Cash Flow Management - An introduction to the basics
October 2005
Cash flow is the basic life blood of a business. Without a firm handle on your existing and future cash requirements your business will not have the gas to grow or even worse, flounder and go out of business.
Cash flow management is a process that involves collecting payments, controlling disbursements, covering shortfalls, forecasting cash needs, investing idle funds, and compensating the banks that support these actions. There are some basic rules and modeling that any business, large or small, can follow to keep tabs on its cash requirements.
First and foremost be sure to periodically check you cash balances and forecasts to ensure that you have adequate reserves to support your business operations and investments. For some businesses this may be a daily activity. For others weekly or monthly may be often enough.
Keep a monthly rolling forecast of sales for at least the next twelve months. Once you books are closed, add the next month to the end of your forecast and drop of the one just completed. Using this simple method you will always have a 12 month window for your future cash needs.
It is important to analyze and understand your collections cycle. How long does it normally take to convert an invoice into cash? You should estimate average collections for 15, 30, 45, 60, and 90 days from invoicing. Apply those averages to existing accounts receivable and projected sales to forecast your cash intake position over the next three months. Don't forget to adjust your model for any expected bad debts.
With your sales forecast as a starting point, estimate the timing of your direct costs. These may include materials costs, labor and other variable costs. As with the timing of accounts receivable, you should lag the cash-out payments to your vendors based upon their terms. Don't forget to adjust for any quick pay discounts you may want to take advantage of.
Finally, prepare a schedule of payments for such recurring expenses as payroll, rent, and utilities. Forecast cash availability by adding your projected collection to your opening cash position and subtracting all variable production and recurring expenses. This will give you your operating cash forecasts.
After determining your cash needs to operate the business you should adjust your model for non-operating cash items. Non-operating cash sources are equity investments and loan proceeds. Non-operating cash uses to adjust for are loan pay-offs, dividends, owner draws, and capital expenditures.
A general rule of thumb is if your ratio of cash available (balances plus receipts) to cash required is less than 120%, you may have to borrow to funds to fulfill the businesses cash needs. Ideally you may be able to defer payments or improve collections efforts to bring in cash more as needed. Alternatively, tapping outside credit lines to help fund short-term working capital fluctuations is also an option.
Your cash flow model is the most important financial statement that you have. Done correctly, it provides your business with the necessary checks, balances, and financial controls to guide performance; wins bankers' hearts; and keeps spending and investment impulses in check. Developing a cash model is simple, and when created with solid sales and expense forecasts in mind, you can feel comfortable that you have a solid pulse on the life blood of your business.
