If you’ve been in business any length of time you will have heard the phrase “Cash is King.” You may even have a poster on your office wall, in your factory or distribution centre proclaiming that bold statement. So, what is Cash Flow, why is it important and what steps can you take to optimise it in your business? We spoke to the team at SME Capital to source their insights.
What is business Cash Flow?
Cash Flow is the increase or decrease in the amount of money a business produces, via its core activities, and retains in a given time period, usually a month, quarter or year.
Consider two very different types of business. The first is a fast-food business, BurgersnBuns Ltd, where all products are made to order. It pays all costs (premises, staff and raw materials) at the end of each month and its customers pay at the point of sale. As the month progresses BurgersnBuns receives increasing cash from customers. If everything goes to plan, BurgersnBuns will have received more cash from its well-fed customers than the amount owed to its staff and suppliers. BurgersnBuns may be described as a positive cash flow business.
The second business is a kitchen equipment manufacturer, FryinHigh Ltd. It receives an order for its new BunMaker from BurgersnBuns which will take one month to manufacture. It allows BurgersnBuns to pay for the BunMaker 60 days after delivery. FryinHigh also pays all its costs for premises, staff and raw materials at the end of each month. It despatches the BunMaker at the end of the month, as planned, and receives payment from BurgersnBuns at the end of the third month, as agreed. The owner of FryinHigh will need to find a way to pay its operating costs for 2-3 months before the cash from BurgersnBuns arrives. FryinHigh may be described as a negative cash flow business.
These two businesses operate with different business models and dynamics. They both may have recorded a profit for the month, but only BurgersnBuns will have generated cash as both had to pay staff and suppliers at the end of each month.
Below are 10 steps you can take to enhance operating cash flow.
1. Know your cash position
Accurate and timely information is the lifeblood of business.
One key performance indicator is the amount of cash available for operations. In established businesses with a developed finance function, the Finance Director or Controller will have online access to the bank account and know on a daily basis the flow of funds and the current account balance. In conjunction, most managers know their way around their financial statements but often overlook the most important section, the cash flow report which comes after the balance sheet.
It’s here that the cash generating ability of the business is explained. In many cases, actually understanding the cash generating ability of the business can be quite surprising.
The bottom line is: Know how much cash you produce and report it!
2. Model your cash position
Business managers can be alienated by complex financial spreadsheets or business models.
But, it is critical to know how income and expenditure will impact the business in the short, medium and longer term; so that sensible decisions may be made.
From a lender’s perspective, a well-managed finance function may be the difference between a positive lending decision and a decline.
If your business is not able to manage and plan its own cash resources effectively what confidence will the lender have that it can manage the term loan!
Bite the bullet, if need be, and develop a financial forecast model to track revenues, direct costs, overhead costs, cash receipts and payments.
Ideally, this financial forecast should be integrated with your profit and loss account and balance sheet.
To make your work easier, there are many forecasting products on the market and most accounting packages have this sort of sophistication built in. So, create and maintain an effective forecasting model!
3. Operate profitably
Sell your product/service at a price that covers (all) relevant costs to provide you with the target profit margin.
Specifically, profit is made up of two components: gross profit (revenues less direct costs) and operating profit (gross profit less overhead costs).
Find out: Is your gross profit sufficient and sustainable?
A manufacturer with a 10% gross profit does not have a viable business model, assuming normal overhead costs.
For instance, there may be times when discounts are required but a business cannot survive on a marginal cost strategy. If it costs you £10 to produce and you’re selling it for £8, you won’t be in business very long.
So, know your costs, set & monitor gross profit and operating profit targets.
4. Invoice well
Many B2B businesses operate like FryinHigh Ltd, described earlier.
This means they produce the product or service, invoice the client and receive payment in line with their credit terms.
To stay on top of your finances, send invoices promptly, accurately (including supplier references) and to the right purchasing/payment contact at the customer.
In addition, monitor payments and, where not payment is not made according to agreed terms, take action with a call, email, letter to establish why there is a delay and when payment can be expected.
The bottom line is: It’s not a sale until the cash is in your bank; so design an effective invoice and cash collection process.
