What Is Cash Flow?
Cash flow, simply defined, is the movement of money in and out of your business; these movements are called inflow and outflow respectively. Inflows for your business primarily come from the sale of goods or services to your customers. The inflow only occurs when you make a cash sale or collect on receivables. Other examples of cash inflow are borrowed funds, income derived from sales of assets, and investment income from interest.
Outflows for your business are generally the result of paying expenses. Examples of cash outflow are paying employee wages, purchasing inventory or raw materials, purchasing fixed assets, operating costs, paying back loans, and paying taxes. Your accountant is the best person to help you make sense of your cash flow statement. Make sure you ask where the numbers come from in your cash flow statement and what they mean.
Cash Flow Verses Profit
Profit and Cash Flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period of time, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS.
Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more importantly, it is concerned with the times at which the movement of the money takes place.
Theoretically even profitable companies can go bankrupt. It would take a lot of negligence and total disregard for cash flow, but it is possible. Consider how the difference between profit and cash flow relate to your business. For example, if your retail business bought a $1,000 item and turned around to sell it for $2,000, then you have made a $1,000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? Despite the profits, you may not have the cash to pay them. Furthermore this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and increase debt. If this scenario is repeated enough times you may even go bankrupt!
Analyzing Your Cash Flow
The sooner you learn how to manage your cash flow, the better your chances for survival will be. Furthermore you will be able to protect your company’s short-term reputation as well as position it for long-term success.
The first step towards taking control of, and properly managing your company’s cash flow is to analyze the components that affect the timing of your cash inflows and outflows. A thorough analysis of these components will reveal problem areas that lead to cash flow gaps in your business. Narrowing, or even closing, these gaps is the key to cash flow management.
Some of the more important components to examine are:
Accounts Receivable. Accounts receivable represent sales that have not yet been collected in cash. An account receivable is created when you sell something to a customer in return for his or her promise to pay at a later date. The longer it takes for your customers to pay on their accounts, the more negative affects there will be on your cash flow.
Credit terms. Credit terms are the time limits you set for your customers' promise to pay for the merchandise or services purchased from your business. Credit terms affect the timing of your cash inflows. One of the simplest ways to improve cash flow is to get customers to pay their bills more quickly.
Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy is necessary to ensure that your cash flow doesn't fall victim to a credit policy that is too generous while not sacrificing sales volumes due to a policy that is too strict.
Inventory. Inventory describes the merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be put to work elsewhere. Too many business owners buy inventory based on hopes and dreams instead of what they can realistically sell. Keep your inventory focused as much as possible on products that turn over rapidly.
Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable sometime within the near future, "near" meaning 30 to 90 days. Without payables and trade credit you'd have to pay for all goods and services at the time you purchase them. For optimum cash flow management, you'll need to examine your payables schedule.
Some cash flow gaps are created intentionally. That is, a business will sometimes purposefully spend more cash to achieve some other financial results. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerating cash outflows to take advantage of significant trade discounts, or spend extra cash to expand its line of business.
For other businesses, cash flow gaps are unavoidable. Take, for example, a company that experiences seasonal fluctuations in its line of business. This business may normally have cash flow gaps during its slow season and then later fill the gaps with cash surpluses from the peak part of its season. Cash flow gaps are often filled by external financing sources. Revolving lines of credit, bank loans, and trade credit are just a few of the external financing options available that you may want to discuss with your accountant.
Managing Your Cash Flow
Now that you have considered how your business practices affect your cash flow, you are ready to develop some additional strategies for dealing with, narrowing, or closing cash flow gaps.
Contingency plans. You should have optimistic, realistic and pessimistic plans. The first plan forecasts high sales, low expenses and everything going better than expected. The second is based on realistically achievable sales and honest expectations as to expenses. The third plan specifies how to survive if everything goes wrong. The flag or indicator for going from the realistic plan to the survival plan is a sudden or steady decline in sales.
Cash Forecasting. The biggest problem for business start-ups is the owner failing to plan for how much cash the business may need throughout the year. This applies especially to businesses where payments usually come in over several months or after the work is complete. Planning is essential when businesses revenue streams are realized in cash weeks or months after cash is paid for the related payroll and other costs.
Spending Controls. Keep an eye on all spending; try to keep enough money in the company to get through tough times. New business owners are often tempted to spend too much for nonessentials. Make sure you carefully negotiate leases and solicit price quotes from several vendors to find the best value. Also, stop selling products that are losing money and avoid buying assets that require substantial cash outlays.
Accumulate Salary. If necessary to maintain a positive cash flow, you may need to defer part of your own salary. Many businesses fail when the owner doesn’t pay attention to the financial state of the business and insist on paying themselves big salaries no matter what.
Add Employees cautiously. Delay hiring workers as long as possible. Instead, look for ways to maximize your own productivity and that of any existing employees. Also consider lower-cost alternatives, such as outsourcing work to independent contractors.
What To Do With A Cash Surplus
Managing and improving your cash flow should result in a cash surplus for your business. How you handle your cash surplus is just as important as the management of money into and out of your cash flow cycle.
Paying down any debt you have is generally the first option you should consider when deciding what to do with your cash surplus, because a short-term investment is not likely to yield a return equal to or greater than the rate of interest on any of your debt. However, the decision to automatically pay down debt may not be correct in all cases. Your accountant is the best person to help you make these decisions.
Monitoring and managing your cash flow is an important task to perform in order to ensure the vitality of your business. The first signs of financial woe will appear in your cash flow statement, giving you time to recognize a forthcoming problem and plan a strategy to deal with it. Furthermore, with periodic cash flow analysis, you can head off those unpleasant financial glitches by recognizing which aspects of your business have the potential to cause cash flow gaps. With cash flow management and analysis, you will be able to plan on how you’re going to direct your cash surplus with assurance that you will have adequate funds to cover day-to-day expenses.
