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How important is cash flow to business?

04 May 2015

Cash Flow

Of all the reasons surrounding why businesses fail, insufficient cash flow is one of the most common. Often this is not due to the lack of actual business, or the amount of sales being made, but to the mismanagement of the funds available. Every business has its differences, but the core principles are the same: cash is the lifeblood of your business, without proper cash flow management and planning your business could suffer.

The difference between profit and cash

It is important to understand that profit and cash flow are two different things. Many operators will tell you that it is possible for a business to generate strong profits but collapse because they have run out of cash. The easiest way to explain this is to imagine a business whose profit and loss statement showed that last year they made a profit of $50,000. What the profit and loss statement doesn't show is that for the first eleven months of the year this business was strapped for cash and nearly went under as they only made enough sales to cover their costs. In the last month of the year they made a couple of large sales and this is what resulted in the annual profit of $50,000. Profit is the result of trade over a given period. Cash flow is required to keep the business in operation by covering day to day expenses. This is why it is important to manage and understand how cash flows through your business.

What is a cash flow budget?

A cash flow budget simply records the amount of money that you expect to flow in and out of your business over a given time frame. It is a financial tool that will help predict the availability of cash in a business at any given time. Income and expenses are calculated monthly to help plan for any future short falls in cash.

How to construct a cash flow budget

A cash flow budget is based around a series of assumptions about the expected performance of the business in the future. These assumptions need to be realistic and supported by the most accurate data you have available. If you have access to previous trading results then the best place to start is the previous year's sales and expense records. Allocate those results into similar for the coming year, unless you know they will change in the future. You may want to increase sales to account for more growth or you may know that you made an unexpected sale/expense in a particular month last year that was a one off. You could be looking at introducing a new product line or service, looking to buy a new piece of equipment or employ another person. These will all have an impact on the cash flow budget and are the type of things you should account for so that you can forecast as accurate a picture as possible.

If you plan to use the information on your profit and loss statement understand that these have been prepared for tax purposes and will account for non-cash payments such as depreciation. This shouldn't be included in a cash flow budget as you don't physically make a payment for these things.

If the business is new, then you will need to base your assumptions on research, market expectations, contracts held, known expenses such as rent, or compare other similar business results. The more information you can build into the picture the stronger the tool will be.

Some will say it is a good idea to have three cash flow budgets that account for the best, most likely and worse-case scenarios. Computer spreadsheets allow you to quickly adjust scenarios.  As you receive your actual figures for each month it is important that you compare these with the projections so that you have an up to date position of the business. This will allow you to react as quickly as possible to any changes that may have occurred. Based on this, the cash flow forecast should be a living document and not filed away and forgotten about. Used properly it is one of the most important business indicators and planning tools you can have.

Many people in business will have their accountant prepare their cash flow budget for them. There is nothing wrong with doing this as long as you, the business owner, understand the information that your accountant has prepared. If you don't understand the assumptions that your accountant has put into the cash flow budget, then you won't be able to use it as an effective tool.

Managing seasonal cash flow in your business

Once you have completed a cash flow budget it will be apparent as to how much cash you will need, when you will need it and why you need it. You may find that you will generate sufficient cash each month to meet the bills, however others may find that their business is seasonal - some months are quieter than others. An overdraft facility is designed specifically for this purpose, to help pay for every day expenses whilst you wait for the cash to come in.

Some business operators believe there is a stigma associated with having to operate with an overdraft facility and that they are not efficient operators. This could not be further from the truth. Many profitable businesses experience peaks and troughs in their cash flow and need the overdraft facility to carry them through these times. The cash flow budget can be used to predict these periods and help calculate the amount of overdraft facility needed. Once the limit is set, the business can use the available funds on a revolving basis within the limit. They will only pay interest on the funds they use e.g. If an overdraft limit is $100,000 and the business writes a cheque for $25,000 using the overdraft facility they will only pay interest on the $25,000 until it is repaid in full.

Match the life of the loan with the life of the asset

One of the most common problems with the overdraft facility is that it is very tempting to write out a cheque for large or unexpected items and worry about it later. The overdraft facility is provided to be a source of funds to pay for day to day expenses such as rent, wages, stock, electricity etc. It is not intended to pay for long term assets. Long term assets are things such as cars, office fit out, forklifts, cool rooms, boats etc. Some businesses get themselves into financial trouble because they buy long term assets by using their overdraft facility. This often uses up a portion of the overdraft facility not accounted for when the limit was set. This is fine when the overdraft funds are not required but when they are the business can come to a sudden halt. It is best to match the life of the loan with the life of the asset. This means long term assets are funded using different types of loans such as leasing and business development loans. Speak to your bank and your accountant about what's the best loan structure for you.

Impact of growth on cash flow

Experiencing rapid sales growth can be a great thing for business, but it can also be the downfall. It is important to manage growth properly. Many operators in this situation can see their sales increasing rapidly, but there never seems to be enough cash. As businesses experience rapid growth they are constantly looking to add more services or stock on the shelf to keep up with demand. This demand tends to consume all available cash and additional funds are often required to support the growth.

History shows that it is difficult for a business experiencing such growth to generate sufficient cash internally and may need to look outside of the business for support. There are four key ways that the funding can be sourced. Operators can look for new equity from an outside investor. This involves giving up a portion of ownership but could improve expertise. They can use net profits, but these are rarely enough to support rapid growth. They can use trade creditors within the given terms but this only provides short term and limited cash availability. Or they can go to a bank. Among other things a cash flow budget will help support your case for growth and the need for additional funding.

Stock control

If you are starting a business from scratch it may be difficult to predict the amount of stock required. You don't want to have too much stock but at the same time you don't want to run out. You need to take into account things such as the availability of stock, the cost of stock, storage and transport, what contracts need to be fulfilled, and the nature of the stock i.e. whether it be perishable or such as fashion, seasonal. Also, how you plan to sell the stock; made to order, or off the shelf.

An existing business faces the same issues except that they have previous trade results to help predict the demand for the following year. These results can be adjusted in line with assumptions about expected changes moving forward and understanding what impacted the business last year.

Some operators can tend to hoard stock regardless of how useless and unsaleable it is. It is important to understand what the real cost of this stock is to your business and how much cash is tied up in the working capital cycle. Sometimes there is a competitive advantage in being able to provide the right product at the right time but if the stock is old and not needed the golden rule is to get rid of it. Recoup the cash as best you can, such as have a sale, and inject the cash back into the business.

Review your product mix regularly. Some stock will turn over faster than other items and in general these will have a lower margin but much higher volume. Other items may turn over more slowly but will make a much higher margin. Buy what you need not what you want. Set up a system that manages stock. This may be having one person responsible for ordering or a centralised computer program. Check all stock against the invoices to make sure what you order is what you get and record when it should be paid for and any discounts available.

 First published Westpac Davidson Institute.