Ravi Chandran
Diligent cash flow management is important in times of plenty for businesses, and more so during turbulent times
The importance of cash flow is particularly pertinent at times when access to cash is difficult and expensive. A credit crunch creates extreme forms of both of these problems. When the `real economy’ slips into recession, businesses face the additional risk of customers running into financial difficulty and becoming unable to pay invoices – which, allied to a scarcity of cash from non-operational sources such as bank loans, can push a company over the edge.
Even during buoyant economic conditions, cash flow management is an important discipline.
Table of Contents
Failure to monitor credit, assess working capital – the cash tied up in inventory and monies owed – or ensure cash is available for investment can hamper a company’s competitiveness or cause it to overtrade.
Cash flow is the life blood of all businesses and is the primary indicator of business health. It is generally acknowledged as the single most pressing concern of most small and medium-sized enterprises (SMEs), although even finance directors of the largest organisations emphasise the importance of cash, and cash flow modelling is a fundamental part of any private equity buy-out. In a credit crunch environment, where access to liquidity is restricted, cash management becomes critical to survival.
In its simplest form, cash flow is the movement of money in and out of your business. It is not profit and loss, although trading clearly has an effect on cash flow. The effect of cash flow is real, immediate and, if mismanaged, totally unforgiving. Cash needs to be monitored, protected, controlled and put to work.
There are four principles regarding cash flow management:
- Cash is not given. It is not the passive, inevitable outcome of your business endeavours. It does not arrive in your bank account willingly. Rather it has to be tracked, chased and captured. You need to control the process and there is always scope for improvement.
- Cash management is as much an integral part of your business cycle as, for example, making and shipping widgets or preparing and providing detailed consultancy services.
- Good cash flow management requires information. For example, you need immediate access to data on:
– your customers’ creditworthiness
– your customers’ current track record on payments
– outstanding receipts
– your suppliers’ payment terms
– short-term cash demands
– short-term surpluses
– investment options
– current debt capacity and maturity of facilities
– longer-term projections. - You must be masterful. Managing cash flow is a skill and only a firm grip on the cash conversion process will yield results.
Professional cash management in business is not, unfortunately, always the norm. For example, a survey conducted by the Better Practice Payment Group in 2006 highlighted that one in three companies do not confirm their credit terms in writing with customers. And many finance functions do not maintain an accurate cash flow forecast (which is crucial).
Good cash management has a double benefit: it can help you to avoid the debilitating downside of cash crises; and it can grant you a commercial edge in all your transactions. For example, companies able to aggressively manage their inventory may require less working capital and be able to extend more competitive credit terms than their rivals.
Cash flow management is all about balancing the cash coming into the business with the cash going out. The danger is that demands for cash, from the landlord, employees or the tax man, arrive before cash you’re owed is collected. More often than not, cash inflows seem to lag behind your cash outflows, leaving your business short. This money shortage is your cash flow gap.
If a company is trading profitably, each time the cycle turns, a little more money is put back into the business than flows out. But not necessarily. If you don’t carefully monitor your cash flow and take corrective action when necessary, your business may find itself in trouble. If cash flow is carefully monitored, you should be able to forecast how much cash will be available on hand at any given time, and plan your business activities to ensure there is always cash to meet upcoming payments.
Advantages of good cash flow management:
Having a clear view of where your businesses’ cash is tied up, unpaid invoices, stock and so on, what cash is coming in (and when) and what cash commitments you have coming up is hugely beneficial:
- you can spot potential cash flow gaps and act to reduce their impact, for example, by negotiating new terms with suppliers, fresh borrowing or chasing overdue invoices.
- you can plan ahead – allowing you to make investments without worrying that existing commitments will not be met.
- you can reduce your dependence on your bankers – and save interest charges by paying down debt.
- you can identify surpluses which can be invested to earn interest.
- you can reassure your bankers, investors, customers and suppliers that your business is healthy in times of a liquidity squeeze.
- you can be reassured that your accounts can be drawn up on a ‘going concern’ basis and, if your accounts are subject to audit, you can also reassure your auditors.
The cash flow forecast, or budget, is an important part of cash flow management. It projects your business cash inflows and outflows over a certain period of time. It can help you see potential cash flow gaps, periods when cash outflows exceed cash inflows when combined with your cash reserves, and allow you to take steps to avoid expensive, uncontrolled overdrafts or failure to meet crucial payments such as wages.
These steps might include lowering your investment in accounts receivable or inventory, increasing or advancing receipts, or looking to outside sources of cash, such as a short-term loan, to fill the cash flow gaps. If you’re applying for a larger loan, you will need to create a cash flow budget that extends for several years into the future. But for most business needs, a six-month cash flow budget is probably about right.
