Essential guide to managing your cash flow

Effective cash flow management is vital to ensure that your business has the funding needed to keep trading and make the most of opportunities to grow. A business can survive for a short time without sales or profits, but not without cash.

You need to keep a careful eye on your cash position at all times. That means systems that let you predict your cash flow with confidence, keep tight control and deal with any potential shortfalls before they become problematic.

Components of cash flow

Cash flow forecasting

Using the forecasts

Sales and marketing

Credit control

Controlling expenditure

Funding options

1. Components of cash flow

Cash flow is the balance of money which flows in and out of your business

• Cash flow is the actual payments of money, as opposed to what is owed to you by your debtors or by you to your creditors.
• The cash flow generation of your business may be limited by what industry you are in. But to a large extent it depends on how well you run your business.

The main inflow of cash is usually the cash from sales

• If you sell on credit, your cash inflow is delayed until you are actually paid. Effective credit control is essential.
• A business which purchases on credit and is paid in cash, such as a retailer, is at a great advantage in cash flow terms.

New finance provides a one-off boost to your cash flow

• In the past, most businesses have relied on bank overdraft finance and have reached their borrowing limits quickly. Different funding options allow you to raise more finance.

Expenditure includes paying for your overheads

• Salaries (including tax and National Insurance) are often the largest and most inflexible cost.
• Other major costs might include stock, raw materials and any capital expenditure.
• Many businesses have to fund large amounts of work-in-progress. For example, you might spend several months working on a project (and paying for materials and labour) before you can invoice a customer and get paid.

VAT and other taxes tend to be paid out in large lumps

• You can be penalised heavily for late payment.
• Buying significant items just before a VAT period ends, rather than at the start of the next one, can help your cash flow. You can immediately offset the VAT you paid, against the VAT received from the sales you have made.

Your business needs to give its owners and financiers a return on their investment

• You must pay interest - and repay capital - to lenders such as the bank.
• If there is spare cash, you and other shareholders may want to draw back any personal loans made to the business or take dividends.

2. Cash flow forecasting

The more warning you have of cash flow peaks and troughs, the more time you have to deal with them.

Accounting software makes it easier to prepare budgets and forecasts

• You can quickly update your projections and make 'what if' calculations. For example, what if sales are 20% below forecast for six months in a row?
• For maximum flexibility and ease of use, you can use special forecasting software.
• You could use graphics to make it easy to detect patterns and step changes.

Prepare budgets

• Show the level of sales and profits you expect to achieve, and the costs involved in doing so.
• Estimate the sales and margins, based on past experience.
• Overheads such as rent can be accurately predicted.

Prepare monthly (or weekly) cash flow forecasts

• Look ahead one year and update your forecasts at least monthly.
• Identify the major outgoings, especially those on fixed dates, such as the monthly payroll. Make sure you will have sufficient cash on the day to cover each payment.
• The key is to be realistic. For your regular sales, use the established figures for sales volumes, debtor periods and bad debts.
• For any new products or customers, be pessimistic - expect problems and delays.
• Be aware that monthly forecasts do not take into account weekly fluctuations.

If appropriate, send regular management accounts to the bank

• Banks use automated processes to monitor their smaller business customers. But if your borrowings are significant, ask what information the bank would like to receive.
• Typically this will be your budgets and forecasts.
• Include key indicators that give a picture of the health (and prospects) of your business. For example, the volume and status of sales leads and the volume of orders.
• Don't be overly optimistic in your sales forecast.
• A bank which trusts your forecasts will be more prepared to extend your borrowing facility when you need extra finance.
• If you have a relationship manager at the bank, consider meeting or speaking with them on a regular basis.

3. Using the forecasts

Monitor your actual performance against your budget and cash flow forecast regularly

• Do this at least once a month, and preferably once a week. By comparing your performance with the budget, you can quickly judge whether sales and profits are going to plan.
• Identify any problems and take immediate action. For example, if you know you will be short of cash in three months' time, you might reduce stocks, slow down sales growth, or agree extended credit from a major supplier for that period.
• The only way to generate cash over the long term is through retained profits.

Check you will have enough cash before taking on large financial commitments

• This includes major new orders.
• Create a useful yardstick by working out how much extra working capital is required to fund each 10% increase in sales.
• Restrict the growth of your business to levels you can comfortably afford to finance. Always keep a financial reserve available for contingencies.

Develop systems that warn you of problems

• You need to know as early as possible if leads, orders or sales fall below a certain threshold, if planned sales will be later than forecast, or if a substantial customer stops buying from you.
• You also need to know when key indicators, such as profit margins, liquidity ratios and stock ratios, deteriorate beyond an agreed limit.
• You want to monitor any substantial invoices which are in dispute, late debts and customers exceeding their credit limits.

