The Facts About Understanding Cash Flow

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To be competitive, small business owners must prepare for all future events and market changes. The most important aspect of preparation is effective cash flow planning. Failure to properly plan cash flow is one of the leading causes for small business failure.

Experience has shown that many small business owners lack an understanding of basic accounting principles. Knowing the basics will help you better manage your cash flow. There are also self instruction guides from which you can obtain a more thorough knowledge of accounting.

THE BASICS

A business's monetary supply can exist either as cash on hand, or in a business checking account available to meet expenses. A sufficient cash flow covers your business by meeting obligations (i.e. paying bills), serving as a cushion in case of emergencies, and providing investment capital.

THE OPERATING CYCLE

The operating cycle is the system through which cash flows, from the purchase of inventory through the collection of accounts receivable. It measures the flow of assets into cash is a "business stopwatch."
For example, your operating cycle may begin with both cash and inventory on hand.

Typically, additional inventory is purchased on account to guarantee that you will not deplete your stock as sales are made. Your sales will consist of cash sales and accounts receivable - credit sales. Accounts receivables are usually paid 30 days after the original purchase date. This applies to both the inventory you purchase and the products you sell. When you make payment for inventory, both cash and accounts payable are reduced. Thirty days after the sale of your inventory, receivables are usually collected, which increases your cash. Now your cash has completed its flow through the operating cycle and is ready to begin again.

CURRENT ASSETS

Cash and other balance-sheet items which convert into cash within 12 months are referred to as current assets. Typical current assets are:

Cash
Marketable securities
Receivables
Prepaid expenses

A PLAN IS NECESSARY

Cash flow analysis should show whether your daily operations generate enough cash to meet your obligations, and how major inflows of cash from sales. As a result, you can tell if inflows and outflows from your operation combine to result in a positive cash flow or in a net drain. Any significant changes over time will also appear. Understanding this will lead to better control of your cash flows and will allow adequate time to plan and prepare for the growth of your business.

It is best to have enough cash on hand each month to pay the cash obligations of the following month. A monthly cash flow projection helps to identify and eliminate deficiencies or surpluses in cash and to compare actual figures to past months. When cash flow deficiencies are found, business financial plans must be altered to provide more cash. When excess cash is revealed, it might indicate excessive borrowing or idle money that could be invested. The objective is to develop a plan that will provide a well-balanced cash flow.

PLANNING A POSITIVE CASH FLOW

To achieve a positive cash flow, you must have a sound plan. Your business can increase cash reserves by:

COLLECTING RECEIVABLES: Actively manage accounts receivable and quickly collect overdue accounts. Revenues are lost when a firm's collection policies are not aggressive. The longer your customer's balance remains unpaid, the less likely it is that you will receive full payment.
TIGHTING CREDIT REQUIREMENTS: As credit and terms become more stringent, more customers must pay cash for their purchases, thereby increasing the cash on hand and reducing the bad debt expense. While tightening credit is helpful in the short run, it may not be advantageous in the long run. Looser credit allow more customers the opportunity to purchase your products or services. Any consequent increase in sales should be measured against a possible increase in bad debt expenses.
MANIPULATING PRICE OF PRODUCTS: Many small businesses fail to make a profit because they erroneously price their products or services. Pricing is the critical element in achieving a profit and maintaining positive cash flow. Before setting your prices, you must understand your product's market, distribution costs and competition. Remember, the marketplace responds rapidly to technological advances and international competition. Monitor all factors that affect pricing on a regular basis and adjust as necessary.
TAKING OUT SHORT TERM LOANS: Loans from various financial institutions are often necessary for covering short term cash flow problems. Revolving credit lines and equity loans are common types of credit used in this situation.
INCREASING YOUR SALES: Increase sales would appear to increase cash flow. However, large portions of your sales will be made on credit. So when sales increase, your accounts receivable increases, not your cash. Collection of receivables is usually 30 days after the purchase date, and sales expenses are most often incurred before receivables are collected. When sales rise, inventory is depleted and must be replaced. Because receivables have not yet been collected, a substantial increase in sales can quickly deplete a firm's cash reserves. A computer will facilitate tracking this critical data, as well as speed the time required to consider "what if" scenarios.

OTHER HELP TIPS

CASH RESERVES

You should always keep enough cash on hand to cover expenses and as an added cushion for security. However, it is unwise to keep more money on hand that is necessary. Excess cash should be invested in an accessible, interest-bearing, low risk account, such as a savings account, short term certificate of deposit or treasury bill. Keeping excess cash on hand limits both your growth and the return on your investment.

PROJECTIONS

Good accounting record and projections are important tools for a small business. Qualified accountants are necessary to help keep your record accurate and current.. However, you can reduce your accounting expenses by producing your own summary statistics and projections.

USING A PERSONAL COMPUTER

With a personal computer, your business can have the added advantage of quick cash flow projections as well as many other useful financial planning tolls. A good financial management package and computer will enable you to review projected inflows and outflows of cash from month to month or year to year. By analyzing these projections, you can see the fluctuations in cash flow and create management policies to avoid potential shortfalls. There are numerous computer programs for making projections and keeping records. Programs range from basic bookkeeping and "what if" analysis to inventory control or market demand projections.