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Understanding Cash Flow
Failure to properly manage cash flow is one of the leading causes of
small business failures. Understanding the basics will help you with your
cash flow management. Your business's monetary supply can exist either as
cash on hand or in a business checking account available to meet expenses. A
sufficient cash flow covers your business by meeting obligations (i.e.,
paying payroll and bills), serving as a cushion in case of emergencies, and
providing investment capital.
The operating cycle
The operating cycle is the system through which cash flows, from the
purchase of inventory through the collection of accounts receivable. It
measures the flow of assets into cash. For example, your operating cycle may
begin with both cash and inventory on hand. Typically, additional inventory
is purchased on account to guarantee that you will not deplete your stock as
sales are made. Your sales will consist of cash sales and accounts
receivable credit sales, usually paid 30 days after the original purchase
date. This applies to both the inventory you purchase and the products you
sell. When you make payment for inventory, both cash and accounts payable
are reduced. Thirty days after the sale of your inventory, receivables are
usually collected, increasing your cash. Now your cash has completed its
flow through the operating cycle, and the process is ready to begin again.
Current assets
Cash and other balance-sheet items that convert into cash within 12 months
are referred to as current assets. Typical current assets include cash,
marketable securities, receivables and prepaid expenses.
Cash flow analysis
Cash-flow analysis should show whether your daily operations generate
enough cash to meet your obligations, and how major outflows of cash to pay
your obligations relate to major inflows of cash from sales. As a result,
you can tell if inflows and outflows from your operation combine to result
in a positive cash flow or in a net drain. Any significant changes over time
will also appear. Understanding this will lead to better control of your
cash flow and will allow adequate time to plan and prepare for the growth of
your business.
It is best to have enough cash on hand each month to pay the cash
obligations of the following month. A monthly cash-flow projection helps to
identify and eliminate deficiencies or surpluses in cash and to compare
actual figures to past months. When cash-flow deficiencies are found,
financial plans must be altered to provide more cash. When excess cash is
revealed, it might indicate excessive borrowing or idle money that could be
invested. The objective is to develop a plan that will provide a
well-balanced cash flow.
Planning a positive cash flow
Here are the basic ways that a business can increase cash reserves:
Collecting receivables: Actively manage accounts receivable and quickly
collect overdue accounts. You stand to lose revenues if your collection
policies are not aggressive. The longer your customer's balance remains
unpaid, the less likely it is that you will receive full payment.
Tightening credit requirements: As credit and terms become more
stringent, more customers must pay cash for their purchases, thereby
increasing the cash on hand and reducing the bad-debt expense. While
tightening credit is helpful in the short run, it may not be advantageous in
the long run. Looser credit allows more customers the opportunity to
purchase your products or services. You should measure, however, any
consequent increase in sales against a possible increase in bad-debt
expenses.
Taking out short-term loans: Loans from various financial institutions
are often necessary for covering short-term cash-flow problems. Revolving
credit lines and equity loans are types of credit used in this situation.
Increasing your sales: Increased sales would appear to increase cash
flow. However, if large portions of your sales are made on credit, when
sales increase, your accounts receivable increase, not your cash. Meanwhile,
inventory is depleted and must be replaced. Because receivables usually will
not be collected until 30 days after sales, a substantial increase in sales
can quickly deplete your company's cash reserves.
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