Phrases like “Cash is king” and “Cash is the lifeblood of your business” emphasize the importance of cash in running a successful business. But have you thought about how to actually take control of your cash flow?
There are 3 steps to this process. It begins with having a deep understanding of your cash flow, where cash flow is the money that moves in and out of your business over a specified period of time. Good cash flow management requires that you understand how cash moves through your business over time.
The next step is to master the skill in tracking your cash flow. The ability to forecast future cash flow reflects how well you understand the flow of sales, receivables, inventory, and payables. Your Cash Forecast will help you plan and build cash reserves to handle emergencies. It is important to update the Cash Forecast regularly to anticipate potential problems so you can be proactive instead of reactive.
The last step is to constantly improve your cash flow. Your cash flow pattern is determined by the structure of your business model. Great cash flow management is all about understanding where your money is stuck and how to get it into your bank account faster. Any tactic you can come up with to encourage clients to pay sooner, or to make your collection process more effective, will improve your access to cash.
Step 1: Having a deep understanding of your cash flow
There are many fast-growing businesses that are profitable but struggle with cash flow. And it’s surprisingly common these companies go out of business simply because they run out of cash. That’s because cash is different from revenue and profit.
It is important to recognize that revenue is recorded when you invoice your customer for your products or services. But earning high revenues does not mean you have enough cash to pay money you owe your suppliers because you are still waiting for your customers to pay their invoices.
Meanwhile profit is the amount left after subtracting all expenses from the revenue you have recorded. If your business isn’t consistently profitable, better cash flow management, while helpful, will be no better than a Band-Aid on a potentially fatal wound.
And cash, or cash flow, is the money you collect and use to purchase inventory and pay suppliers. It represents the amount of money that is coming in and leaving your business over a given period of time. This is impacted primarily by the 3 elements of cash flow.
The 3 key elements of cash flow
The 3 elements are – accounts receivable, accounts payable, and inventory (if you are in the business of selling goods). Accounts receivable is the money customers owe your business for goods or services they have received but not yet paid for. Accounts payable is the money your business owes to suppliers for goods and services that have been provided but not yet paid for. And inventory is the raw materials and finished goods that are purchased from suppliers and then sold to customers to generate revenue. When you buy inventory on credit, it creates accounts payable. When you sell inventory or services on credit, it creates accounts receivable.
Cash Conversion Cycle
When these elements are taken together, it gives you the company’s cash conversion cycle. It is an essential tool to boost your cash flow. The cash conversion cycle measures how fast your business can convert its cash on hand into inventory, and then convert the sale of goods or services back into cash. Figuring out how long this cycle takes allows you to understand how many days your company’s cash will be tied up, making it unavailable for use in the business.
The shorter your cash conversion cycle is, the better, because shorter cycles mean cash is moving faster through your business. The faster you sell your inventory, the lower your average days inventory is, so make sure you don’t over-order or let it collect dust from holding it too long.
The quicker you collect your accounts receivable, the lower your average days receivable and the sooner you have access to this cash to use in your business. The longer your average days payable, the more your suppliers are helping you finance your business. This is helpful, but you should avoid pushing them too hard to maintain a good business relationship.
Here’s the formula to calculate your cash conversion cycle:
Average days inventory + Average days receivable – Average days payable = Cash conversion cycle
A higher number means cash is moving slowly in your daily operations. It is a result of a poor business model with cash being tied up. You may need to get extra financing to support the business and be able to pay your suppliers on time.
A lower number means cash is moving quickly in your day-to-day operations. It is a positive sign as your business will not experience any problem paying supplier invoices. The lower the number, the easier it is for the business to meet its financial obligations.
Step 2: Tracking cash flow
A key step to take control of your cash flow is by learning how to track it. One of the easiest ways to keep track of your cash is by using a Cash Flow Statement and a Cash Forecast. Cash Flow Statement shows how cash was used in the past and it is broken down into 3 categories – operations, investing, and financing. Historical performances allow you to reflect on the current structure and explore ways to improve. On the other hand, Cash Forecast projects into the future and shows all the expected money inflows and outflows for your business. This tool can be used to forecast and estimate changes to cash flow. Your ability to track your cash flow depends on your ability to monitor expenses, manage receivables and payables, and plan your business activities.
Best practice
At the start of a new fiscal year, you should take stock of your business strategy and identify your expenses. Answering the questions below is a critical part of your company’s annual financial planning. Once you have a clearer view of your situation, create a Cash Forecast to see if you have enough cash available to implement your strategy. If you don’t, then you need to find ways to improve your cash flow.
Questions to consider: Do I need to hire more staff? Do I need more equipment? Do I need to expand? Do I need other new resources? How will my plan affect my cash flow? Will I need financing? If yes, how much?
Step 3: Improve your cash flow
Your business can get into a situation where your sales have grown, but your bank account balance hasn’t. While there can be many reasons for this, the way you collect your accounts receivables is especially important.
Here are 4 tips to take control of your cash flow and help you collect money faster:
1. Send invoices immediately
The earlier you invoice, the sooner you get paid. Be sure to send invoices immediately after the product sale or service is rendered. You also should consider using accounting software such as Quickbooks Online to collect faster. If you’re working on a large job, consider negotiating upfront deposits and progress payments.
2. Establish a reminder system
Define how many times, when and in what form you will contact late payers. Is it a reminder email or a phone call? Will it be once a week or more often? You may also want to consider using an invoicing reminder software to automate this process.
3. Offer discounts
You can consider offering a small discount for quick payment. For example, a discount of 2% if paid within 10 days is common. But these discounts are costly and should be used only if you need to get cash in the door very quickly.
4. Identify barriers to change
Consider setting your business up to accept credit card and e-transfer payments from slow payers to speed up the payment process. In addition, you can consider delaying additional work to slow payers until their outstanding invoices are paid.