getting paid.
  • Consider exercising your right to charge penalty interest for late payment.
  • Consider offering discounts for prompt payment.
  • Negotiate deposits or staged payments for large contracts. It's in your customers' interests that you don't go out of business trying to meet their demands.
  • Consider using a third party to buy your invoices in return for a percentage of the total.

Supplier management

Ask for extended credit terms. Giving your suppliers incentives such as large or regular orders may help, but make sure you have a market for the orders you're placing. Alternatively, consider reducing stock levels and using just-in-time systems

Taxation

You may be liable for several different taxes including income tax, corporation tax, VAT, business rates and stamp duty. It is important to keep good records to help you calculate your liability and complete your returns accurately.

If you are registered for VAT, it makes sense to buy major items at the end rather than the start of a VAT period. This can often improve your cashflow, because you can set the VAT on the purchase off against the VAT you charge on sales. This may help plug a temporary cashflow gap.

Asset management

Consider leasing fixed assets, eg equipment, or buying them on hire purchase. Buying outright can result in a huge drain on cash in the first year of business. 

 

Cashflow problems and how to avoid them

No matter how effective your negotiations with customers and suppliers, poor business practices can put your cashflow at risk.

Look out for:

  • Poor credit controls - failure to run credit checks on your customers is risky, especially if your debt collection strategy is inefficient.
  • Failure to fulfil your order - if you don't deliver on time, or to specification, you won't get paid. Implement systems to measure production efficiency and the quantity and quality of stock you hold and produce.
  • Ineffective marketing - if your sales are stagnating or falling, revisit your marketing plan.
  • Inefficient ordering service - make it easy for your customers to do business with you. Where possible, accept orders over the telephone, email or Internet. Ensure catalogues and order forms are clear and easy to use.
  • Poor management accounting - keep an eye on key accounting ratios that will alert you to an impending cashflow crisis or prevent you from taking orders you can't handle.
  • Inadequate supplier management - your suppliers may be overcharging, or taking too long to deliver. Create a supplier management system
  • Poor control of gross profits or overhead costs.

Using your cashflow forecast as a business tool

A cashflow forecast can be an invaluable business tool if it is used effectively. Bear in mind that it is dynamic - you will need to change and adjust it frequently depending on business activity, payment patterns and supplier demands.

It's helpful to set up a regular review of the forecast, changing the figures in light of your sales, purchases and staff costs. Legislation, interest rates and tax changes will also impact on the forecast.

Having a regular review of your cashflow forecast will enable you to:

  • see when problems are likely to occur and sort them out in advance
  • identify any potential cash shortfalls and take appropriate action
  • ensure you have sufficient cashflow before you take on any major financial commitment

Using a cashflow forecast to avoid overtrading

Having an accurate cashflow forecast will help ensure that you can achieve steady growth without overtrading. You will know when you have sufficient assets to take on additional business - and, just as importantly, when you need to consolidate. This will enable you to keep staff, customers and suppliers happy.

It is important that you incorporate warning signals into your cashflow forecast. For example, if predicted cash levels come close to your overdraft limits, this should sound an alarm and trigger action to bring cash back to an acceptable level.

Ideally, you should always have a contingency plan, such as retaining a minimum amount of cash in the business, perhaps in an interest-earning account. This "rainy day" money can be used to meet short-term cash shortages.

 

Cash management in action

The following simple example shows how a small, profitable business can run into unforeseen cashflow problems when it takes on a new large order.
 
XYZ manufacturer is a small but profitable gift designer and supplier with three full-time staff (including the two owners). It outsources production, but supplies the raw materials itself to save on costs. It then finishes and packages the final product on site.

XYZ does not have any loans or overdrafts. It has a long-term customer base of small gift shops and visitor centres.

XYZ suddenly wins a large order to supply bespoke wall plaques for a chain of stores. The contract promises to double its turnover.

The team takes on an additional employee and works flat out to meet the deadlines. It doesn't notice an impending cashflow crisis resulting from a fall in repeat orders from existing customers combined with a jump in raw material costs.

