Cash flow, the difference between the available cash at the beginning of an accounting period and that at the end of the period, is a fundamental element of any business. Managers will spend a good deal of time focussing on cash flow forecasts and ensuring that there is sufficient cash available to meet requirements as they fall through.

This will involve looking at the cash that comes in from sales, loan proceeds, investments and the sale of assets. They will then compare this to the cash that is required to meet direct expenses, operating expenses, principal debt service, and the purchase of assets.

If the business has a positive cash flow this means that a company’s liquid assets are increasing, enabling it to meet debts, return money to shareholders, pay expenses, reinvest in its business for future growth, and provide a buffer against any future financial challenges that may arise.

Negative cash flow, on the other hand, will indicate that the business’s liquid assets are decreasing. Their trade receivable and other items for which payment is due have not been received.

Cash flow forecasts are a good way to assess the quality of the company’s income. It involves assessing how liquid the business is. Liquidity essentially means looking at the ability of the business to pay its debts as they fall due which can indicate whether the company is in a good positioned to remain solvent.

Increases and decreases in our working capital items can have a direct and immediate effect on our cash in the business which can give us access to finance that may be used in other areas of the business to increase profitability. By focussing on tighter credit control, reducing our inventory levels and delaying payments to trade payables we may be able to create additional internal sources of finance.

How to Effectively Manage Cash Flow

1) Tighter Credit Control

If we apply tighter control over our credit customers this will help reduce the amount of funds tied up in this form of asset. This means that we can then use this cash for other purposes in our business. In this way money tied up in our credit customers represents a cost to us, an opportunity cost, because this money could be used for other profit generating activities.

How do we go about tightening our credit control?

If our credit terms have not been strictly administered in the past, then the customer may have become relaxed in terms of paying on time. It is, therefore, essential that we ensure that our business has an efficient and effective credit control system in place. We may need to address questions such as how long is it taking to get paid?

Do you have the right level of contact with your customers? Are you identifying and settling disputes fast enough?

Addressing the above will help with getting payment in faster.

Establish terms and conditions from the onset of the business relationship. In this way the customer is clearly aware of the credit terms such as payment due date, any settlement discounts for early payments should you decide to incentivise early payment.

It is important to weigh up the cost and benefits of offering early payment discounts to customers as it can be costly to the business. Establish the interest that will be applied if the customer exceeds the payment due date etc.

It’s also a good idea to do a credit check on new customers before entering into a contract with them as it will reduce the likelihood of bad debts. Bad debts are amounts that have to be written off because the customer cannot pay.

It is also good practice that we promptly follow up with an invoice once the sale has been made. This means that when we make a sale to our customer that we issue the invoice shortly after. The customer is likely to interpret the 30-day credit term for example, as meaning 30 days from when they receive the invoice. Therefore, delays in issuing the invoice on our end is likely to increase the time taken by customers to pay us.

However, it is very important that we weigh up the costs and benefits of tighter credit control. While getting our customers to pay their accounts quicker will improve our cash flow we must ensure that it does not come at the expense of customer goodwill. It is extremely important that we consider the impact of tighter credit control on customer goodwill and their needs as it could lead to lost sales.

For example, if we have a customer that has been with us for years and we regard them as being good to settle their account, despite being a slow payer, we might need to consider the effects that tighter credit control will have on them.

If we suddenly start putting pressure on them to pay faster it may tempt them to go elsewhere.

Another factor to consider is the credit policies of our competitors. It is important that we consider credit policies adopted by rival businesses in our industry so that we can remain competitive and attract and maintain customers.

If competitors are offering 60 days credit and we are offering 45 days we may need to increase our credit period in order to incentivise customers to do business with us or not leave to go to our competitor. While it may not be necessary to have our credit period exactly the same, we should try to establish a period that suits our cash flow needs but still makes us attractive.

Tighter credit control can be made trickier where we deal or have the potential to deal with a large customer who demands a set credit period. For example, if we have a credit period of 40 days but this particular customer wants a credit period of 120 days. It is essential to weight up the costs and benefits of doing business with this larger customer. Can we get them to reduce it? Can we afford to deal them?

