Wednesday, February 22, 2012

Cash Flow: The lifeblood of any business

Cash flow and cash management are intrinsically important to the vitality and viability of a business.  Ignoring this part of management responsibility and planning can crush a business with otherwise very healthy prospects.  There are a number of methods to improve it, and one of the most effective is to make sure that any customers which you offer credit terms to are paying their bills in the agreed upon manner.  A customer who you have sold to on Net 30 terms which takes 60 days to actually pay you is hurting your cash flow - you are effectively becoming a banker and not getting paid for the short term loan.  Receivables financing or factoring can be a great help in these situations not only because this type of funding can improve your cash flow, but most factoring companies also act as a de facto collections department shrinking the average days your invoices are outstanding and unpaid.

Dunn & Bradstreet has a few ideas about how to keep this area of your finanical picture healthy:

Cash management is ultimately about cash flow -- and very few small businesses are awash in cash. Even successful, growing companies are vulnerable to cash flow problems because they tend to add employees and inventory rapidly. This may quickly deplete the company coffers and lead to cash shortages.

Because having cash at the right time is so important, entrepreneurs must pay close attention to cash management.

Here are some tips for saving money and managing cash flow:

Make financial projections. Forecast both expenses and anticipated revenues for at least the coming year. This will help you predict when you're likely to have cash and when you're likely to need it. You should also maintain a cash reserve if possible.

Create contingency plans. Have several budget projections, including best case and worst case scenarios, and think about how you might respond. In the event sales don't take off as expected or there's some unforeseen problem, you'll be better prepared.

Keep a lid on spending. One of the most common problems with new businesses is the owners' tendency to spend freely. There's no need to have lavish offices or expensive furniture. Remember, you're in this for the long haul: You should try to get as much value as possible out of every transaction, whether you're leasing office space or stocking the company kitchen.

Keep inventory low. Don't stock inventory based on your fantasy of what you think you'll be selling in six months. Instead, stock only what you know you can sell in the short term.

Lease, don't buy. Another good way to conserve cash is to lease equipment instead of buying it. Although leasing can be more expensive in the long run, it helps you avoid laying out a lot of capital all at once for things like office furniture, computers and copiers.

Delay hiring employees. Try to improve the productivity of current employees (without burning them out), use independent contractors and consider outsourcing certain nonessential functions. Employees are expensive, so you should put off adding permanent hires as long as you can -- or at least until you're earning the revenue to support them.

Go without a salary. Some experts recommend stockpiling a year's worth of living expenses before going into business. Admittedly, this may be difficult, but you should at least avoid paying yourself an excessive salary. Too many entrepreneurs waste cash by paying themselves big salaries without the revenues to justify them.

Speed up customer payments. Try to get customers to pay on time or early, if possible. Offer incentives like discounts or late fees, and adopt more effective collection techniques for deadbeat customers.

Don't be wasteful. Recycle and reuse what you can -- for example, boxes, computer discs and file folders. The savings may not be large on any given item, but they can add up over time.

Using Income Statement Ratio Analysis to Stay on Track

Savvy entrepreneurs track how their businesses are progressing by doing ratio analysis each month. Examining several key ratios on your income statement will reveal whether your business is in good shape or headed for a cash crunch.

Using your income statement data to figure your accounts receivable, accounts payable, and inventory ratios will tell you how fast you are having to pay suppliers, getting paid by customers, and moving products off the shelves. (If you sell services instead of goods, the inventory calculation won't apply.)

Accounts Receivable Turnover

To figure accounts receivable turnover, look at a year's worth of past monthly statements and add up the daily amount of accounts receivables (unpaid customer bills). Divide by 365 to get your average daily receivables. Next add up the total amount of sales you made that year on credit to get your total annual credit sales. Now you can figure your accounts receivable turnover rate:

Accounts receivable turnover = average daily receivables x 365 / total annual credit sales

For example, if your daily average is $25,000 and the total you sold on credit for the year was $200,000, you're taking 45.6 days to collect on an average bill. If your terms are net 30 days, slow payers are choking off your cash flow.

Accounts Payable Turnover

Next compare this figure with your accounts payable turnover rate: how quickly you pay suppliers. Ideally this figure is larger than the accounts receivable turnover rate.

To figure your payables turnover ratio, first add up your payables for each day of a year and divide by 365 to get your average daily payables. Then add up how much you bought on credit for the year to get your total credit purchases. Now you're ready to do the accounts payable turnover ratio formula:

Accounts payable turnover = average daily payables x 365 / total annual credit purchases

If your average payables are $8,000 and you purchase $98,000 in goods on credit in a year, your ratio is 29.8 days. This means you pay suppliers in just less than 30 days. Since customers aren't paying you for more than 45 days, you likely have a cash-flow problem because you need to cover the gap between when you pay for the item and when you collect the customer's payment.

Inventory Turns

The next key ratio is inventory turns. How long do products sit on your shelves before they're sold? Here's the formula:

Inventory turns = average daily inventory x 365 / total annual cost of goods sold

If you have $45,000 of average daily inventory on hand and your total annual cost of goods is $120,000, it's taking an average of 136.8 days for an item to be sold.

Now we have the story of your business: You buy an item, and on day 29 you pay for it. Then on day 137, a customer buys it on credit, taking 45 more days to pay for it. That means from the day you buy an item, it takes 182 days for you to get paid, leaving a 153-day gap during which your business has to finance that purchase. That's an important fact to know when you're figuring whether you are really selling goods at a profit because you need to include the finance cost of any borrowing needed to stay afloat.

Tracking these three ratios each month will show whether your business metrics are improving or deteriorating. Other ratios you can calculate to track important trends in your business include gross margin and net profit.

To make the most of ratio analysis, obtain industry average ratios or ideal targets to compare with your own ratios. Your industry association may have some helpful data, or tap business networking groups to find chatty colleagues with similar businesses.



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