Cash Flow Management: More Important and Complex Than Ever

Effective Cash Flow Forecasting Delivers 
Confidence in Times of Uncertainty

Businesses talk a lot about budgets, revenue projections, and actuals. However, one of the most
important planning tools that a business of any size must do is forecast cash flow.

Without cash to handle expenses, a business would flounder and die. Understanding your business’s
cash flow needs, and staying on top of them, will help keep your operations and your overall
organization running along smoothly. The more accurate your reporting from previous years is, the
better your cash flow projections will be in the coming year. Revisit your cash flow forecast frequently
to keep your business running smoothly

Cash flow management is a crucial part of running a business

Cash flow formula:

  • Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure
  • Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
  • Cash Flow Forecast = Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash

Managing Cash Flow

Part 1: Learning Objectives

  1. The importance of cash management to a small company’s success.
  2. Differentiate between cash and profits.
  3. Understand the five steps in creating a cash budget.
  4. The fundamental principles involved in managing the “big three” of cash management: accounts receivable, accounts payable, and inventory.
  5. Techniques for avoiding a cash crunch in a small company.

Introduction Running out of cash has driven countless small companies into bankruptcy.  A cash forecast is essential for new businesses because they usually do not generate positive cash flow right away.  It is essential to collect accounts receivable.  New businesses must forecast how much cash the company will need to get through the valley of death, which is the time period during which start-up companies experience negative cash flow as they ramp up operations, build their customer bases, and become self-supporting.  Refer to Figure 12.1, The Valley of Death.

Cash Management                                              LO 1

Cash is the most important, yet least productive, asset that a small business owns. Businesses must have enough cash to meet their obligations or run the risk of declaring bankruptcy. It is entirely possible for a business to earn a profit and still go out of business by running out of cash. Disruption to cash flow is most often caused by customers paying their bills late or not at all.  The Great Recession has intensified this problem, as demonstrated in Figure 12.2, Small Business Owners’ Ratings of Their Companies’ Cash Flow.

Cash management is the process of forecasting, collecting, disbursing, investing, and planning for the cash a company needs to operate smoothly.  Any excess cash should be invested, even if for a short time.  Managing cash flow is also an acute problem for rapidly growing businesses, which are also likely to run out of cash to meet the needs of a growing business with a booming sales volume because of the requirement to hire more employees, expand plant capacity, etc.  Refer to Table 12.1, Signs of an Impending Cash Flow Crisis, and Table 12.2, How Much Cash Is Required to Support an Increase in Sales?

The first step in managing cash more effectively is to understand the company’s cash flow cycle which is the time lag between paying suppliers for merchandise or materials and receiving payment from customers.  The longer this cycle, the more likely the business will encounter a cash crisis.  Refer to Figure 12.3, the Cash Flow Cycle.

The next step is to analyze their cash flow cycle, looking for ways to reduce its length.  Business owners should calculate their cash conversion cycle whenever they prepare their financial statements, at least quarterly. On a daily basis, business owners should generate reports showing the following: total cash on hand, bank balances, summary of day’s sales, summary of the day’s cash receipts, summary of the day’s cash disbursements, and a summary of accounts-receivable collections.

Cash and Profits                                       

As important as earning a profit is, a company’s survival depends on its ability to generate positive cash flow.  Profitability is not necessarily highly correlated with cash flow. Cash and profits are not the same. Profit is the net increase over a period of time in capital cycled through the business, indicating how effectively the firm is being managed.

Cash is the money that flows through the business in a continuous cycle. In other words, the profit a business shows does not mean they have that same amount of money in their checking account!

Profit (or net income) is the difference between a company’s total revenues and total expenses. It measures how efficiently the business is operating.

Cash flow is a method of tracking a company’s liquidity and its ability to pay its bills and other financial obligations on time by tracking the flow of cash into and out of the business over a period of time. Cash flow is the volume of actual cash that comes into and goes out of the business during an accounting period.

The Cash Budget                                               

The need for a cash budget arises because the uneven flow of cash in a business cycle creates surpluses and shortages throughout that period.  This uneven flow of cash creates periodic cash surpluses and shortages.

cash budget is a “cash map” showing the amount and the timing of cash receipts and cash disbursements on a daily, weekly, or monthly basis.  It is used to predict the amount of cash needed to operate smoothly over a period of time.   This provides the entrepreneur the opportunity to anticipate cash crunches and handle them, or to avoid them.