Cash flow is, without a doubt, the most critical issue in successfully managing a business. More businesses fail due to lack of cash than any other issue (even very profitable ones!!)
We’ve compiled a simple and high level explanation of cash flow, what impacts it and the best way to manage it to help you sleep better at night.
What is Cash Flow and how is it different from Profit?
What is Profit?
Profit is the difference between what you sell and what it costs to deliver your product or service to customers. You also deduct general overheads from sales to arrive at a net profit figure. These factors are recorded in the same period, so that you can see if the business was profitable or not. I.e. If you work on projects, you measure the total value of the project against the costs relating to the project. This is where it gets tricky… if a project is in progress over more than one accounting period. You need to manage it in a job management system and make certain accounting entries into the general accounting system to report the true profitability of the project.
What is Cash Flow?
Cash flow differs from profit, because cash flows in and out of the business at a different rate to invoicing customers and paying suppliers and overheads. Whilst you may invoice a customer as soon as a product or job is delivered, a slow payer may not pay for 60 days! You may have had to pay for materials and labour on that job way before you even invoiced the job, let alone received payment from your customer.
This is the answer to the question people often ask “How come I’ve sold plenty, but I don’t have enough cash?”
What are the factors affecting cash flow and how can you influence them?
- Sales growth percentage
This is the percentage by which sales go up or down from one period to another. Everything you can do to improve marketing and selling your product/service has a positive impact on this figure. Sometimes an increase in sales can cause cash flow issues, because you need more cash to fund the time it takes between paying suppliers and getting paid by customers.
- Cost of goods/services sold percentage
This is the cost of goods/services compared to sales by percentage. It’s important to measure this by percentage, so that you can see how they are comparing as sales change. If you don’t measure them by percentage, it’s often the case that costs grow and eat up the extra sales and profit! Focus on reducing this percentage. Actions such as negotiating with suppliers for better pricing and payment terms and finding efficiencies in supply, will have a big impact on not only profitability, but also on cash flow.
- Price change percentage – up/down
This is the percentage by which you increase or decrease the price of your goods and services. Many businesses fail to do small regular price increases and this leads to margin squeeze i.e. falling profitability over a period of time. It then becomes difficult to achieve a big increase and customers may defect to a competitor. Small regular increases are the way to go. Every dollar of price increase ends up straight on the bottom line!
Discounting on the other hand is a tool often used when times are tough or stock needs to be shifted quickly. The issue with discounting is that you need to sell a lot more volume to avoid making losses due to discounting. The discount comes straight off the bottom line!
- Overheads percentage
This is the amount of overheads compared to the sales you’re making. It’s important to measure this by percentage, so that you can see how they are comparing as sales change. If you don’t measure them by percentage, it’s often the case that overheads grow and eat up the extra sales and profit! A budget is a great way to keep control of overheads. Once you’ve worked it out (usually in a spreadsheet) you can enter it into your accounting system and compare the actuals against the budget every month, to check things are on track. If they get off track you can fix it quickly and avoid further losses.
- Customer Payment Days
This is the number of days, on average, that all your customers are taking to pay you. Not to be confused with the terms you offer to customers e.g. 14 days. Often if poor collection processes are in place, this number can blow out to 60, 90 or 120 days! This is a cash flow killer. Effectively your customers are using you as a bank. You must put processes in place to speed up payment. Actions like clear credit terms, quick invoicing, regular statements and follow ups, easy ways to pay etc. will speed up customer payments.
- Supplier Payment Days
This is the number of days, on average, that you are taking to pay all your suppliers. Not to be confused with the terms they offer you e.g. 30 days. Often suppliers will try and get you to pay before the agreed terms and this is another cash flow killer. Effectively they are using you as a bank. Don’t pay early unless you’re offered incentives such as a discount.
- Inventory/Work in Progress Days (WIP Days)
This is the number of days, on average, that all your stock is on the shelf waiting to be sold or your jobs are in progress before invoicing your customer. If you’ve got too much of either of these, they are sucking up precious cash flow. Think of stock as dollars piled up on the stock room floor and jobs are dollars piled up on the workroom floor. Informed stock buying is the way to reduce inventory days. Systems that help you to analyse stock usage will guide you to optimise purchasing to avoid over/under stock. The same goes for WIP days – a job management system will help you to see where jobs can be invoiced quicker or better still deposits, pre payment or progress payments achieved to alleviate cash shortages.
- Interest, Tax and Loans
Interest on loans is an obvious one. The better you can manage the factors above and reduce reliance on loans the less you will pay. Taxes unfortunately can’t be avoided, so need to be allowed for, to ensure the cash is available when the bill needs to be paid. Loans have to be repaid eventually and repayments factored into the cash flow.
What is the best way to manage business cash flow?
This is a simple tool that plots out in black and white when you expect cash to come into the bank account and when it goes out.
You start with the opening balance and depending on the health of your cash situation, you may want to view the forecast on a monthly, weekly or daily basis. You add in the funds coming in and going out for each period and calculate what will be the bank balance at the end of each period. That way you can see beforehand where issues are likely to occur and fix them.
You can speed up payment from customers, slow down payment to suppliers, reduce spending, increase lending or put some business owner funds in for a while to cover shortfalls. You can do the forecast on a spreadsheet or a dedicated app. Either way you will sleep better at night if you know what the situation will be with plenty of time to manage it.