5. Choose customers wisely
When your business is new and small, you will celebrate every customer, and probably every order!
However, as you grow, do you really want on-board customers who gripe about the price, have high levels of returns or don’t pay on time?
You will soon realise that not every customer is a good customer! In particular, some are high cost to serve and those may suit a different price structure or even being managed out of the business.
On the other hand, for new accounts, if possible, agree payment in advance or prior to shipment.
Similarly, if you must provide credit terms, try net 7 or net 10 or end of month before offering net 30.
To minimise your risk, obtain a credit report from one of the credit agencies such as Experian, Creditsafe or Equifax and pay to monitor adverse reports to your key accounts.
So, try not to offer credit terms, but if you must, check your customer’s credit-worthiness.
6. Buy well
A typical manufacturing business will spend 30% to 50% of its revenue with a variety of suppliers, related to raw materials, production consumables, energy and overhead costs.
Similarly, larger businesses will have a purchasing function focused on managing those relationships, the interface with operations, purchase transactions and associated cash flow.
Here, purchase efficiencies are not just about achieving the lowest unit price; they include quality, delivery frequency, the need to carry inventory, design for manufacture and payment terms.
Overall, pay attention to purchasing.
7. Discount with care
You might be surprised to know that if your gross profit is 50% and you offer your customer a 10% price discount, to make the same amount of revenue you will need to sell 25% more volume!
Similarly, at 30% gross profit, you’ll need an additional 50% more volume.
That’s pretty scary.
Yes, there’s a place for discounts, usually related to preferred supplier commitments, contract length and volumes. However, don’t ever let your sales team unilaterally offer them! Without defined guidance, you can be sure they will! Try and sell £1 for £1.10, not 90p!
8. Improve your processes and reduce costs
If your business operates through slow, complicated processes, you will be burning unnecessary cash.
It’s a longer term effort but if you are not implementing JIT/Lean/Six Sigma type improvement, you are missing opportunities to run faster, with fewer defects and lower inventory.
Mind that the efforts don’t have to be grand to have a large effect. In particular, a 1% improvement in revenues, gross profit and overhead costs will yield a 15%-20% profit increase and free up cash.
You may ask: how do you know if you need to improve?
Simply, take a look at a few critical operating cash flow indicators such as Stock Turn (COGS/Stock), Sales/Working Capital (Sales/Debtors+Stock-Creditors) or DSO (Debtors/Sales x Days) to check your start point.
Remember: Working hard and working smart can sometimes be two different things.
9. Increase revenues
When you throw into the mix routes to market, product range, territories and pricing strategies, increasing revenues can become quite complex.
Assuming a business has customers who wish to buy its product or service; revenue at its simplest is a function of price and volume; so there are only 4 levers to pull:
- increase the number of customers,
- increase the average transaction size,
- increase order frequency and
- increase prices.
So, why don’t you spend some time with your team and brainstorm workable ideas for each one, and implement them?
Remember: If you’re not taking care of your customer, your competitor will!
10. Build a surplus
Many families operate a holiday fund in their domestic finances, keeping a little in reserve every month to provide funds to pay for a vacation.
However, no matter how carefully you plan, budget, forecast and improve something can emerge unexpectedly.
No one saw 2020 coming in 2019!
So, it’s a great business habit to keep cash available for times when things do not go according to plan.
That’s why some large and successful companies have cash balances greater than the GDP of many countries!
About SME Capital
SME Capital was founded to support the growing number of SMEs who face difficulty or frustration in accessing capital through traditional methods. We understand the importance of real and trusted relationships in the SME lending market and have dedicated Regional Directors based across the UK. By combining traditional lending expertise with the latest in data analytics, we are supporting established UK SMEs with their long-term objectives and business ambitions.
SME Capital provides SME funding for businesses which are integral to the UK economy. We support UK businesses able to demonstrate recurring revenues and a track record of profitability. They often have unique needs that fall between traditional lending routes and the automated response from online only business loan lenders. We cater to businesses with strong cash flows, assessing each business on its strengths, rather than focusing on the asset base.