Managing Cash Flow
By Kerry King | Prudent Partners Consulting Pty Ltd

Hello everyone, in my years of experience working with and helping owners and managers of small business the thing that shows up most is the misunderstanding of the relationship between profitability and cash flow.

It is one thing to have a profitable business but it is quite another to be able to generate cash sufficient to meet the needs of the business.

Now I'm not saying that profitability isn’t important because it is. In fact this should be your first goal when starting out in business, to become profitable as quickly as you can.

However, from thereon after there is a second goal that must follow and that is to generate positive (more coming in than what’s going out) cash flow so that you can meet the needs for the business e.g. paying your rent on time (usually in advance) or paying insurance premiums when they fall due (usually 12 months in advance).

You see, cash flow is like the lifeblood of your business; your business maybe fit and healthy (read profitable) but if blood flow is restricted (read cash flow) your financial health will soon be in jeopardy.

To help illustrate how important positive cash flow is for your business, I have included an extract from our Financial Management Budget Workbook© which hopefully will give you a broad outline of how cash flow works in a business.

Understanding What Impacts on Cash Flow
The purpose of the cash flow budget is to predict on paper what money will be on hand to meet the financial obligations of your business during the budget period. The profit budget will let you know whether the business is viable and how much profit you can expect to earn over the budget period, but it does not provide your cash position.

This is because the profit budget contains noncash items (eg. depreciation, unpaid purchases and uncollected sales) and excludes capital items (eg. purchase of new equipment, repayment of loans etc.) and both of these have a direct impact on your bank account.

What To Look For
You must therefore relate your profit budget to your cash position during the budget period. Your cash position must be continually assessed to ensure that there will be sufficient cash to meet the financial obligations of your business.

The basis for preparing the cash flow budget is the profit budget. This is done by identifying and detailing the following items:

• Cash flow effect of your sales (based on your credit terms and collection history)

• Cash flow effect of your purchases (based on your credit terms and payment history)

• Bank finance repayment program (including finance leases) to be met during the budget period

• Proposed asset purchase or disposal during the budget period and what the cash flow effect will be (i.e. will you paying/receiving cash or will bank finance be used).

• Proposed cash drawings from or funds introduced (invested) into the business during the budget period This information is then used to adjust the profit budget so that it reflects the cash flow impact of these items.

Annual Expenses
There are some overhead items that particular attention must be paid to. These are expenses that cover a full budget period but the cash outlay for the total cost is made with a single payment and usually in advance. These expenses would typically include:

• Insurance premiums (including employee Workcover premium)

• Motor Vehicle registration fee

• Government filing or registration fees (e.g. ASIC Annual Return fees for companies or business name registration fees)

Understanding the Cash Flow Cycle
The constant circulation of money in your business is known as the cash flow cycle. You should therefore have an understanding of the cash flow cycle for your business i.e. when, where from, and for what purpose your business will receive or pay out cash.

The cash flow cycle operates as follows:

• Cash arrives in the business from external sources such as accumulated savings, share issues, loans received, sale of assets and investment income.

• This cash, together with the cash generated by the business, is used to pay suppliers for the purchase of materials and production supplies and to pay operating expenses such as wages, rent and electricity. However part of the cash is required for other purposes such as taxes, dividend payments or drawings, purchase of assets and loan repayments.

• Cash then flows in from sales – this includes both cash received immediately and from credit sales, where customers are invoiced and the cash is collected later.

This simple diagram (Figure A) depicts the cash flow cycle in a typical business. Calculating how much cash your business needs is your first key to successful cash management. A cash flow budget is the tool used for determining your business cash requirements.

The cash flow cycle of your business can be measured in terms of it’s efficiency and this is done by calculating the number of days it takes from when cash is introduced into the business (banked) until it goes through the expenses, purchases and sales period and returns to your bank account. The lower the figure the better!

Your Credit Policy
In order to attract customers most businesses have to offer credit facilities on customer purchases. This is not a finance consideration but is one of marketing. The reason being, if you don’t provide the same payment terms as your competitors then you are unlikely to attract your fair share of the market.

This fact of life means that most business owners and managers must develop a credit policy for their business. As a result this will impact on your cash flow, particularly as a large portion of your expenses (which sales income pays for) must be paid for in cash e.g. wages and rent.

How much impact this will have on your cash flow will depend on how well you manage your credit policy.

Therefore you must review your customer payments history and determine what percentage of your sales is collected within your credit policy terms (usually 30 days after the end of the month in which the sale was made). After this you must establish the percentage that remains outstanding for each monthly period thereafter until it is all collected.

Naturally your business will not have all of these features e.g. trade debtors, but it will have most if not all of the others e.g. tax payments, equipment purchases etc.

An effective tool that many business owners use is the cash flow forecast. This is prepared each month when the financial statements are prepared. The forecast aims to predict exactly how much cash you’ll have in the bank at the end of each week for the period of the forecast – usually 13 weeks.

Doing this means that you won’t have any surprises when it comes to time to make major payments from your business because you will already have predicted when this will occur and how much effect it will have on your bank balance.

Even if there are times when your cash flow is being crunched you’ll have plenty of time to decide how the crunch will be managed. Like I said - no surprises, no stress.

If you would like Prudent Partners to assist you with the preparation of a Cash Flow Budget for the 2008/09 financial year or calculate your cash flow cycle, telephone Kerry on 07-5572 6762 to schedule a consultation.