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Effective cash flow management

Managing cash flow is crucial to a company's financial health. While it's a relatively simple concept, mismanagement can make the difference between profitability and bankruptcy.

Cash flow is easily understood by definition – it's the flow of money into and out of a business. It's also a measure of a company's financial health or liquidity. If a business spends more than it earns and runs out of cash it may go bankrupt.

While the concept of cash flow is straight forward, executing a cash flow strategy can be difficult. Every business faces its own unique challenges as cash is needed to pay fixed expenses such as property lease, bills and salaries, as well as to purchase assets and inventory.

If cash flow projections are not made and a six month cash flow budget not created, a cash shortage can materialize causing stress to business operations.

Profit doesn't equal cash flow

While it may sound counter-intuitive, just because a company is profitable doesn't mean it can't have a cash flow problem. After-tax profit equals revenues less expenses and taxes. On paper this can show a profitable enterprise.

But if expenses are due before revenues get collected, how will rent, bills and employees be paid without cash on hand? While sales may be strong and the profit margin substantial, there can still be a cash flow issue if revenue is tied up in receivables.

What affects cash flow?

The four areas of a business that most impact cash flow are:

  • Accounts receivable
  • Inventory
  • Accounts payable
  • Credit

While this is only a partial list, let's explore some ideas about managing each of these.

Collect receivables as soon as possible

Receivables are the primary source of incoming cash for many companies and must therefore be well managed. The following can help turn receivables into cash and help align cash outlays with inputs:

  • Invoice clients promptly. The less time between the sale and the invoice, the sooner you will be paid. Contracts should outline payment terms agreed to by both parties.
  • When client credit is questionable, or a client is new, obtain a bank confirmation or credit check. You can also ask for cash in advance.
  • Review aging reports regularly and have your collection department make scheduled calls. Don't procrastinate with delinquent accounts and ensure open communication with clients to find solutions.
  • Make slow payers pay in advance on future purchases.
  • For older accounts receivable speak with your legal advisors or hire a collections firm.

Streamlining inventory

Inventory can also be a big drain on cash though there is often a fine line between buying too much and not having enough to meet demand. The more items you need to have on hand the more likely inventory will impact your cash reserves. To help in this area, you can:

  • Analyze trends in your inventory, establish forecasts and purchase inventory around these patterns.
  • Enact "just in time delivery" and buy inventory as close to the sale date as possible. For some this might mean the product sold is "made to order."
  • Avoid "dead inventory" and sell inventory at a markdown before it becomes outdated. For some businesses outdated may be only 3-6 months old.
  • Increase your inventory turnover rate. Buying more because it is cheaper may mean cash is tied-up in low turnover items. Paying a bit more for inventory but buying less, can be more efficient.
  • Negotiate better (read longer) payment terms with your suppliers and ensure you are getting the best price/terms combination.
  • Arrange for drop-shipment if possible on lower demand products (where the manufacturer or distributor ships directly to your customers).

Companies experiencing high growth often have to increase inventory that is sold on credit. Cash injection by investors or special financing may be necessary.

Managing accounts payable

Understanding and using your payment terms is a key to managing accounts payable:

  • Negotiate terms so they meet your needs.
  • Don't be afraid to ask creditors for extended payment periods.
  • Don't pay early, only pay when payment is due.

Maintaining working capital, and minimizing down payments and monthly payments when purchasing larger assets and equipment are also important considerations. Work with your lender to structure payments so they meet your needs and consider leasing when acquiring large assets. Down payments are typically substantial when it comes to purchasing equipment which ties-up cash. Leasing is a great option to consider since you can finance 100% of the asset and in most cases, payment terms can be negotiated.

Keeping your cash and credit available to manage inventory and other revenue-generating sources is a good strategy.

Establish sources of credit

Most businesses run into cash flow problems at some point and having sources of credit is essential. For smaller purchases, business credit cards do the trick, although just like with personal cards, it's important to pay them off every month to avoid interest charges building up.

For large amounts and other types of expenses such as salaries, establishing a line of credit can help your company survive short-term periods when cash is scarce. It's important to remember that borrowing when there is a cash flow problem can be more difficult than borrowing when your finances are strong.

It's therefore best to plan ahead even if it means paying a little in fees to keep an unutilized line of credit available.

There's value in business advice

Establishing a relationship with a business advisor associated with your financial institution can be extremely beneficial when it comes to cash flow management. Expert advice can prepare you for future challenges and greatly ease your road to success.

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This article is provided as a general source of information and should not be considered personal financial or investment advice or solicitation. The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete.
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