What is a cash flow management?

One can find much material in the books and online on the subject. However, in this article, we will try to make it easy for our audience to understand the concept of cash flow management, situations generally causing cash flow problems and certain tips for effective cash flow management.

Business definition of cash flow management says that it’s a process of monitoring, analysing and optimizing the amount of net cash flows. In other words, net cash flow is an important measure of financial health for any business.

According to a study performed by Jessie Hagen of U.S Bank, “82% of businesses fail due to poor cash flow management.”

The effective cash flow management is about avoiding a situation where the cash spending exceeds cash earnings. Because such a situation may, in extreme circumstances, push a business to collapse, if not tackled in time.

Common situations causing cash flow problems

Some examples of situations, which may lead to cash shortages, include:

  1. Cyclical businesses: where significant time lag is involved from the stage the product/service/project is developed to the stage when it is realized. Such businesses remain cash hungry due to heavy initial cash outflows and ongoing costs of operations before the business can realize the cash by selling its products / services. Construction industry is one such example of cyclical business.
  2. Fast growing businesses: Available cash reserves are consumed, or cash shortfalls occur when invested in equipment, infrastructure, HR, advertising or inventory to match growth. It becomes difficult to meet cash flow demands due to the time lag between growth outlay (increased production and supplier costs) and sales realization. Such situations put businesses in vulnerable position.
  3. Flexible credit period, where your customers take leverage to delay payments beyond normal credit terms, say 30-60 days, resulting in mismatch between cash inflows and outflows. The reason can be poor collection management or poor credit terms.

5 Top tips for effective cash flow management

1- Cash flow forecasting – A must have

Cash flow forecasting plays a pivotal role in keeping an eye on your cash flow patterns. Regular cash flow forecasting will not only prepare your business for any expected cash shortfalls but will also help you manage potential shortfalls. Many accounting softwares are available in the market that provide additional tools for cash flow forecasting through budgeting e.g. Xero, Quick Books, MYOB etc. However, due to complexity involved in using budgeting/forecasting feature, small businesses tend to avoid its usage altogether.

Small businesses who cannot afford to invest in accounting softwares or hire professional accountants to help them with cash flow forecasting can use simple excel templates designed for this purpose. Accurate cash flow forecasting can help you make the right financial decisions.

While doing cash forecasting for your business, you need to be careful in certain areas where inaccurate assumptions could be very costly. Here are few examples;

  1. Accurate sales forecast: Be realistic while forecasting your sales as overestimating sales means you are forecasting inflows which would never be realized and will potentially lead you to cash shortfalls.
  2. Don’t overlook expenditures: Another potential issue while forecasting your outflows is to miss out certain expenses or ignore an anticipated increase in expenses. Government levies, cost of materials and increases in rent, rates, and taxes, are a few to name.
  3. Project cash inflows/outflows in the right period: Anticipating cash receipts from customers in an earlier month than its actually due or projecting supplier payments in a later month than its due could distort your cash flow position and may bring surprises.

2- Managing working capital cycle

Working capital management is about optimizing three key areas i.e. accounts receivable, accounts payable and inventory. If excessive cash is tied up in working capital, businesses are then left with limited resources to pay off their liabilities as they fall due. Similarly, excessive tied up working capital can hamper growth which could have been achieved by reinvesting in business. Consequently, the businesses may need to rely on external financing to fund any cash flow shortages.

Some of the ways to improve working capital cycle are:

  1. Incentivize your customers to pay early by offering discounts for early settlement of their accounts.
  2. Pay your suppliers on time or earlier, if they offer discounts for early settlements. Often the discounts availed offsets the financing cost of short term borrowing.
  3. Don’t tie up your working capital in excessive inventories and try to rotate them as quickly as possible. Examples include replacing slow moving items and dead inventories with fast moving items.
  4. Explore alternative source of financing such as invoice financing, running finance facility from banks etc. as this will not only reduce financing cost but will also help secure funds quickly.

3- Appraising capital expenditures  

Its critical for a business to decide whether to utilize any available surplus cash for growth or to finance the working capital. However, delaying or abandoning capital expenditure plans could hamper business growth, so such decisions should always be backed up by an ROI analysis.

You may seek professional advice from an accountant for best course of action before you decide to initiate capital expenditure plans.

4- Paying taxes

If income tax expense is taking a bigger pie in your cash outflows then you probably should consider consulting an accountant or a business advisor to review your business structure, operational procedures, and accounting methods to optimize your tax outflows through proper tax planning. They could also help you identify any tax incentives available for small businesses or for specific industries or for businesses operating in industrial areas declared as tax free zones.

5- Establishing cash conscious culture

This can be achieved by putting in place strict financial controls in certain areas. Examples of business expenditures where this can be achieved include travel expenses, overtime, entertainment, electricity and telephone usage, office supplies etc. However, this can only be achieved if tone is set at the top. This can be very well understood by the quote from Benjamin Franklin, “Beware of little expenses; a small leak will sink a great ship”.

Another example could be liberal credit terms offered by sales teams to achieve their periodic sales targets without showing concern whether those sales are realized in time or not. The best way to handle this could be to link the incentives of sales team with collections alongside sales itself.

Conclusion

To sum it up, cash flow becomes an issue when businesses are run like small businesses, no matter what is the size of business. You cannot arbitrarily spend money on things that may be working or carry on business for months without analysing your cash flows.

Being your own boss is great, but there is much to learn from better business practices being followed by large corporations. Alternatively, you should seek guidance from professionals who help businesses in such areas. Lastly it is important to start from somewhere and initiating these 5 tips could be a good start towards cash flow management.