Understanding the concept of cash flow and how to manage it is essential in today’s business environment. Many small businesses fail because of inadequate working capital and poor cash flow management. The owner often confuses the terms “profit” and “cash flow.”
Profit is not the same as cash flow even though there is a relationship between them. A company can be profitable but at the same time be forced into bankruptcy due to its inability to meet current obligations.
Profit is an accounting concept that basically measures the overall performance of the company. A company can earn thousands of dollars of profit in a given period and still have a negative cash flow during that same period.
Let’s examine the basics of cash flow planning and analysis that can help a business to survive.
During a company’s daily and monthly operations, cash is received and cash is dispersed. There will often be times that a company has more cash going out during a given period than cash coming in. At other times, this position will be reversed and there will be excess cash available to the business.
For example, many retailers incur large outflows of cash prior to the Christmas season in order to build inventory. This cash outflow does not constitute a loss. However, a business owner must anticipate and plan for an adequate amount of cash on hand to pay vendors or make other financing arrangements in advance.
In this scenario, the business owner could liquidate any short-term investments on hand, make special financing arrangements with vendors, or contact his banker and start the paperwork to secure a short-term loan or a line of credit. A banker’s response would be more favorable for a customer who understands his company’s cash flow needs in advance.
It is also important to know when you have excess cash on hand and how to properly invest the monies in order to ensure you do not lose purchasing power during periods of inflation and high interest rates.
It is a combination of understanding your company’s operational cash flow, investment cash flow, and financing cash flow that will help you manage your business more effectively.
The first step to this planning process is to prepare short-term cash flow forecasts. This is normally done on a monthly basis. Such planning will help you anticipate and deal with any shortages or surpluses.
It can also reveal when would be a good time to make capital investments in your company or when you might need to delay some large purchase. It can provide insight on inventory purchases and credit policies.
In short, a business must be able to cover its current debt to remain solvent. The best way to do that is to know your cash position at all times. The accuracy of the forecast determines the value of the cash plan.
Next, let’s examine the areas that small-business owners most often mismanage with regard to cash flow. The most common error occurs in the management of accounts receivable. The first rule of thumb is not to sell on account unless you need to because of industry practice or competition.
If you do have to issue credit, be sure that you have methods to determine credit risk. Once you have receivables on your books, you need to keep up with the age of the accounts. The older the account, the harder it is to collect. You should establish a policy of notifying customers on overdue accounts and possibly charging interest on these accounts. You must be persistent in following up on the overdue accounts.
Another area in which small businesses can generate more cash flow is in leasing equipment. Many start-up operations incur large cash outlays for capital equipment. These large purchases can leave the owners little or no working capital.
Often this same equipment could be leased with a smaller outlay of cash. This option may not be desirable for long-term profit but it can help in the critical start-up phase when companies lack sufficient operating capital.
Another area that one must focus on is accounts payable. Most times it is to your advantage to use your vendor’s money as long as possible without incurring finance charges or losing cash discounts.
In general, if you have the working capital to take advantage of early payment discounts you should. There are times that you have to bypass such discounts in order to conserve your cash. On the other side of this issue, you should use your full 30 days if there are no incentives to pay early.
Just remember, all business owners could benefit from cash flow planning. The more you work with your “numbers” the better you will become in managing your cash flow.
Lynn Vos is area director of the University of Georgia’s Small Business Development Center. Contact her at 651-3200.