Cash & Liquidity ManagementCash ManagementAccounts PayableThe Business of Cash Flow

The Business of Cash Flow

The present economy has created an unfortunate environment, where companies can fall into cash flow problems and run the risk of going out of business. Cash flow can be an issue for most businesses, but with the unpredictability of the economy, there is less room for error because it is difficult to determine what the future holds. Here are three different scenarios where cash flow needs to be analysed.

Scenario 1: Existing Customers

Company A – call it SMB for the purpose of this article – needs to pay its vendors and the cheques need to go out right away to be on time. In addition, for the first time in its business life, SMB finds that it does not have the cash to cover these cheques. How did this happen?

SMB did not keep a close eye on its own debtors because it has always had the cash on hand, which is not the case this month. The company decides to investigate its cash flow issue and some research uncovers that a specific customer is currently 45 days late paying its invoice. Additionally, because the current economic climate is tough, business in general has just slowed for SMB. This is a huge problem because this customer makes up the majority of SMB’s business volume. As a result, a few different problems began to develop with SMB’s cash flow.

First, SMB should have known when all of its cash receivables were due. When an account is 30 days past due and going into collections, that situation should be dealt with immediately. Collecting receivables on time is one of the only ways to safeguard against your own company’s payments being late. Two years ago, it was easy to take for granted that receivables were being paid on time, or even early, but in today’s market, businesses need to stay on top of their own cash flow situation and know when money is due and when it is paid.

Second, as soon as the debt was in delinquent status, SMB should have contacted the customer immediately once it realised the payment was late. The longer it waits to contact them, the less likely it is to see any money. It is not uncommon to hear that a business has delinquent payments on their accounts from up to a year previously, because they are not effectively tracking their receivables. Surprisingly, some of these businesses only realise a vendor or customer is late when that company either pays or tries to access additional services.

This sort of situation is preventable. Some accounting software packages include alerts for when a customer owes money, when that money is due, and even when your own business debts are due. If your accounting software does not, you can set your own alerts through your email – it is important to be proactive. Both SMB’s and its customer could also schedule payments to go out electronically so that they are not late. Accounting software packages also allow users to track payment trends, as well as restrict accounts once they are past due so that more money is not lost through unguarded credit. Understanding how to use your accounting software to its fullest potential is very important in managing your cash flow effectively.

Another key factor in keeping money liquid within the business is for companies to look inside themselves. Is the company currently doing anything that could potentially jeopardise their cash flow? Companies need to reduce their own bottom line and cut unneeded expenses, particularly today when timely payments can often be unreliable.

Additionally, companies need to stay on top of their own accounts payable (A/P), and make sure that their own company credit is good by paying bills on time or early, and take advantage of early payment discounts, such as a 2/10 net 30 discount. Reflecting back to our fictitious company SMB and its customer, if SMB had more liquid capital to weather poor economic storms, it might not have had to rely on its customer as much to pay its own debts. In terms of accounting software, the ability to track company expenses is critical.

Scenario 2: Taking on New Business

Effectively managing your accounts receivable (A/R) is important at all times. Most service businesses conduct their due diligence when taking on new clients in order to ensure that they receive payment back in a timely manner, but sometimes taking on that new piece of business also implies a level of trust in this relationship. If a new business, or any business for that matter, decides not to pay you, for whatever reason, you can then find yourself having performed your services free. That inherent trust makes accrual-based accounting a risk. So how do you know if the risk is less than the reward when taking on a new customer?

The best safeguard for your company’s cash flow is to be proactive before new customer billing even begins. When taking on a new customer, always ensure there is a contract in place, setting out the terms of repayment, and make sure you cover all your hard costs before beginning work.

When a company is going to start work with a new customer, it conducts a process of due diligence and ask itself these five questions to ascertain whether there is any risk involved, and if so, to what degree and how that risk will be handled.

