Cash flow is crucial for small business survival
One of the main reasons that businesses fail is their inability to meet their financial obligations when they become due as they have run out of cash. Knowing how to maintain a healthy cash flow is essential to a successful business.
Cash cycles through the business, from sales, to debtors, cash in the bank, then purchases create creditors and cash flows from the bank. A healthy flow of cash can decrease the amount of capital required and increase profitability by reducing interest expenses. It can also help you to generate income on surplus funds so the business can expand and grow.
Why worry about cash flow management?
While failure to generate profits is critical to a business, it is only one cause of business failure. Profits don’t guarantee positive cash flow. The immediate continued operation of a business is at risk of insolvency if it does not have the cash to finance working capital needs. Measuring the movement of money in and out of your business allows you to monitor your position and set in place strategies to deal with shortages and surpluses.
Timing of cash inflows and outflows is the basis of cash flow management. That is, making sure there are sufficient funds to pay essential payments such as wages and salaries, suppliers’ payments and taxes when they fall due. Yet, surprisingly many small businesses don’t have a cash flow plan, or if they do prepare one, it is rarely updated to reflect changing circumstances.
Improving cash management
Generally, cash flow can be improved by cutting costs, increasing turnover or by speeding up cash inflows and delaying outflows. Some examples of ways to improve your businesses’ performance include:
l Look for ways to increase the number of customers, the frequency of their visits, the value of their purchases (do you want fries with that!).
l Review costs, but be wary of cutting costs that may have a negative impact on the future of the business such as investment in staff, marketing or technology that will leave your business behind your competitors.
l Cash from sales. Ensure cash is flowing into the business as efficiently as possible by reviewing processes, send bills out quickly, shorten the collection period and bank money promptly.
l Credit policy and debt collection. Screen credit customers carefully, set realistic credit limits and follow up on outstanding accounts quickly to reduce delays receiving payments.
l Paying bills. Use trade credit where it is available as this amounts to a short-term interest-free loan and work out the value of discounts for prompt payment.
l Alternative credit. Use credit cards for business purchases (as long as they are paid on time, this can be an effective form of credit).
l Progress payments. If you are providing a service over a period of time, negotiate a payment schedule that gives progress payments during the job rather than just a lump sum at the end.
l Buyers’ terms. Check out the terms and conditions of payment before taking on a big job to ensure you will receive the cash when you expect you will.
l Inventory control. Buy smaller quantities, if possible, or introduce just-in-time inventory strategies where the supplier holds stock until it is needed.
l Capital purchases. Ensure you finance your purchases appropriately and don’t use short term funds for a major asset.
Getting the most out of your surplus
The other side of cash flow management deals with how you handle your surpluses. Cash surpluses should be put to work, by either investing the surplus or using it to repay debt. It is usually a good policy to repay debt before considering alternatives, as debt usually attracts a higher interest rate than investments. However, this decision should be considered in the context of future cash needs and business strategies. As your business grows, so does your need for cash. You can use internally generated funds to expand and reduce interest charges.
Cash flow planning
A cash flow budget is a projection of your business’ cash inflows and outflows over a period of time. Preparing a cash flow budget:
l Provides early warnings of potential cash shortages so corrective action can be taken quickly.
l Identifies if additional funds will be needed.
l Assists in preparing requests to financiers for additional funding by demonstrating that the business can meet repayments.
l Identifies potential surpluses that can be invested to generate additional income.
Your cash flow budget should be prepared on a month-to-month basis. Unlike business plans and operating budgets, which are a mix of forecasting and goal setting, cash projections are strictly forecasts although they are usually based on past experiences. The purpose is to anticipate cash needs, not to set targets for performance. These should be conservative, as the impact of a cash crisis can be severe. Update forecasts if they become outdated.
Accounting for your tax obligations
Every business should ensure its cash management strategies take account of tax obligations. If you use cash accounting for GST, the impact on cash flow will be minimal. However, businesses using accrual accounting may be required to pay GST before they have received the money, therefore they need careful planning. Businesses should plan to retain sufficient cash to pay the tax office when commitments fall due. With PAYG they can plan for tax installments and manage their cash flow. Putting cash into a separate account to cover all tax commitments may be a wise move, as some businesses have failed through poor management of their tax obligations. At the very least, failure to pay tax, including GST, on time may result in penalties.
For more information, contact your tax agent.
This article is Adapted from CPA Australia.