Managing Your Cash Flows: Part One - Cash Management Principles
About the Author:
Paul Wilton (editor)
CA with degrees in commerce, accounting and information technology. Paul worked overseas in the “Big 4” accounting firms and served as a director at Audit New Zealand before setting up his own consultancy. Author of A-Z of New Zealand Business Law, Paul has over 20 years of experience as a business owner and consultant. He joined FBA in 2004 and is totally committed to providing excellence in quality and value to our subscribers.
You may check your financial information monthly but are you doing enough? Do you create a cash flow chart? And have you established the cash flow goals for your business, both long and short term?
The essence of any business is to make money. This means a growth in the cash reserves of the business before dispersion to the stakeholders. However, despite the fact that cash reserves can grow over time, many businesses suffer interim deficits in the balance of cash available at any one time. In order to overcome this it is essential that business owners project cash flows and use means to improve cash flows. Over the next three series of Financial and Business Advisor we will produce articles to assist you in understanding cash management. This article in particular is introductory in nature.
A picture speaks a thousand words and so we have used the diagram below to depict the various types of flows of cash that would affect a business:
Cash Flow Issues
There are a number of issues that affect the management of cash. Over this series of articles we are going to examine in more detail the following:
1. External sources of funding
owner’s investment
grants & loans
overdrafts
factoring
2. Internal sources of funding
stock management and JIT
finished goods management
reducing costs
improving buying power
increasing sales
improving debtor management
deploying creditor funds elsewhere and managing creditors
managing assets
3. Management processes
How to budget & forecast
How to manage cash reserves
How to manage petty cash
In addressing the above issues it should be pointed out that there is often a roll-on effect as the consequence of a particular action. For example, if you are short of cash you may decide not to pay your creditors. Although this is probably the cheapest form of funding available to you a consequence may be that some of your suppliers refuse to supply you for future work – there goes your cheapest source of goods. Another example demonstrating a potential roll-on effect is using increased sales to improve cash flows. Ultimately an increase in sales will result in more cash at some time in the future, but an increase in sales is often accompanied by a lead time of additional expenses for sales staff and products with a growing debtor’s ledger thus creating increase short-term deficits.
External Sources of Funding
If funds cannot be raised within the business then the manager/owner will have to look at external sources of funding.
Funds in a company can be increased by one of two means: either shareholders/owners’ funds or via a loan. This subject can be extensive and quite complex as there are many ways to raise funds for each of the two alternatives. The most simplistic situation is the case of a self-employed person where money is simply utilized as “negative” drawings. For a company there would generally be an issue of additional shares. However, these shares may be of a different class such as preference shares with different rights to those of ordinary shares. Alternatively, the business may acquire a loan.
The question is: Is it better for the owners to invest money in the business or to borrow funds? In reality, the answer isn’t too straightforward. Many people have difficulty accepting that a loan often provides a useful tool in a business to maximise the tax benefit. A recent example was Auckland International Airport Ltd (AIAL) which had very little debt and so borrowed significant amounts of money to pay out its shareholders. The acceptability of borrowed funds is usually measured by the “debt to equity” ratio (i.e. the amount of debt relative to the owners’ capital investment) and many larger businesses have a policy to maximise this ratio. The advantage of introducing funds through the owners (shares or negative drawings) is the flexibility the business has in terms of repayment or interest over the investment. The major negative effect is that an issue of shares to new shareholders may reduce the control of existing owners. This could be a high price to pay especially if owners lose a majority interest. This should not be considered where short term relief leads to long-term consequences that could be avoided through other forms of funding. Also, for a self-employed person a negative effect may be that money has been sunk into the business and may not be recoverable if things go sour.
Generally speaking, companies trying to get equity capital are very early stage businesses with little or no real assets. On the other hand, companies on their way to a steady growth curve tend to use debt financing.
It is worth remembering that you get nothing for free. In the case of a very small business you either introduce your own funds or borrow from the bank. The borrowing will in almost every case involve security over your personal assets. The only advantage attributable to this is that you pay interest on a home mortgage which is tax deductible to the business - as opposed to higher rates for a business mortgage which in turn requires security over the business. Obtaining security over an unlisted business from a bank is very difficult because goodwill has no value to a bank. You may get a low percentage (say 30%) on your fixed assets depending on what they are.
Grants/Investors
Grants are a useful way to obtain funds if you are in a startup business or in the early stages of developing a new product. Unfortunately, New Zealand is not as forward as many other OECD countries in regards to grants and the required criteria for eligibility can provide a very narrow gap. We do not intend to elaborate on this subject as we have covered it in a number of previous articles.