  1. Who are they? If a company has a reputation for paying late, this is an instant red flag. You might still want to further research why or how they developed this reputation, but ultimately you may find they are just not worth the high risk. It is always a good idea to research a business’ reputation by contacting other companies who have worked with this person or business.
  2. What is the volume of business that you will be doing with this customer? Small businesses taking on larger clients who make up over 10% of their revenue may end up sacrificing the needs of their current customers and, or service, and even putting their own resources at risk in order to fulfil the needs of the larger client. As a small business, you do not want to be at the mercy of this larger client for survival and ability to do good business. Before entering into this type of work relationship, careful examination should take place in regards to your own resources, and certainly, have a plan of action in place should that larger business ever default. This one large client, if late on payments, could have a dramatic and negative impact on your business. Explore, if possible, the pursuit of other new pieces of business so that your client base is diversified. Alternatively, look at your own expenses because you may find areas that can be reduced or streamlined
  3. When was the business and their credit established? If the company or customer is new, or has less than stellar credit, be creative about extending credit to them. Always make sure you cover your hard costs before taking on any type of payment schedule with them, if you choose to take the risk at all.
  4. Where have they taken current loans? Always check references and their credit rating. Do not be afraid to ask. This is your money. Get the answers you need to make educated decisions.
  5. When does the benefit of working with this new person/company outweigh the risk of taking them on? That is a difficult answer because even if you did your due diligence, the future is still the future and ‘stuff’ happens. In the end, it is still your decision to make.

Scenario 3: Small Businesses Who Sell Retail

The biggest challenge in managing cash flow for retail businesses is the time between paying for inventory and selling it. If a company purchases too much inventory and sales drop, they could be stuck in a negative cash position with no way out. However, if they are watching their sales, inventory, and other factors closely, the ability to make quick adjustments can happen if downward trends develop. In other words, you might be able to prevent being stuck with unsold inventory and tying up cash.

To manage inventory effectively, businesses need to be able to analyse sales trends, seasonal variances in inventory, and the lead-time and terms of their major suppliers in order to make better purchase decisions that allow them to keep the right levels of inventory in stock to meet daily sales needs. Businesses dealing with inventory should also have point-of-sale (POS) software that gives them information about price adjustments from their suppliers so they can react more quickly to price changes that impact profitability.

For retailers with multiple locations, a good POS software product should also allow them to manage inventory levels at all locations and move it between locations to quickly free up needed capital to reinvest in new product or other areas of the business.

If you are a business with inventory that you cannot sell right away, you may have to resort to terms. In this case, even though you are still making the sale, you have to wait months or years to get the cash. Are you in business to make money or are you in business to be a bank? Obviously, you are not a bank – therefore do not think like one. Examine your own terms, and try not to extend credit if you do not have to. However, if you do find yourself in a position where you will allow an extension of credit, know that there are several types of credit and find the one that works best for you.

Contract of sale

The standard payment we have been referring to throughout this paper. Ensure your own expenses are covered when creating a contract for repayment and make sure there is a defined schedule for that repayment.

Capital lease

This lease is very similar to a contract of sale and requires that one of four criteria be met:

  1. The lease is classified as a purchase.
  2. The lease is worth more than 75% of the products’ estimated worth.
  3. The lease contains the option to purchase for less than market value.
  4. The value of the lease payment at the beginning of the lease is at least equal to 90% of the fair value of the leased product.
Operating lease (true lease)

This lease allows the lessee to use the product but not own the product. At the end of the lease term, the lessee can choose to purchase the good or return it.

Lay-away

The customer can purchase the product without paying the entire amount but does not take the item home with them until the product is paid in full. This repayment option has not been practiced as frequently in recent years but is making a comeback as Americans are rethinking the use of their credit cards for purchases.

The Bottom Line

Businesses have choices when it comes to extending credit terms, so know your options and the guidelines on those options in order to find the best way to maintain your cash flow. Stay on top of your payables and receivables, without causing any undue stress on your business’ finance. In short, make sure that you have covered your bases so that all you hard costs are always covered – your suppliers/vendors, overhead, payroll, etc. You need to know when your receivables are due and, if necessary, ensure that you have written contracts. Both the money and the contract are economic resources for your company. If you make good decisions and plan correctly, your business should be able to weather the economic storm and cover the majority of the loss with minimal damage.

Finding fully-integrated accounting software is best because its single-entry integration cuts down on user error. Nevertheless, accounting software cannot do it all. Small business owners need to prepare for, and expect, the worst in these uncertain times. Through preparedness, which includes the implementation of valuable software assistance, they will have the tools to stay afloat in this turbulent economy.

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