Managing Your Cash Flow

Why we run out of cash

We know our business needs cash flow. We need cash to:

• Finance growth – growth eats resources including cash
• Take opportunities
• Prevent resources being sucked up in dealing with creditors and financiers
• Pay ourselves properly – if we are not paying ourselves a market salary, we are personally funding the business

But ultimately, we need cash to stop our business from failing. Otherwise successful and profitable businesses fail when they can’t pay their bills.

Cash is the ultimate “lagging indicator” of business success, meaning it is the final result of all our business efforts.

1. Resources are invested into providing services (or products)
2. Hopefully, these services create a profit
3. Finally, the profit is collected in cash

Resources, including cash, are invested in the business process before it generates more cash creating a gap between cash invested and cash generated. This gap is magnified when a business is growing as more resources are needed to fund the increased business before the resulting increased cash is generated.

Where do we get the cash funding from?

Businesses are funded from either internal operations or external sources. When we cannot generate enough cash quickly enough from our business operations, we need to use external funding. But external funding, whether debt (borrowing money) or equity (selling part of the business), comes at a cost.

Debt finance

The costs of raising debt finance include:

• Our time and energy collating information for potential lenders
• The financial cost of the debt, including interest and loan fees

The financial cost puts a further burden on our business by using cash to service it. We must generate more cash internally in future to cover the cost.

Equity finance

The costs of raising equity finance include:

• Our time and energy finding an investor and arranging the deal
• A share of our future profits – an equity investor buys an entitlement to all future cash flows of the business
• Accountability to someone else
• Friends and family investors may be less financially demanding but more emotionally demanding, especially when things don’t work out
• a pure business investor may demand less emotional investment, but invests for a return and will want some say in how the business generates that return

Cash funding with the lowest cost, in all respects, is internally generated cash. Our first job is to ensure we finance as much of our business needs as possible from our operations. How do we do that when it takes time to get to the cash collection?

Our cash conversion cycle

By understanding our business operations’ process of turning cash investment into cash generation, we can improve the process, increasing our internal funding and decreasing our need for external funding.

How does it work?

Let’s look at the cash conversion cycle which calculates the days taken to turn cash investment into cash generated:

CCC = WIP days + Debtor days – Creditor days

A typical professional services or consulting business has this process:

WIP days

When a client job is started, direct labour costs (or our time if doing it ourselves) and job disbursement costs are invested to create Work in Progress (WIP). WIP days are the number of days taken from incurring WIP expenses to turning the WIP into debtors.

Debtors days

Once the job is delivered it can be invoiced, converting the WIP into debtors. Debtor days are the number of days taken from invoicing until being paid by the debtor.

Creditor days

Our costs that go into WIP are generally not paid immediately. The time taken to pay those costs decreases the time our cash is tied up. Creditor days are the number of days from incurring costs to paying for them.

Ways to improve our CCC

The shorter our cash conversion cycle, the less cash we need to tie up in the process and the less we need to find finance for. Options for improving our CCC include:

WIP days improvement

Decrease the number of days to complete a job:

• Collect all required information before starting the job, maybe using checklists and questionnaires
• Complete one job before starting another. The less jobs open at once, the more efficient the turnaround
• Staff training
  Systems and technology to do the job efficiently
• Measure WIP days and focus on reducing them

Debtor days improvement

Decrease the number of days to collect the cash:

• Invoice all or some of the job up front if possible
• Progress invoices for long projects
• Invoice promptly after job completion
• Agree fees in advance to avoid disputes holding up payment
• Automate prompt outstanding invoice reminders
• Improve credit control
• Measure debtor days and focus on reducing them

Creditor days improvement

Contrary to WIP and debtors, stretching out creditors improves the CCC. We are effectively using our creditors, usually cost free, to help finance our operations. Remember, the aim is to increase creditor days without affecting our business relations. Don’t screw your suppliers!:

• Negotiate good trade terms
• Monitor creditors and pay on time but not early
• Measure creditor days and focus on increasing them without affecting business

Taking control

While external funding relies on outsiders, internal cash generation is within the business owner’s control and should be our primary funding source. Ultimately, internally generated cash pays all financial obligations including servicing and repaying external funding.

Our primary planning tool for taking control of our cash flows is our financial plan. Our financial plan, including a cash flow forecast, predicts how much cash we will need and when we will need it. It is also our tool for improving our cash conversion cycle and predicting the financial impact of those improvements. Use your accountant for help preparing a financial plan for your specific business model.

Having a cash shortfall is only a problem when we don’t have time to fix it.

Contact us with your business questions