How to Understand and Control Your Business's Cash Flow

Over 50% of businesses close their doors after 4 to 5 years. Although this could be for a wide variety of reasons, one of the largest is due to cash flow management.

Cash Flow Management Problems for Startups

The concept of how to manage your cash flow is not always on the top of mind. Topics like getting customers, revenues, and awareness are usually the driving force for many growing businesses. The typical thought process is, "sell a product, get paid, repeat". Sounds easy, right?

Wrong! There are a lot of different variables that play a drastic role in your cash flow. Just because you are making sales, does not mean you are making a profit.

The following article will explain the pain that all companies face when managing cash and the balancing act it usually requires. If you are not a finance professional, don't worry -  these are all rudimentary concepts. Even though they are basic, they will offer actionable strategies to not only forecast cash flow, but control it!

Purchasing Scenarios and The Role They Play on Cash Flow

In the following scenarios, the order to cash cycle will be overly simplified to make cash flow gains and losses easier to witness. The scenarios will also assume that all inventory is bought solely for the job at hand and takes the same time to deliver as to manufacture.

1. Order to Cash = Inventory Turnover

Cash Flow without Accounts Receivable

This buying scenario (as seen above) is what typical business owners expect when creating a company. They have a product and inventory, they sell it, buy more stock and put the net profit into working capital or cash reserves. If every transaction were like this, cash flow would be pretty easy to manage because an organization can control the levers that get them paid. The quicker a business sells inventory, the faster the company gets paid.

That might be the case for many B2C companies that only sell direct to the consumer base. Sadly what many business do not expect are other variables that play a role in receiving cash.

2. Order to Cash = Inventory Turnover + Days Sales Outstanding

Reminder: Days sales outstanding or DSO is a metric used by a company to estimate their average collection period, whereas Days payable outstanding or DPO is a company's average payable period. DPO shows how long it takes a company to pay its invoices from suppliers.

Balanced Cash Flow from equal DSO and DPO

In this scenario, a supplier is allowing their customer to buy on net 30 terms, and it is taking them 30 days to sell through their inventory. Because an invoice is commonly issued after shipment of the product, the days sales outstanding must be added after the inventory turnover and cannot be issued before the project is completed.

On the flip side, the business needs to buy more inventory and order stock immediately after the job is complete. The business is not billed for that inventory until it’s been shipped. If receivables and payables align, your business will be receiving cash at the same time payment is due to your vendors. The net profit in this scenario is the same as it would be with no receivable, it just takes longer to obtain.

3. When Your Customer Pays Late or Not at All

Order to cash cycles are like a pendulum - to have good cash flow, your days sales outstanding has to be equal (or be less) to your days payable outstanding in order to be profitable. You can't pay your bills if you do not have any cash.

Sadly extending credit to your customers comes with a lot of risks. One main concern is, "What if the customer never pays?" If that is the case, there is no profit, but instead a loss from your sales. What most organizations do not recognize is how a late payment is also a temporary loss.

Late Payments of defaults of accounts receivable

In the image above we see that the days sales outstanding has stretched out another 20 days. Sadly, the business has already ordered the next job’s inventory, and the bill is due immediately. The cash from the previous job will not be received for another 20 days. Unfortunately, the business has been limited to a couple of potential options:

1. Take the cash from your reserves

Pay your vendors from the net profits of your previous deals and hopefully replenish your losses in 20 days when your customer pays their invoice. Watch out! If you do this action too often, you might find that your reserves are getting low, and you may find yourself with permanent cash flow issues

2. Invoice Factoring

Get money upfront for your outstanding invoices from a financial institution. The money up front may cover your outstanding payables for inventory but the fees of this process will undoubtedly lower your net profits from the sale.

3. Short-Term Loan

This may not be an option for many small or new companies. Take out a small, low-interest loan to pay off vendors and then immediately pay it off when your customer pays you. This cost comes with a lower fee compared to factoring, but it also incurs a higher risk. If your customer does not pay, you have only moved your vendor debt to debt owed to a bank with accrued interest.

4. Don't pay your bill on time

If there is no money, wait until there is. This may be ok to do once in awhile, but it will destroy the relationship companies built with vendors and risks the possibility of them ending a financially beneficial relationship.

How often do scenarios like this happen? A lot!

  • 40% of American businesses have delayed their supplier payments due to a customer's late payment
  • 47% of domestic receivables are past due
  • 1.4% of receivables are uncollectible
Click here for More Receivables Stats

Oddly enough, a customer does not even need to pay late for this to happen either! Let's say a buysiness gets a new large customer. This customer will undoubtedly abuse their buying power to get a lengthier payment term, moving the usual order to cash cycle from 60 to 90 or even 150 days! On the plus side of these instances, the negative cash flow does not come as a surprise, and you can coordinate how you will finance your upcoming inventory purchases.

How Can a Business Manage Cash Flow?

