Managing Cash Flow

by: Patricia Oshier Franks

Cash flow refers not only to money flowing in and out of a business on a daily basis, but also to such short term investments as treasury bills, certificates of deposit (cd's) and commercial paper that can be converted to cash fast and easy. Cash flow allows a company to pay bills, pay off loans, and pay employees in the course of providing goods and services to their customers. It is essential that the business owner know how to prepare a cash flow statement.

Cash flow statements were not always required by law when reporting business activities. Originally, businesses were required to file a statement of changes in financial position, sometimes referred to as a funds statement. The funds statement went through several years of development before it was widely used. In 1961, Accounting Research Study No. 2, sponsored by the American Institute of Certified Public Accountants (AICPA), recommended that a funds statement be included with the income statement and balance sheet in annual reports to shareholders.

Two years later, the Accounting Principles Board (APB) Opinion No. 3 was issued, providing funds statement preparation guidelines. Although Opinion No. 3 did not go so far as to make the funds statement mandatory, most businesses, aware of the statement's value, included it in their annual reports anyway. Finally in 1971, APB Opinion No. 19 officially made the funds statement one of the three primary financial documents required in annual reports to shareholders. The APB also said a funds statement must be covered by the auditor's report. Because Opinion No. 19 didn't specify a particular format for the funds statement, businesses still enjoyed considerable flexibility in how they reported their funds flow information.

That flexibility ended in late 1987, with the Financial Accounting Standards Board's (FASB) issuance of Statement No. 95, which called for a statement of cash flow to replace the more general funds statement. Additionally, the FASB, to help investors and creditors better predict future cash flow, specified a universal statement format that highlighted cash flow from operating, investing, and financing activities. This format is still used today. Cash flow statements are broken down into three key sections: operating activities, investing activities, and financing activities.

Operating activities, those transactions and events that normally enter into the determination of operating income, include cash receipts from selling goods or providing services as well as income from items such as interest and dividends. Operating activities also include cash payments like inventory, payroll, taxes, interest, utilities, and rent. The net amount of cash used by operating activities is the key figure on a statement of cash flows.

Cash receipts include sales of goods and services, interest revenue, and dividend revenue. Cash payments include inventory purchases, payroll, tax interest expense, and such expenses as rent, utilities, and overhead expenditures (ie: business and office supplies, equipment, etc).

Investing activities include transactions and events involving the purchase and sale of securities (excluding cash equivalents), land, buildings, equipment, and other assets not generally held for resale. It also covers the making and collecting of loans. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of your business,usually the sale of goods or services. For investing activities purposes, cash receipts includes sale of plant assets/equipment, sale of a business segment, sale of investments in equity securities of other parties or debt securities other than cash equivalents, and the collection of principal on loans to other parties. Cash payments include purchase of plant assets/equipment, purchase of equity securities of other parties or debt securities of other parties, and loans to other entities.

All financing activities deal with the flow of cash to or from the business owners (equity financing) and creditors (debt financing). For example, cash proceeds from issuing capital stock or bonds would be classified under financing activities. Likewise, payments to repurchase stock (treasury stock) or to retire bonds and the payment of dividends are financing activities as well. Cash receipts include issuance of own stock and borrowing in such items as bonds, notes, and mortgages, etc. Cash payments include dividends paid to stockholders, repaying principal amounts borrowed, and repurchasing business's own stocks.

Basically, cash flow is primarily the difference between cash coming into the business and cash going out of the business during a given time period. But every business has a cash cycle. The cash that comes into the business does not always correspond to the same time or same rate as the cash that goes out. It is practically impossible to iron out all the discrepancies in cash inflows and outflows, and do a perfect job of controlling and coordinating the movement of cash in a business. However, it is possible to develop an understanding, appreciation and consciousness of cash flow. This is the first crucial step in managing the cash flow of a business.

Simply generating sales revenue does not ensure that the business is profitable. Therefore, the cash handled by a business must be monitored through proper cash flow management. Cash that flows irregularly and unpredictably can be as disastrous as no cash at all. Effective cash flow management addresses both short-term and long-term planning.

Short-term cash flow management strategies rely on record-keeping systems that provide quick and

accurate access to revenues and expenditures. Important information for cash flow management can be obtained from a variety of sources including procedure manuals, bank statements, cash flow forecasts, reports on debt collection and accounts payable. Routine cash management reviews must keep a close eye on debt collection, sales and deliveries, status of invoices, receipt of payments and depositing of payments. The best cash flow management strategies usually result from systems that are fully understood by the cash flow manager. Sometimes such systems are computerized, while others are manual. Cash flow management does not need to be complex to be effective. It must, however, be performed.

