The mystery of cash flow
What is cash flow?
The Cambridge dictionary defines cash flow as:
noun ËˆkÃ¦Êƒ ËŒflÉ™ÊŠ/
the amount of money moving into and out of a business
Imagine trying to live without blood flowing through your body. You would have no oxygen or energy to function and eventually you’d die! This is the exact analogy to use when considering cash flow in your business. Cash is the lifeblood that keeps your business running. You must constantly replenish the amount of cash in your business to keep it going, just as you need to breath each day.
This is a very simplified diagram of what cash flow is:
For a business to remain viable there needs to be enough funds available to meet the financial obligations of the business, as they become due for payment.
Cash is King
Unless you are a predominantly cash only business, e.g. a restaurant or some type of retailer, you will more than likely sell your products or services and get paid later. You extend a period of credit to your customer which can vary from a few weeks to a few months. The business needs to survive without the cash from the sale for this period. It’s almost like taking a deep breath and ducking underwater.
One of the earliest questions I ask a business owner is What’s your credit control procedure?. Too often, I get a perplexed or even blank look (and an inward sigh from myself) from the business owner! They are often too busy to chase outstanding payments due to them.
Lack of cash is one of the biggest reasons small (and large) businesses fail.
There are other reasons of course, but a business owner who is tied up on a day-to-day basis firefighting all the little things going on in their business often takes their eye off the ball and considers a sale to be money in the bank. In many ways, nothing could be further from the truth.
The timing of cash coming in doesn’t always neatly match with the timing of payments out. If a business cannot meet its financial obligations as they become due for payment, then the business suffers from a lack of cash flow and could potentially become insolvent.
In the simplified diagram above, assuming you’re doing okay with sales, cash flow often suffers earlier than most would think. The weak point is at Customer pays you. Any business wants to maximise the amount of cash it has in order to meet its own outgoings and invest for the future. The trick is to make sure that your customer pays on time and the money ends up in your bank account and doesn’t stay in theirs.
I advised a client recently who had made (for them) record-breaking sales over the last 12 months. On paper they had made a six-figure net profit. However, they were using a large overdraft on the business bank account to ensure they paid everything they owed on time. A simple review of the debtors (the customers who owed the business money) showed that the amount due in from them was roughly equal to the net profit plus the overdraft.
This simple comparison confirmed that the six-figure profit wasn’t money in the bank – the cash was sitting in their customers’ bank accounts and not theirs as they hadn’t paid him in good time!
Tips for good cash flow
This isn’t rocket science and most successful businesses apply these tips on a monthly, weekly or even daily basis:
- Make sure your financial records are up to date. This means that for every sales invoice you issue you know what each customer owes you. This is usually pretty easy if you use an up-to-date financial software package as you can generate invoices from the software which will automatically keep a record;
- Set a due date for payment on every single sales invoice, not just a global payment date (e.g. month-end). This means you can generate a report from your financial software to show what is owed to you each day;
- Issue sales invoices to customers when the sale is made and not at the end of each month. You make a sale on the 2nd day of the month but don’t issue the invoice until the 31st. Your customer then gets an extra 29 days of credit on top of your normal credit period meaning you have to hold your breath for longer;
- Most customers will pay at the end of the month. Contact the customer 7 – 10 days either before an invoice is due or before the month end and simply ask them Have you got our invoice number XXXX and is it in your payment run to be paid by [date]?. Depending on their answer, you will then know whether your cash flow is on track and can plan accordingly;
- If a customer regularly pays late, or sometimes not at all on small invoices, this pattern will emerge quite quickly if your records are up-to-date and you track things regularly. You can then decide whether to take the risk of making further sales to them when they may not pay you;
- If a customer is late in paying, chase them! Don’t be afraid of being firm with them…put them on stop if necessary until they have paid. If you lose them as a customer, that’s actually fine! Making sales to them that they never pay for is the same result, but it costs you money!
What happens when cash flow suffers?
If you regularly take the ‘pulse’ of the business by monitoring cash flow you will have a good idea of the health of your business.
However, when the cash flow falters or stops, the yawning pit at 3am in the morning beckonsâ€¦ Seriously, a lack of cash flow causes sleepless nights for many business owners. They worry more and more about paying what is owed than keeping the business running. The knock-on effect of this is that they are no longer in control of how the business operates and it could ultimately fail.
Before that happens, unless there is a catastrophe, there will be quite a few signs that the business is heading towards ill-health which will build up over time:
- customers may start to stretch their credit period by paying late;
- customers may also request an increase in their credit limit, but then still take longer to pay you;
- the bank account balance will show a downward trend;
- the business may start to regularly use its overdraft facility;
- Introducing personal funds to cover temporary cash flow issues when there isn’t enough money around to pay everything;
- payments/cheques made from the business bank account are bounced;
- initial polite letters for payment from suppliers will start to get firmer and nastier when you still fail pay them and may eventually lead to legal action.
What else can you do to prevent cash flow problems?
Simple! Just apply the tips above on a regular basis.
Alternatively, book a free health check with me for your business. Between us, we will identify any actual or potential signs of ill-health (not just relating to cash flow) and I can work with you to provide support and advice with a difference. More information can be found here, or contact me directly on 07976 260065. My profile as an introduction is here.
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