To make matters worse, the new client keeps changing its mind about designs. A misunderstanding means the first run of goods is rejected, causing a delay in payment and increased production costs. XYZ orders additional materials to make up the shortfall in the run.

By the time the order is complete, XYZ is running an expensive overdraft. Profit margins have been squeezed to the limit and it has lost several of its existing customers. A downturn in the fortunes of the retail chain means that it doesn't place any further orders.

After a lot of hard work, XYZ finds itself back where it was five years earlier.

Tighter cashflow management would have highlighted the fall in repeat orders and rise in raw material costs. XYZ would also have benefited from a client contract that included:

  • milestone payments and penalty provisions for changes such as those to designs - eg increased fees
  • sharing the cost of additional materials with the new client or getting the client to pay for them

Find an illustration of the impact of the new order on XYZ's cashflow - Opens in a new window.

 

Refinements to a simple cashflow forecast

There is no single best way to set out a cashflow forecast. However, some refinements to the most basic ways of setting out the information will give you a more sophisticated view of your business' situation.

You could, for example, separate cashflow for business operations from funding cashflow. This gives a clearer picture of the actual performance of your business and is a format that many accountants prefer.

Cashflow from operations

Includes inflows such as:

  • cash sales
  • receipts from credit sales in earlier periods
  • interest on savings

Includes outflows such as:

  • payments to suppliers
  • hire purchase and lease payments
  • expenses - rent, rates, insurance, utilities, telephone, etc
  • wages
  • taxes and National Insurance
  • interest on loans and bank charges

Funding cashflows

Includes inflows such as:

  • loans from banks
  • increase in share capital

Includes outflows such as:

  • dividends paid
  • loans repaid

With these two types of cashflow separated you can gauge how self-sufficient the day-to-day working of your business is. A net outflow in operational cashflow is usually an indicator of problems that need to be addressed quickly.

Here's how I manage my cashflow

When Peter Spivack and his three partners opened their restaurant, Rendezvous, in Wallasey Village, Merseyside in 2004, they knew sound cashflow management would be key to success during that crucial first year. As managing director, Peter assumed responsibility for cashflow management.

What I did

Set up systems

"I prepared my first year's cashflow forecast as part of my business plan, which helped me secure a start-up loan. I decided early on that I would review the forecast monthly, although I update the figures on a weekly basis to keep on top of things.

"I started off using Excel spreadsheets, but now I also use Sage accounting software. The software incorporates a range of reporting tools that let me present the information in whatever format I need. For example, I can see average spend per head at the touch of a button. 

"I also had a marketing plan and budget from day one. That may not sound like managing cashflow, but it's actually crucial for keeping the cash flowing in."

Manage suppliers

"We arranged with key suppliers to be billed quarterly for the biggest costs. That makes budgeting and planning easier. We also negotiate 30-day accounts with suppliers wherever we can, which definitely helps cashflow. 

"We're fortunate that our customers pay for goods and services at the time of purchase, but we still need to control outgoings. I'm always looking for ways to cut costs without affecting quality, such as switching suppliers if necessary and negotiating discounts on one-off purchases."

Use the forecast to spot problems

"It's no good having the figures if you don't actively use them. For example, we used to open at lunchtime seven days a week, as well as evenings. As business picked up, I was considering employing another chef to help us cope.

"I analysed the figures to see how much extra cash we were likely to collect, compared to the increased staff expenditure. I concluded that we would actually be better off keeping staffing levels the same, but only opening Tuesday to Saturday evenings.

"The forecast has also enabled me to spot looming cash imbalances on three occasions. I didn't panic because I could see the problem was only temporary. I used a pre-arranged overdraft facility to tide us over, confident that the money could be paid back the following month."

What I'd do differently

Get accounting software sooner

"Incorporating all the financial information in one place with accounting software has been a great help in managing cashflow and I wish I'd had it right from the start. It also makes it easier to prepare our end-of-year accounts and means I have up-to-date figures whenever I need them."

 

 

 


 

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Add your comment (2)
861
...This
written by laaiqah, February 11, 2009
great article - I find this really useful! smilies/wink.gif
62
...This
written by Angie, February 06, 2009
is there anything that you specifically need help with when it comes to cash flow?





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