Cash flow management is key to running a successful business.
Cash (including money in the bank) underpins all businesses. On paper you can make a profit, but if you don’t have cash to pay your suppliers, then you are trading insolvent. A director who allows a registered company to continue to trade whilst insolvent may risk criminal prosecution*, whilst sole traders risk losing other assets that they own.
Cash flow is a sign of a business’s health.
- A positive cash flow is good and if you have a positive cash flow over several months or quarters, it may indicate that you have money available to invest in growing your business.
- A negative cash flow one month is not necessarily going to ruin your business – it will depend on what cash you have in the bank and what assets you have which, if necessary, you can easily convert to cash. If you have several months of negative cash flow, then this may indicate that you will have issues paying your suppliers and other liabilities such as bank loans if you don’t take action.
* New insolvency provisions came into force on 26 June 2020. The Act provides temporary relief until 30 September 2020 from being subject to a winding up petition and wrongful trading provisions where a business can demonstrate its difficulties arose from trading conditions arising from the COVID-19 pandemic.
To take control of your cash flow, follow these five top tips:
1. Remember cash is not profit
Don’t make the mistake of thinking that cash in the bank is profit. Cash in the bank is often required to pay suppliers and to settle other liabilities such as loans.
Similarly, profit is not always readily available in cash, particularly if you have outstanding debtors (customers who owe you money) or you have purchased assets out of profit. When you purchase assets, the cost does not affect your profit and loss until you start to depreciate the value of that asset. When assets are depreciated, then the depreciation is treated as an expense and that will reduce your profit and show as an expense in your profit and loss report.
2. Use cash flow forecasting to understand what cash you need to run and grow your business
A cash flow forecast captures what cash you expect to come into the business and what cash you need to spend in order to keep your business running and to grow your business over a period of time. It will be linked to your sales and expenditure (Profit and Loss) forecasts, but unlike a Profit and Loss report, t will based on when you will receive income rather than when the sale might be closed, and when expenses and other liabilities need to be paid rather than when they were incurred.
Learn how to prepare a cash flow forecast so that you can anticipate potential problems and take action sooner rather than later.
Cash flow forecasting is used for both short-term planning and long-term business planning. Your forecast should take into account one-off events, seasonality and ideally different scenarios. This will help with strategic business planning.
3. Optimise your cash flow to help grow your business
Cash is king when it comes to running a business – you need it to remain solvent and you need it to take advantage of opportunities which will give you a competitive edge e.g. investing in the development of new products or services, or breaking into a new market. Business owners and managers often seek external funding to do this and overlook how they can release working capital from their own balance sheet.
1. Know what working capital you need to run your business
Working capital is the term used to describe the money you need to keep your business running on a day-to-day basis. Some businesses need a higher working capital than others because they need premises, high value equipment or stock.
In addition, you need to keep a level of cash in the bank ready to pay your suppliers (also referred to as your creditors because they have provided you with credit, and sometimes referred to as your accounts payable as they are the accounts you need to pay).
You need to make sure you’ve got enough working capital to run your business. If you don’t have enough, then you need to release working capital or seek external funding. If you have more working capital than you need, then you can review how best to utilise it to further grow your business or provide a return to investors/shareholders/owners etc.
To do this well, it is essential that your cash flow forecast is as accurate as possible and therefore that you update it regularly to take into account changing variables and assumptions.
2. Monitor stock and only buy when you need to
This will avoid stock pile ups and dead stock that goes out of date or out of fashion. Holding too much stock means that capital is tied up in stock and is not available to pay off suppliers and other liabilities, or available to invest in new activities to grow the business. Managing stock levels is closely tied to forecasting sales and when stock doesn’t sell within expected timeframes, then strategies to sell it off should be considered so that your capital can be put to more effective use. Monitoring inventory turnover and, for example, the number of days you hold stock before it is sold are useful metrics to monitor how effective you are at using your capital.
3. Avoid overtrading
This happens when you make sales that require you to spend money upfront e.g. on materials and wages and the proceeds from that trade will not be collected until after you need to pay, for example, your suppliers and employees. If you end without enough money to pay off your debts, then you have over traded.
To avoid overtrading, pay attention to your cash flow forecast and think twice about whether some lines of revenue are worthwhile. If your profit margin on such trade is low and could lead to over trading, then it’s not worthwhile taking the risk. On the other hand, if the profit margin is likely to be high, then you may be able to put in place funding e.g. through invoice financing to enable you to take on profitable opportunities without risking a cash flow crisis.
4. Shorten your cash flow cycle
The key to shortening your cash flow cycle, is to invoice promptly and make it easy for your clients to pay you. It may also be possible for you to reduce the number of days that you provide your customers with credit.
To make it easy for your customers to pay you promptly, use payment methods that are easy for your customers to use e.g. contactless payment by credit or debit card if in store, payment by card or PayPal if online, and even by cheque if that is what is easy for your client. Of course, if only one client wants to pay by cheque, then it may not be worthwhile offering that particular option.
Another technique to shorten your cash flow cycle is to consider offering discounts for early payment and charging interest for late payments. This will incentivise your customers to pay sooner rather than later.
5. Implement effective credit control
Follow our guide on avoiding late payments and collecting bad debt to as a last resort to shortening your cash cycle.
4. Have a backup plan for cash flow management
Contingency planning will help you to make business decisions when events don’t go according to plan and to recover more quickly when something unexpected happens that you have no control over e.g. another pandemic, a key member of staff is ill, your key supplier goes bust or you’re the victim of fraud.
Contingency planning may include:
- making sure that you are not too reliant on any one customer or supplier;
- making financial arrangements with banks or other lenders that you can turn on when required;
- building up a rainy day reserve; or
- paying for peace of mind by taking out appropriate insurance cover e.g. business continuity insurance, cybercrime insurance and keyperson insurance.
The other advantage of contingency planning is that it reduces panic and worry, again helping you to recover more quickly and get your business back on track.
5. Make cash flow forecasting part of your business planning and decision making process
Effective cash flow management is about forecasting your cash flow needs as accurately as possible and making timely business decisions. To do this well, you need to have a good understanding of your business which means linking your cash flow forecasts (for different scenarios) to your business plan forecasts, and using data from your key financial reports to validate forecast assumptions.
If you need help with cash flow forecasting and scenario planning, then do get in touch with our accountancy team and business advisers. You may also be interested in reading and downloading our cash flow management checklist.