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. Let’s see what the process of good cash flow management looks like and consider the payoffs it can provide.
Without proper planning, action and follow through, growth can actually cause cash shortages and financial failures. It is counterintuitive to think that cash gets worse when revenues grow, but it really does happen. Growth comes with investment demands for equipment, inventory, employees, infrastructure and possibly even facilities. Some of these investments do not pay for themselves quickly. Using money from your bank account or credit line to fund investments in long-term assets (like long-lived equipment, vehicles or leasehold improvements) depletes liquid cash. This can make it difficult to stay current with future monthly bills. A better strategy is to obtain long-term financing for those investments so you can reserve your cash and short-term financing for your operating cash flow.
How can you grow while still keeping cash under control? First, don’t get caught in the trap of using your cash or credit line to fund growth of long-term assets. Match the life of the loan with the life of the asset. Then, as with most pathways to success, you’ll need a plan and a commitment.
Most businesses have a revenue goal. Some even have an Income Statement Budget to help keep watch on expenses. Such a budget detailing monthly revenue and expenses is an essential management tool. It helps you understand and therefore predict how seasonality impacts your business, and comparing actual revenue and expenses to the budget enables you to assess whether you’re staying on track with your profit plan. Unfortunately, the Income Statement Budget does not show what will happen to your bank balance. You could hit all of your revenue and expense targets and still run out of cash. The only way to predict and plan for cash flow is to also forecast what will happen in the bank account (“cash in” and “cash out”) which may be very different from revenues and expenses on the Income Statement Budget. We’ll refer to the bank account forecast as the Cash Budget.
How do you know what the future will hold for your bank account? A crystal ball would help, but they are a bit hard to come by. The next best indicators are historical trends and seasonal patterns.
Start by reviewing financial statements – the Income Statement 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 to your own performance from your best year in recent history. A business that underperforms at managing these things, or that shows low liquidity as compared to its peers should establish goals and action plans to improve cash flow. Our “Tips for Improving Cash Flow” should help you in your planning.
Still, answering the question “Where is the cash?” can be a mystery for many as they read the Income Statement (also known as the Profit and Loss, or P&L). Because the accrual basis of accounting provides the most accurate picture of profitability, most businesses use it to produce their financial statements. Unfortunately, when the accrual basis is used, the P&L 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 Cash Flow unlocks the clues by measuring cash in and/or cash out through these functional areas of the business:
- Operating – revenue, expenses, inventory, accounts receivable, accounts payable and short term financing (like credit lines or credit cards)
- Investing – vehicles and equipment purchases , facility expansion or other long-term investments
- Financing – new borrowing and repaying existing debt
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. Yet monthly or even annual reviews of this spoiler alert are rare, because it can be challenging to understand until you have some practice reading it. The chart below details how the Statement of Cash Flow answers the question “Where is the cash?”
Cash Came In
Cash Went Out
|Net Profit||Net Loss|
Accounts Receivable (collect)
Other Current Assets (liquidate)
Accounts Receivable (advance)
Other Current Assets (deposit/pay)
Accounts Payable (borrow)
Credit Lines/Credit Cards (borrow)
Other Current Liabilities (borrow)
Accounts Payable (pay back)
Credit Lines/Credit Cards (pay back)
Other Current Liabilities (pay back)
(add back non-cash expense)
Fixed Assets (disposals)
Other Assets (collect or liquidate)
Fixed Assets (buy/acquire)
Other Assets (buy/acquire)
Owner Loans (borrowing)
Long Term Debt (borrow)
Owner Loans (repayments)
Long Term Debt (payments)
The 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 chart above outlines the many things on the Balance Sheet that impact cash. Those familiar with the Statement of Cash Flow will recognize 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. Predicting distributions is particularly important for LLCs and S corporations that pay owners amounts that don’t appear on a W2 since those payments are excluded from the Income Statement. 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 make a realistic forecast, get help from a professional. Even if you are an accountant yourself, another perspective is helpful – from the technical side of how your cash flow spreadsheet is set up, and from the common-sense side, providing a reality check for your assumptions.
To summarize, these disciplines can help you understand and predict your cash flow needs, assuring you’ll have the funds available when you need them.
- Review financial statements and cash flow ratios regularly including the Statement of Cash Flow
- Prepare a monthly Income Statement Budget that accounts for seasonality to serve as your Profit Plan
- Prepare a monthly Cash Budget that accounts for all cash in and cash out to predict your borrowing needs and possible cash shortages
- Use the Cash Budget and Profit Plan to negotiate for financing well in advance of the time you’ll need the funds
What’s the Payoff?
When you use budgets to predict and understand how and when cash comes in and goes out, you are more likely to make good investment decisions and less likely to make costly financing mistakes. You’ll improve your intuitive sense about how much cash to leave in the business and make smarter choices. You’ll be more successful negotiating for financing because you will know how much you need to borrow and how you will pay it back. You will be more profitable, because you will have an Income Statement Budget that gives you financial feedback about the profitability of your decisions. In the long run, these are building blocks for business value. And best of all, you’ll sleep better at night knowing the cash will be there when you need it.