Build productive relationships with your key suppliers

• They will be more likely to extend extra credit to you when you need it.
• If you expect problems paying a tax bill, contact the HM Revenue & Customs (HMRC) Business Payment Support Service (0300 200 3835, Mon–Fri 8am to 6pm).

4. Sales and marketing

Review your pricing regularly

• Increasing prices may reduce sales (and therefore cash flow) in the short-term. But this is often outweighed by its major positive impact on profitability and cash generation over the longer term.

Avoid overtrading

• Even profitable companies can (and do) become insolvent through overtrading.
• This happens when you have to pay the costs you incurred fulfilling an order before you receive payment from your customer.
• To avoid this risk, you might need to delay some orders and decline others.

Negotiate favourable payment terms with customers

• You may be surprised how easy it is to obtain deposits. For example, to pay for materials you need to buy in.
• Negotiate stage payments for contracts that will take time to complete. Include a timetable for the customer to pay invoices as part of this agreement.
• Agree a clear specification for the work to be completed, to minimise the chance of the customer disputing any invoices.
• Ask to be paid directly via BACS, which delivers cleared funds.

Make sure all your work is invoiced for

• Suppliers are often asked to perform beyond their original remit. Get confirmation in writing if agreements are made outside the original contract terms and negotiate additional payments.

If you need to improve cash flow temporarily, adjust your sales and marketing plans

• Bring forward sales by offering customers incentives to purchase quickly.
• Bring forward payments by offering early-payment incentives (eg discounts).
• Focus your marketing on short-term lead generation, rather than longer-term objectives like brand recognition.

If you pay sales commission, link it to receipt of payment rather than the order

• You delay payment of the commission.
• Your sales people will persuade your customers to pay promptly.

5. Credit control

An efficient credit control system saves time, speeds up your cash collection and reduces bad debt.

Control how much credit you provide and to which customers

• Consider using credit scoring systems and setting appropriate credit limits for all customers.
• Avoid giving any customer more credit than you could afford to lose.
• Set reasonable payment periods. The maximum payment period is generally 60 days from date of invoice or 30 days where no period has been agreed.

Send out invoices immediately after you have supplied the goods or service

• If appropriate, make a follow-up call. Confirm that all the invoice details were correct and that there will be no problem paying it by the due date.
• Plan ahead for Christmas and other holiday periods.

Monitor and chase late payments

• Pursue your largest debtors first.
• You have a legal right to charge late-paying business and public sector customers interest on late payments.
• Using a debt collection agency, or a specialist solicitor, can be an effective method of dealing with non-payers.

6. Controlling expenditure

Shop around

• If you know the current best prices and service levels, you can insist on better terms from your suppliers.
• Consider whether you could make savings by purchasing some types of capital equipment second-hand.

Implement simple cost control systems

Easy savings can usually be found. For example:

• overcharging by your suppliers, such as double billing or missing discounts
• unnecessary costs, such as heating your premises at night
• excessive costs, such as high priced services that can be sourced more cheaply
• inefficiency, such as laborious paper-based systems which could be computerised

Effective stock control can free up significant amounts of cash

• Aim to hold just enough stock to service your customers. Identify seasonal peaks and troughs.
• Set a target stock-turn (eg six times a year), then monitor your performance.
• The faster your suppliers can deliver to you, the less stock you need hold.
• Consider selling off any old or obsolete stock to free up capital.

7. Funding options

Only use overdrafts for short-term cash requirements

• Where possible, longer-term financing should be in the form of loans or other alternatives.
• Bank borrowings may be limited by the security you can give the bank.

Factoring allows you to raise finance based on the value of outstanding invoices

• Growing businesses in particular often find that factoring provides a more substantial and flexible source of working capital than overdrafts or loans.

Consider using asset finance to purchase computers, vehicles, plant and machinery

• Hire purchase or leasing allows you to spread the cost of the purchase, with the asset itself providing the main security.
• Consider generating cash by selling assets and leasing them back. Before doing so check the impact on your profit and loss account.

A strong base of equity finance is vital

• Injections of equity finance can help you achieve step changes in the growth of the business. For example, if you need extra finance to buy another firm or open a new factory.
• Directors' loans can play a similar role.

Expert quote

"Preparing, and regularly updating, a cash flow budget is one of the most important management tools that you can use in your business. It is vital to know how much cash is coming in and going out, and this is where most businesses fail. Knowing what problems you may have ahead of you enables you to prepare for this and avoid running out of cash." - Martin Dunne, Sayers Butterworth

"Cash flow forecasts are the responsibility of the management team, not just your accountant. Be warned, profitable companies can, and do, run out of cash." - Brian Hayden, Hayden Associates