As children, we all look forward to the day when we can 1. Have a job, so that we can 2. Make some money, from which we can 3. Buy our own car or truck. It seems like such an easy equation to a child’s mind. All you have to do is get a job, then boom! You get a car.
But then you get your first paycheck. Whoa, who is Social Security and why is she taking your money!? And taxes? You don’t even vote yet! And then you have to pay for gas to drive your parents’ car, and then there’s the insurance cost you’re paying them. And then there were those stops at Sonic. And the new shoes you just had to have. And before you know it, that great paycheck you were looking forward to getting has dwindled to pocket change.
Your problem wasn’t your job. And it wasn’t your pay rate. Your problem was your cash flow management.
How many of our businesses are in the same situation? We have customers. They’re paying their invoices. But managing where the money is going—that’s the problem. And if you fail to have enough cash to pay your suppliers, creditors, or employees, you’re out of business!
WHAT IS CASH FLOW?
Cash flow, simply defined, is the movement of money in and out of your business; these movements are called inflow and outflow. Inflows for your business primarily come from the sale of goods or services to your customers. The inflow only occurs when you make a cash sale or collect on receivables, however. Remember, it is the cash that counts! Other examples of cash inflows are borrowed funds, income derived from sales of assets, and investment income from interest.
Outflows for your business are generally the result of paying expenses. Examples of cash outflows include paying employee wages, purchasing inventory or raw materials, purchasing fixed assets, operating costs, paying back loans, and paying taxes.
CASH FLOW VERSUS PROFIT
Though they seem similar, cash flow and profit are two different concepts leading to entirely different results. Profit is broad in aspect and only looks at income and expenses over a certain period, e.g. a single fiscal quarter or a year. Profit is a useful figure for calculating your taxes and reporting to the IRS.
Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more important, it is concerned with the times at which the movement of the money takes place.
In theory, even companies that are profitable can go bankrupt. If your retail business bought a $1,000 item and turned around to sell it for $2,000, then you have made a $1,000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? You may not have the cash to pay the bills despite the profits you earned on the sale. Furthermore, this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and create debt. If this mistake is repeated enough times, you may go bankrupt.
MAXIMIZING YOUR CASH FLOW
But you don’t have to go down that road! With a little know-how (and a CPA on your side to help make a cash flow plan), you can walk in the certainty that your cash flow is healthy, allowing you to be nimble and agile as your business grows.
KNOW THE LAY OF THE LAND
Farmers know this. You don’t start planting a field or building your barn before you first know the lay of the land. Where’s water going to pool when it rains? Where is the sun going to hit the hardest (or not at all)? You’ve to know the potential external hazards before you start.
Your move toward better cash flow management is the same. You need to know the hazards, in this case, they’re the things that affect the timing of your cash inflows and outflows. A thorough analysis of where and when your money is coming from and going out will reveal problem areas that lead to cash flow gaps in your business. Narrowing, or even closing, these gaps is the key to cash flow management.
AREAS OF FOCUS
Here are some things you should keep an eye on as you seek to take control of your cash flow:
- Accounts receivable. Accounts receivable represent sales that have not yet been collected in the form of cash. An accounts receivable is created when you sell something to a customer in return for his or her promise to pay at a later date. The longer it takes for your customers to pay on their accounts, the more negative the effect on your cash flow.
- Credit terms. Credit terms are the time limits you set for your customers’ promise to pay for their purchases. Credit terms affect the timing of your cash inflows. A simple way to improve cash flow is to get customers to pay their bills more quickly.
- Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy – neither too strict nor too generous – is crucial for a healthy cash flow.
- Inventory. Inventory describes the extra merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be used for other cash outflows. Too many business owners buy inventory based on hopes and dreams instead of what they can realistically sell. Keep your inventory as low as possible.
- Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable sometime in the near future – “near” meaning 30 to 90 days. Without payables and trade credit, you’d have to pay for all goods and services at the time you purchase them. For optimum cash flow management, examine your payables schedule.
DO YOU NEED HELP?
We know that you may be struggling to keep your head above water as it is. Your time is stretched, and trying to master cash flow may be one of those things you know you need to do (like changing the oil in your car), but you don’t have the time or expertise to do. But like the oil in your car, if you keep putting it off, you will be sorry. For your oil, you head to the 15-minute oil change shop down the road. For your cash flow, you can give us a call and we can help you diagnose a way forward. It’ll take longer than 15 minutes, but will be worth every second! Let us know if you need help and we’ll be there!