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Everybody wants better cash flow. Even the most profitable businesses run short of cash at times, especially seasonal businesses or those that are growing quickly. And many growing and profitable businesses have failed because there simply wasn’t enough cash to pay the bills. Assuring the cash will be there when you need it takes time, good management and an understanding of how much working capital (cash flow) your growing business requires.
START BY reviewing financial statements – the profit and loss and the balance sheet – and look for things like sales growth, profit, asset growth and changes in current assets, current liabilities, inventory levels, equipment and total liabilities. Then have a serious look at the business ratios that measure the drivers of cash flow, including inventory turn days and accounts receivable collection days.
Assess the metrics in relation to other companies like yours or compared with your own best performance in a prior year. A business that underperforms at managing these things, or that shows low liquidity as compared with its peers, should establish goals and action plans to improve cash flow.
Still, answering the question ‘Where is the cash?’ can be a mystery for many statement readers. As the accrual basis of accounting provides the most accurate picture of profitability, most businesses use it to produce their financial statements. Unfortunately, it does not provide a clear picture of cash flow.
The balance sheet also falls short – while it holds the clues, it only shows a snapshot of the bank balance at the end of the period without detailing the movement of cash throughout the period under review.
The statement of sources and application of funds unlocks the clues by measuring cash in and/or cash out through these functional areas of the business:
Every business needs a regular statement of cash flow because it clearly identifies the differences between profit and cash, and shows the impact all business activities have on cash. T
he income statement shows all revenues, expenses and the “bottom line” difference between the two, net profit. Many things other than expenses consume cash, and businesses receive money for things other than revenue.
The sources and application of funds statement will recognise these categories. The statement shows the beginning balance of cash and then details the amount provided by or consumed by operating, investing and financing activities of the business, to arrive at the ending balance of cash.
This is how the statement answers the question ‘Where is the cash?’
A monthly cash budget is constructed by forecasting (estimating) these same things. For most companies, a complete cash budget accounts for predicted inventory purchases, borrowing, debt repayments and distributions to owners because these items are not included in the income statement budget.
In addition, companies carrying significant accounts receivable must account for a lag between the time when revenues are earned and collected (accounts receivable collection assumptions).
With budgets for both profit and cash, you are armed with two powerful tools for planning and control that no business should be without.
To summarise, these disciplines can help you understand and predict your cash flow needs, assuring you’ll have the funds available when you need them.
Tips for improving your cash flow
Stuart Donaldson business educator