Despite the complexities of dealing with cash flow, there are some rule-of-thumb items that can be

considered effective in managing cash flow.

1) Decrease the amount of money that is owed to you. In other words, get people to pay their

bills. Overdue accounts receivables can pull down a business. One way to address this problem is

to keep credit current and at a minimum. This is often a bigger task than it may seem. Caution

should be taken when credit is first extended to customers. Consider giving discounts or advance

payments incentives for payments made by the due date.

2) Cut out excess overhead expenditures. Keep unnecessary expenditures to a minimum. Good cash flow management should help eliminate excess overhead expenditures. Bad spending habits are often picked up when cash is plentiful.

3) Keep a close eye on inventory. Product sales and inventory management are complex issues that

can be likened to the "chicken and egg." A business needs enough inventory to fill orders in a

timely manner, but adequate sales are needed to minimize inventory. Inventory includes finished

products held for future sales as well as raw materials held for future production. Both types of

inventory represent cash that has been spent but that has not generated a return. It is often best to

sell inventory items that are just gathering dust at a discounted price.

4) Don't overpay Uncle Sam. Many small businesses pay quarterly taxes based on

estimates of their tax burdens; 90% of current year or 100% of prior year taxes. Although often

a minor difference, cash flow can be improved by paying the lesser amount of estimated taxes.

5) Review owners' compensation. For some small businesses, the owner's compensation is often a

large portion of the business' expense. Especially in the developing years of a business, the

owner's draw can be a big burden on the cash flow of the business. That is why secondary

incomes are valuable to the success of many small business ventures, especially in the early years.

6) Maintain tight reigns on billing and collections. Because cash flow management is so closely

tied to time (flows), the time lag between shipping finished products and receiving payment for

them should be minimized. This time lag issue must be aggressively addressed by collecting

payments and sending invoices in a timely manner. Consider weekly or semimonthly invoicing

rather than monthly or bimonthly invoicing. Another tactic for improving the timing of billing and

collections is to establish a quick turnaround on incoming and outgoing mail. Daily deposits can

help minimize cash flow problems.

7) Consciously structure the payment of your bills. Electronic deposits and delayed payment of

bills can improve cash flow problems. However, there is often a fine line between delayed

payments and late payments. Crossing that line and incurring additional costs for late payments is not a good cash flow management procedure. Discounts on bills should be evaluated, ie., consider discounts that offer less than the amount you save by delayed payments. All non-discount bills should be delayed as late as possible without compromising good relations. Do not hesitate to take advantage of credit offered by suppliers and feel free to negotiate for more favorable terms.

8) Consider biweekly or monthly paychecks. Biweekly and monthly payrolls allow the business to

hold onto money longer, thus increasing interest income on accounts. It also allows for less frequent deposit of payroll taxes.

9) Continually update company procedures. Monitoring certain customers may provide insight

into their payment schedule. A business should consider dropping or implementing new payment

procedures for customers who continually pay late. When taking on new customers, consider

implications on cash flow as part of the evaluation criteria, not just increased sales. Payment

terms influence potential customers, but be cautious. Do not offer over generous payment terms.

Also consider leasing assets rather than buying them.

10) Plan ahead. A projected cash flow plan should be developed. Deposits into the business

operating account in times of cash deficiencies should be made from a line-of-credit loan or

from a savings account, whichever offers the lowest interest rate. Excess funds in the operating

account should be quickly transferred to accounts that earn higher rates of interest. Electronic

transfers speed up this process as well. Consider cash saving activities such as renting versus

buying, used equipment versus new, automation versus labor, subcontracting versus manufacturing, and cash and quick paying customers versus credit and late payers.

11) Develop a good record-keeping system. Continual cash flow management is only as good as

the information on which it is implemented. A record-keeping system that provides information

useful to making decisions regarding cash inflows and outflows is essential.

Cash reigns in financial management of a company, small or large. The period of time between the time you pay vendors and employees and the time you collect from customers is the problem. Cash flow management is the solution. Delay the outpouring of cash as long as possible while encouraging anyone owing you money to pay as soon as possible. Keep meticulous, easy to analyze and understand records and reports. Be aware of cash movement in and out of your company, and cash flow will be easier to manage.