In the previous scenarios, inventory turnover and inventory replenishment is under the control of the business (at least for this instance). The items causing the most havoc with cash flow are the receivables. When money is not received promptly from a customer, vendor bills can not be paid on time. To improve the financial health of a business, companies must implement processes to improve when money comes in, and when it goes out.  Here are a couple of suggestions:

Minimizing Days Sales Outstanding

  • EIPP
    Electronic Invoice Presentment and Payment (EIPP) is a web-based technology that automates and streamlines business processes and transactions through self-service portals, which have proven to shorten invoice collections. Not only does EIPP improve DSO and the customer experience, it also cuts costs surrounding customer support.
  • Wording
    Freshbooks found that using language such as "30 days" instead of "net 30" resulted in higher paid invoices. The reason behind this is that the business issuing an invoice is fully aware of certain terms but customers may not be. A simple switch from "terms" to more clarifying language such as "days" can have a big impact.

In the image below, you can see the blue bar for "30 days" is paid quicker than the bar for "net 30". Shorter bars are better.

Wording to improve cash flow on invoices
Image Source

  • Early Payment Discounts
    Early Payment Discounts offer a discounted rate to companies who pay their invoices early. As a vendor, define how many days early any discount will be applied. For example, you might send out an invoice with the following terms:
    • 2/10 - net 30
    • The above is a net 30 invoice with a 2% early payment discount if paid within 10 days rather than 30.
  • Finding a Customer’s Creditworthiness
     A customer who can afford to pay for your product is creditworthy. In a perfect world, businesses can extend as much credit to their customers as they can afford. The challenge is figuring out how much while still meeting their business needs.

Getting longer payment terms

  • Pay on Time
    Getting a longer payment term with a supplier does not happen overnight. Be sure to pay on time or early whenever possible. This will demonstrate to the supplier that there is little risk with extending longer terms.
  • Credit Score
    Before a company extends net terms to any buyer they need to know their creditworthiness. The higher the credit score, the more likely a company will receive a higher credit limit with longer terms.
  • Buying Power
    Every company is in business to make money. The more money a buyer can provide to a supplier, the more value they offer and will go out of their way to promote future prosperity, including extending payment terms.

The above steps when executed correctly, should be able to help you improve your cash flow performance. The downside of these activities is that they are only a treatment for the problem at hand, not a cure.

The difference between managing and controlling your Cash Flow

In this article we have covered scenarios where the DSO and DPO were balanced to create a predictable cash flow. We then looked at what happens when they become unbalanced, and the outcome of a negative cash flow.

The steps to improve DSO and DPO, when executed correctly, should be able to help you improve your cash flow performance. Using the top accounts receivable management processes may help to reduce the negative occurrences, but late payments and defaults will undoubtedly still be a part of your day to day operations.

So how is it possible to make money from extending terms instead of losing it? When its controlled!

Extending credit loses money due to its irregularity. If customers paid on time every time, every business would be able to pay bills on time, every time and cash flow issues would be solved. Therefore, a business's goal should not be to manage a credit program, but instead, control when money comes in, and when it goes out.

How Controlling Your Cash Flow Can Make You Money

The ideal scenario for any business would be getting paid immediately after every project is complete. In doing so, the company would have the sales revenue in cash for an extra X number of days before the cost of replenishing inventory is due. This scenario is illustrated below:

The perfect Cash Flow Scenario

By having the cash on hand immediately after the sale, a business can make money in the following ways:

  • Lower Cost of Goods Sold for an Upcoming Project
    Utilize cash on hand to take advantage of a vendor's early discount. This is commonly 2% off when paid within ten days, allowing businesses to lower its cost of goods sold by 2% (at least as it pertains to your inventory.)
  • High-Interest Account
    Due to the short nature of this investment, this will not be a sizeable profit unless it is a very large sale but it gets more sizeable if the length of payment terms from vendors gets extended.
  • Increase Buying Power
    With the uncertainty of a late payment gone, businesses can purchase double the inventory, increasing its buying power to receive lower pricing from volume discounts.
  • Creating a Safety Net
    A company will have more cash on hand, allowing short-term expenses such as investing in seasonal work, repairing machines or other small expenditures to be easily accomplished with minimal impact on cash flow.

Businesses know their own strengths. How would your business profit most from a short-term influx of cash? With larger sales and longer payment terms to your vendors, the strategies and the payouts can increase exponentially for many companies.

How To Control Your Cash Flow

The only way to control a business's cash flow is to integrate a third party into the equation,eliminating the irregularities of B2B payments as well as the risk associated with lending to a business customer. When a third party underwrites buyers and orders they make, each transaction is automatically financed and provides payment to the supplier within 24 hours.

In this scenario, money coming in has no irregularities, allowing a business to have flexibility to manage its cash and eliminate the possibility of temporary and permanent losses.

On top of that, by handing off the risk and underwriting to a third party, a business can drastically decrease the overhead required to manage a credit program. This could include software, human capital, paper expenses and payment processing.  

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