What does cash flow really mean?
Simply stated, cash flow is the amount of cash received and paid by a business during a defined period. As an owner/manager, it is one of the most important measures you have to operate your business. Your net cash flow statement is far more important to you in the day-to-day operation and health of your company than your profit and loss statement.
Unfavorable cash flow can result in the failure of a profitable business simply due to a lack of liquidity and ability to pay current bills. In today’s economic environment maintaining liquidity is critical. If you think otherwise — remember all of our former investment bankers!
If you think it strange for an engineer to be writing about cash flow management; you might be right — except that I learned this expensive lesson years ago when my then profitable business failed due to my failure to manage accounts receivables.
Like everything important in business your cash flow must be both monitored and aggressively managed. Your cash flow statement needs to be current, correct and within arms reach constantly. If you do not operate with a formal cash flow statement, you need to. Talk to your accountant to set up an easy-to-use form — or find one you can download on the internet — but get one and base your operating decisions on the information it provides!
The “period” of your projections will vary depending on your business model. The longer your lead time, the longer your effective projection period can be. A company working on two week lead times will find quarterly projections less certain — but take them out as far as practical. As you gain experience (and realism) you will find the process far less cumbersome and more beneficial.
If you are currently on shaky ground, you need to be revising your statement on a weekly basis. In no case should your statement be done on an interval greater than once a month.
Don’t make the mistake of thinking your checking account provides this information — there is only one way to get it—and that is to create it.
Preparing a cash flow statement
Possibly the easiest way to start a cash flow statement is to use your balance sheet from the last six months as a basis. If you are preparing a one month statement, it is simply your receivables and your payables. Don’t forget to include periodic charges such as real estate taxes, payroll taxes and insurance in those projections. You can choose to use monthly accruals to “anticipate” these outflows.
Be realistic in projecting your accounts receivables; if you have a customer who pays in 90 days why would you think in your projection that he will somehow become current next month? If you see a trend of accounts receivables aging by a day or two each month — don’t ignore that — and don’t think that it will stop or reverse on its own.
If you are in a declining market, be realistic about what you project as business volume — remember this is a management tool not a marketing tool — this is no time to be unreasonably exuberant! It is far better to “over ship” than to “under ship” to the plan. At the same time, being overly conservative about shipments can raise accounts payable to a level not anticipated in your statement.
Include as a line item cash on hand at the beginning of each period — and pay particular attention to that trend. Keep in front of you both the current and future statements as well as the “audited” past statements so that you can see how accurate your projections have been.
Managing Your Cash Flow
Obviously there is a portion of your cash flow you have limited ability to manage (like taxes and payroll) — but for the most part you can effectively manage cash flow to your benefit.
There are timing issues you can take advantage of, some beneficial to you, some not. If your cash reserve allows taking advantage of trade discounts, that is often advisable — but look at the details carefully. A 1 percent 10-day, net 30 trade discount will yield an annualized return of 18.2 percent compared to paying net 30. While that is often attractive — have you asked that vendor if they have a consignment program?
Be very careful about penalties — late penalties are almost always onerous. If you are paying net 30 — pay at 30 — not 29 and certainly not 31. Electronic transfers with your vendors will help manage that aspect. In the event you find yourself having to extend terms — talk to your vendors before the bill is due — this is paramount if it is a payment to your bank!
Aggressively manage your receivables! You need not be either embarrassed or abusive — but contact customers that are slow paying — silent “understanding” on your part is not a responsible approach. Remember the old adage about nice guys — asking for your money does not make you a bad guy — it is part of being a business man.
Unfortunately, too often we are no longer small town folks that still honor a hand shake — don’t extend credit to anyone without looking at their credit history. Use down payments to both manage cash flow and reduce your exposure.
Offer your customers trade discounts if it fits your business model and is beneficial to you. If you are simply trading off discounts between receivable and payables, there is little benefit to you to offer discounts.
Put chronic slow paying customers on COD — they won’t be insulted — you aren’t likely the first to do that.
Leverage Lean
The most significant tool you have to increase your cash on hand and improve your cash flow stream is through lean methods.
Despite what your accountant thinks — inventory is NOT an asset — it is cash that is not available to you to make more cash. It is lost liquidity — convert it!
If you have obsolete and slow moving inventory in your warehouses, get rid of it — have a fire sale — take the hit, let your accountant whine — but convert as much as you can to cash.
Compress your manufacturing cycles, compress your supply cycles, compress your billing cycles — and if at all possible — produce only to order and don’t start an order until it is fully workable.
Be holistic in your buying decisions, saving two cents less per widget might not be a good deal if you have to take six months of usage at a time. Two cents more delivered to the point of use on a just-in-time fashion might be a much better deal.
An absolute goal should be that any product that ships today—is invoiced today—no exceptions.
A closing thought
Imagine if you will:
- Your incoming warehouse has an average of 45 days of inventory and a value of $1 million.
- Your manufacturing cycle is three weeks with $2 million in WIP (work in process).
- Your shipping warehouse has an average of 30 days inventory at a value of $4 million.
- Your accounts receivables are an average of 45 days (after shipment) and $6 million.
- The total of committed operating funds = $13 million.
Now — imagine:
- You take five days out of the incoming warehouse and reduce the value proportionality to $900,000.
- You compress the manufacturing cycle by one week and the WIP proportionality to $1,333,000.
- The shipping warehouse drops to 25 days inventory and a value of $3,333,000.
- Finally your accounts receivable drop to an average 40 days and a value of $5,333,000.
- The total of committed operating funds = $10,899,000.
The net result is an increase of $2,101,000 cash on hand (not to mention the space you just freed up)!
We are in trying times; you all know that. Remember the old adage: “cash is king”. In times like these it is imperative that you manage the king.