Famous US venture capitalist Fred Adler said, "Happiness is a positive cash flow". Cash flow, as defined in the Cambridge Dictionary, is ‘the amount of money moving into and out of a business’. Think of cash flow like putting petrol in your car; you fill up the car’s tank with petrol, and it empties as you drive. The goal, however, is to have enough petrol in your tank so you never run on empty. Cash is the lifeblood of every business – big, small, public, private, sole trader, company, new or old. Without cash, your business will not survive.
A positive cash flow should be a goal for all businesses. That is, spending less money than you generate. Just because you may be profitable, does not mean you have a positive cash flow. It’s paradoxical! In the best of times, you might have the worst of times. You might build things two months in advance and not receive the monies for sales for six months.
There are several factors that can mean even profitable companies have negative cash flows:
- Cash to cash cycle: an easy-to-use metric to calculate how long cash is tied up in the main cash producing and cash consuming areas – receivables, payables and inventory. In most cases, the lower the number, the better. Often, the cash to cash cycle is much longer than the accounting recognition, so while it looks like you are making a profit, there is a mismatch between the profit and when cash leaves and enters the business.
- Quick growth: I have seen many companies grow fast but struggle to pay their bills (including taxes and employee entitlements). What has not received the necessary attention is how the business was funding the growth. These businesses usually try to grow with inadequate cash reserves at the start.
The two most useful financial reports, in my opinion, are the cash flow forecast and the cash flow statement.
Cash flow forecast
I find the cash flow forecast the most useful report for the day-to-day management of a business. Unlike most accounting reports that review what has occurred in the past, such as the profit and loss statement or balance sheet, the cash flow forecast is a proactive tool.
Building a cash flow forecast
To build a cash flow forecast is relatively easy. Start with your current bank balance, add all certain inflows for cash, and subtract all certain outflows of cash. You should do this based on the incremental period that you choose – daily, weekly or monthly. It’s important to only include inflows and outflows that you are certain will occur; those you can bank on (excuse the pun).
Most accounting software packages can produce a simple cash flow forecast; however, this should be used only as a starting point.
Here are some questions to ask when building a cash flow forecast:
- Are all the invoices in the accounting system? (Make sure they are not sitting unopened on someone’s desk or filed in a drawer or wastepaper basket.)
- Are the payment and receipt dates reflective not just of the payment terms but of when they are expected to be paid and received?
- Are all cash items (GST, wages, taxes, superannuation) included? Put the GST-inclusive amounts in your cash flow forecast and not the GST-exclusive amounts that you have in your financial plan or profit and loss statement.
Don’t include projected sales into the cash flow forecast; only count actual sales. When you only have the cash items you are certain of, you will see the cash flow gap and you can start getting busy working out how to close the gap.
Improving cash flow
After building the cash flow forecast, you may find that there are periods where cash is tight. The good news is that this cash flow forecast allows you to be proactive at improving that situation.
Some ways and areas to look at are:
- Chase up overdue receivables
- Tighten payment terms for customers
- Lengthen payment times to suppliers
- Look at how much cash is tied up in inventory and see if it can be converted to cash quicker and/or whether the inventory levels can be reduced.
- Separate personal expenses from business expenses
- Start discussions early with banks and investors to cover the shortfall period
- Look at the funding structure and look to put in place the most appropriate and cash efficient arrangement for your business
- Get your accounting up to date and accurate (no leaving invoices in the drawer and only putting them in the accounting system once in a blue moon)
- Change your growth plans to fit within your cash flow forecast
Cash flow statement
Unlike the cash flow forecast, the cash flow statement looks at how the business has funded itself over a period of time. Consequently, the cash flow statement is often included in financial statements.
The cash flow statement is broken into three areas of cash movement:
- Cash flow from operations: this is the actual money that your business generated from core business activities. This will show if the current core business activities generated a positive or negative cash flow. It excludes accounts receivables and depreciation so is a good indicator if the cash to cash cycle is too long and there are delays receiving monies from customers. Historical reports are best looked at and compared to regular intervals than just a one-off. The trend is the real power.
- Cash flow from investing: this is the money that was spent on infrastructure – plant, equipment, IT systems, property. This is important as it may help explain a large decrease in the cash that is not actually a day-to-day business expense but an investment in the business’s future.
- Cash flow from financing: this includes loan repayments, interest, monies from or to the business owners and loans. This helps to clarify each type of cash injection or withdrawal and gives a basis to decide if they are healthy or not. Again, the greatest benefit is comparing periods.
I believe one of the biggest – and most overlooked – benefits of analysing cash flow through a cash flow forecast or cash flow statement is that management and business owners gain deep insight into their business.
This may be understanding process issues, discovering incorrect payment terms on invoices, finding said invoices are not funded appropriately or their working capital does not support their sales strategy. So apart from avoiding a cash squeeze, the information garnered will help you run your business better.
Stephen Barnes is business turnaround and recovery specialist, Board advisor and the principal of management consultancy Byronvale Advisors.