Another source of funds is from investors. Once again, New Zealand is not as advanced in this area as many other countries but investor funding can be a useful tool for a company with a very rapid growth rate. One major disadvantage is that often investors want a large stake of the company because this in turn can provide them with greater influence over the management of their investment which offers a measured form of security.
Factoring
We have had a number of articles written and contributed regarding factoring. Factoring is useful when a company is growing and has foreseeable future growth. This is because the money on the debtors ledger, or sales, can be made available almost immediately after invoicing your clients. Thus you do not have to “invest” in a large and growing debtors ledger.
Some businesses do not appreciate, however, that factoring is not the answer to a business which is short of cash and has no projected growth. In this situation the company will benefit from the immediate injection of cash as soon as the contact is agreed with the factoring company, but thereafter this contract will remain an expense item for the availability of the service. This problem can only be overcome where increased growth follows.
Overdrafts
Overdrafts can be a useful tool for businesses. They a business with access to an increased amount of funds to help avoid a negative cash flow. However, this service comes at a cost, both for the availability of the service and for the use of the service. If an overdraft can be avoided then it should be. However, some companies have seasonal fluctuations in sales and during periods of higher sales these months often incorporate higher costs (to effect the sales) and larger debtors ledgers as a consequence of these sales. Thus some form of bridging finance is required and an overdraft may well be best suited to this particular situation.
Internal Sources of Funding: Bottlenecks
We listed a number of internal sources of funding above ( cash flow Issues). We first examine bottlenecks in cash because these are areas that we can most readily improve. Obvious bottlenecks in cash occur with:
Fixed assets
Raw materials
Saleable stocks or finished products
Debtors
1. Fixed Assets
Without fixed assets we may not be able to produce goods or services. We are dependent on computers, vehicles, premises, plant and equipment to varying degrees to enable us to undertake business effectively. You need to consider your investment in fixed assets. This is generally a longer term plan because liquidating fixed assets quickly is not very practical.
If cash is tied up in assets that are under utilised then you may be able to simply sell the asset and rent or lease as required. Under utilised assets can be a waste of cash and space.
Reduce the total cost of ownership. Consider being more modest when looking at a new vehicle. If it does the same job, particularly if simply to get a sales rep from A to B, then you do not need a 6 cylinder car.
Prestige as opposed to profit can be a dangerous precedent and is particularly prevalent in cash rich corporations and some Government agencies. Focus on what is important to your stakeholders.
There are tax advantages with certain types of leases and you may have a better cash flow and it may cost you less in the long run to lease as opposed to buying. Always look at these alternatives. By reducing the amount of purchased assets you are reducing the amount of capital wrapped up in such assets. You may also need to consider whether ownership is important to your business from a risk perspective.
2. Raw Materials
Purchasing an excess of raw materials where these will not be used for a while means that you have increased your stock levels thereby tying up extra cash in working capital. Effective management of raw materials can be complex especially in larger organisations.
Where possible, consideration should be made of the principle of JIT or Just-In-Time supply chain. This means that you hold as little stock as possible which in turn minimises warehousing costs and the amount of funds tied up in raw materials. In order for this system to work you need dependable suppliers. Your agreement for supply should tie them up with the consequences of failure of supply. You may be prepared to pay a little more for this service but the amount of cash freed up can be significant. Also consider the type of stock control system you have on board. Most companies tend to have stock control systems which are in excess of their requirements – they simply don’t need or adequately process the information. However, some basic controls are essential to guard against theft and to ensure that material is available for processing.
3. Saleable Stock
Saleable stock is more expensive to store than raw materials. Saleable stock has had processing which involves a capital injection (time and money to make the goods) and this money is not recoverable until the goods are sold. Hence forecasting sales and producing products to suit is important. Companies which manufacture to demand are relatively lucky in this regard because output matches demand.
For retailers especially, be prepared to lower the cost of slow moving items because the longer you hold them the more they cost you.
4. Debtors
Debt needs to be recovered as quickly as possible to assist with positive cash flows. The debtor’s ledger is an area where significant sums of money can be “locked up”. Debtors management is a complex issue and is discussed in some length in our November/ December journal with practical hints on how to manage your debtors.
You may check your financial information monthly but are you doing enough? Do you create a cash flow chart? And have you established the cash flow goals for your business, both long and short term?