There is a misconception that once a business is making profit, everything is fine! This is far from the truth. If the cash flow position of the firm is negative, it means the business may be in severe trouble. Profit is defined as revenue less expenses and cash flow refers to the actual receipt and payment of cash. If a business buys $1,000.00 worth of stock and sells it on credit for $1,500.00, profit is $500.00 but cash flow is negative as cash inflows would be nil. Many businesses may continue to trade in the short to medium term even if they are making a loss. This is possible if they can, for example, delay paying creditors and/or have enough money to pay variable costs. However, no business can survive long without enough cash to meet its immediate needs, for example, payment of bills. This is why effective cash flow management is necessary. Hereunder are 5 key points to assist with effective cash flow management.
- Managing your payables
A key strategy in cash flow management is to hold onto your cash as long as possible by managing your payables. This means that the business should take full advantage of creditor payment terms and even negotiate with suppliers for more liberal or extended payment terms, as well as, discounts. This would require maintaining an open, healthy relationship with the suppliers.
- Improving your receivables
Another key strategy in cash flow management is to retrieve cash as quickly as possible. There are several ways in which this can be done. One way is to offer discounts to customers who pay quickly. This will encourage customers to continue to pay promptly. Another technique is requesting customers to make a downpayment or deposit payment at the time the order is taken. Thirdly, collection policies need to be aggressive and follow ups for payment need to be conducted consistently and immediately if payments are behind.
- Preparing cash flow projections
Cash flow is the life-blood of any business. As such, cash flow projections should be prepared for a year by estimating cash inflows and cash outflows for each month over the next twelve months. This is essential to ensure that the business has enough to survive. Preparing cash flow projections are considered just as important as preparing business plans for the following:
- It acts as an “early warning system” by identifying potential shortfalls in cash balances in advance.
- Makes sure that the business can afford to pay suppliers and employees. Suppliers who do not get paid will soon stop supplying the business; it is even worse if employees are not paid on time.
- It spots problems with customer payments. Preparing the cash flow forecast encourages the business to look at how quickly customers are paying their debts.
When completing the cash flow statement it is important to note seasonal fluctuations in sales and record them accordingly.
- Avoid over-investing
Especially for new/start-up businesses, while using extra cash to purchase assets for the business can improve productivity and competitiveness, it can be very useful to retain backup funds to cover any unexpected costs that may arise, such as repairs for breakdowns of equipment.
- Taking out short-term loans
As a business owner, it is wise to plan for the rainy day. Financial institutions would be more willing to lend to a business that has a healthy cash flow position than to one that has a negative cash flow position. It is suggested that a business plans ahead and asks for money even before it is needed. The bank can arrange a line of credit for the business so that in the event that the business is strapped for cash or any unforeseen day-to-day expenses occur, this line of credit can be utilized.