What do I have to manage? # 1 – The Cash Flow
Wednesday, March 3rd, 2010WHAT IS THIS THING CALLED “CASH FLOW”?
Business stands or falls on its cash flow. Let me emphasise this again: – Business stands or falls on its cash flow! As a business owner you have to manage your cash flow!
So what is this thing called “cash flow”? And why is it something that gets so little attention, at least until its stretched to its limits?
Well there are two types of cash flow:
- inflows – usually represented by sales, and
- outflows - usually represented by expenses.
So, isn’t this just another way of talking about income and expenses? Well, no, it isn’t!
And one of the differences between the two is timing.
I can sell something to somebody today and it’s referred to as a sale. It only becomes an inflow, when I receive the money for it, which could be tomorrow, or next week or next month, depending on the terms of the sale.
Conversely, I could purchase something today on credit, and even receive the goods, and it will be known as an expense of the business. It only becomes a cash flow item – in this case, an outflow, – when I finally pay for it.
Another difference between the two is the nature of the transaction. Cash flows can be both ‘trading’ and ‘capital’ in nature.
I may decide to purchase a new machine for my factory. It’s going to be used to manufacture products which I will be selling. The cost of the machine is not a trading expense but a capital one. I may also be paying for the machine over a period of years, so although it is a capital expense in the current period, it is a cash outflow each month over the term of the loan. Sales are known as trading income, while the proceeds of a loan would be regarded as capital inflows.
IS IT EASY TO DO?
Surprisingly, even a number of experienced bookkeepers and accountants struggle to prepare cash flow forecasts. This is simply because some businesses are very complex in nature, and their terms and conditions of trade are complex too. At other times, its simply because the nature of cash flow is not fully understood.
Paradoxically, it’s the most important function of financial management of a business and if not done well, can spell doom for any enterprise.
Most small businesses I know manage their cash on the basis of ‘what comes in, goes out – and what goes out, goes to the one who is making the most noise.’
It’s called crisis management! They are unaware of any potential cash flow crunches a few weeks down the line and any assault on their overdraft limit results in a frantic call to the bank manager for help!
The cost to the business of this kind of cash flow management is enormous because everyone in the organisation gets involved. The salesman has to stop selling to collect outstanding receipts (which negatively affects sales), the bookkeeper stops keeping the books (which negatively affects the financial management of the business); and even the cleaner may have to stop cleaning to run down to a customer’s premises to collect a promised cheque.
So, there are a couple of key things to constantly bear in mind about managing your cash flow, if you want to keep control of it. There are 8 of them:
- Make profits, not losses,
In this newsletter, we will deal with the first three, which is all about the effects of profits and losses on the cash in your business.
MAKE PROFITS, NOT LOSSES!
The first thing we must realise as business owners/managers/entrepreneurs is that unless we are making profits in the business, it is unlikely we will continue to have a positive cash flow.
If you’re making money, you’ll feel it in your cash flow. And, – if you’re losing money, you’ll also feel it in the cash flow!
In the days when business was largely transacted on a cash basis, the business owner would know that as long as he had money in the bank, and that it was growing, he was making a profit. It’s not quite so easy these days! So, every attempt should be made to ensure that the business remains profitable, at all times.
HOW DOES THE CASH KEEP FLOWING IF YOU’RE TRADING AT A LOSS?
But – what if you are making a loss?
This is what I find usually happens: losses aren’t really known (the full extent of them anyway.) because of poor record keeping, so as soon as the cash runs out, many small business owners cover their shortfall by extending the payment due date to their suppliers.
I’ve even heard them tell an irate supplier, “well, I haven’t been paid yet, so you’ll have to wait!”
The problem may have nothing to do with when you receive your money from your customers – it may have to do with recurring losses that you don’t know about!
Losses have to be funded by someone, and if you’re not funding it by putting more money into the business, then it’s likely your suppliers will be doing so! (And usually without their permission!)
This creates a vicious circle because it initially disguises the extent of the problem. It later leads to other supplier-related problems, and inevitably, the eventual demise of the business. In the wild, animals that become sick or are wounded eventually get hunted down by wolves or hyenas. Its not too different in the business environment – if you’re struggling with your cash flow (you business lifeblood) and you’re financially wounded, it won’t be long before the supplier ‘wolves’ will close in for the kill!
MAKE ENOUGH PROFIT!
Even if you are making a profit every month, that profit should be enough to pay you a salary and to cover the capital portion of any loan repayments you have to make.
Profits, remember, are calculated only after the interest portion of a loan instalment is accounted for. This is particularly important as you near the end of the life span of a loan agreement because the capital portion of the instalment will account for most of that instalment. (Everyone generally knows that the first months of an instalment loan are usually made up mostly of interest!)
If you’re only just breaking even every month, and your interest costs are low, then you may be in for a “cash” surprise because you won’t have enough cash to meet the capital portion of your loan instalments.
It is also important if you, as the business owner, are in the habit of drawing additional amounts out of the business “on loan account”. These withdrawals have nothing to do with profits or losses, but are very definitely cash outflows.
Don’t – and let me stress this again, – DON’T – take out more money than your business is generating in profits each month! Far too often, business owners tend to regard their drawings in the same way an employee regards his or her salary – as a right and a business obligation. You have to get it into your head that when you start up a business, you lose those rights. At the same time, if the business is highly profitable, and cash-flush – you are at liberty to help yourself!