How to Effectively Manage Cash Flow

2) Reducing Inventory Level

Decreasing the amount of stock that we carry in our business can be an attractive way to raise finance that can then be used for other activities. Holding large quantities of inventory represents an opportunity cost for our business.

This money that is tied up in our stock could be used for other profit generating activities. By reducing inventory we can use that money for those purposes.

A reduction in inventory may also lead to lower storage and other associated costs which will further improve cash flow.

However, it is important that we do not decrease the level too low as we need to ensure that we can meet customer sales when they arise. Otherwise, this could result in loss of sales and customer goodwill. Therefore, it is necessary to consider likely future sales so that we can ensure that we have sufficient stock available to meet those demands.

We must also consider the impact of a large unexpected order coming in. If we are unable to meet it, it will mean a lost sale and may also impact on customer goodwill. Many businesses today have implemented IT systems to manage inventory levels, however, this can require a large investment and often not feasible for smaller businesses, especially businesses starting out.

To determine if it is possible to reduce our inventory level we need to consider the nature and condition of the stock. If we have excessive stock because it is absolute or due to a poor buying decision, then this stock may not liquidate easily.

3) Delaying Payments To Trade Payables

This involves taking longer than the agreed period of time to pay our suppliers. When supplier gives us a period of credit, they are effectively giving us an interest-free loan. By extending this period, we are holding the funds in our business which can then be used for other activities to generate profit.

While credit was once available to the majority of businesses, the financial crisis has made it more difficult for new businesses to get credit from suppliers initially. More often than not, newly established business will need to establish a relationship with the supplier first, before receiving a credit period or will be given a short initial credit period.

While extending the time taken to pay our trade payables does represent a cheap form of finance, it is not always the case. It can result in significant costs as the supplier may charge interest on overdue accounts, we may lose discounts, loss of goodwill and the supplier may retract our credit facilities.

In addition to this, our business may obtain a bad reputation which could lead to other suppliers being reluctant to provide us with credit facilities. As a result, due care should always be exercised when considering raising cash in this manner.

A better approach would be to establish an agreement with the supplier. This is often referred to as “leaning on the trade” and can be very beneficial in times of crisis. It is usually possible where we have established a good relationship with our supplier and they agree to extend our period of credit to help ease our cash flow.

It is a simple, flexible and convenient way we can obtain additional finance.

Further notes:

It is also wise to make a comparison of your trade payable (suppliers) and trade receivable (customers) days.

Trade receivable days is calculated by dividing your credit sales by your average trade receivables and multiplying by 365. The average trade receivables figure can be calculated by adding the value of trade receivable at the beginning of the desired period to their value at the end of the period and dividing the sum by two.

The ratio can be used to find quarterly or monthly trade receivable turnover also.

Trade payable days is calculated by dividing your credit purchases by your average trade payables and multiplying by 365. The average trade payables figure can be calculated by adding the value of trade payables at the beginning of the desired period to their value at the end of the period and dividing the sum by two.

The ratio can be used to find quarterly or monthly trade receivable turnover also.

When we obtain these figures we can then make a comparison. So if our trade receivables (customers) are taken 50 days to settle their accounts but our trade payables (suppliers) require payment in 30 days, this means we need to have an appropriate level of working capital in place to keep us afloat for those 20 days.

It is, therefore, necessary to try establish the optimal level of working capital required. We need to ensure that we have a sufficient level so that it will not negatively impact on our businesses operations and that we maintain an adequate level of liquidity. While it is also important that we try to minimize the cost associated with holding working capital.

In this case, we would evaluate our terms with both our customers and suppliers and try to establish more suitable terms. For instance, we may try to negotiate a longer period with our suppliers or see what other suppliers are offering and will their product/services meet our needs.

With our customers, we could try to reduce the credit period or try to offer an incentive to entice them to pay earlier. But it is important to weigh up the cost of offering discounts etc versus the benefit. Likewise, we might discover that we are missing out on a discount by paying our suppliers later rather than earlier.

This discount might be more valuable to use than the goal of shortening the receivables-payables gap.

To improve cash flow we need to make it a priority in our business. Therefore, it is essential to make our employees understand the importance of these systems we have put in place to help ensure efficient operations. Establishing goals and targets can be a good way to motivate everyone to perform and ensure goal congruence.


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