Methods of improving cash flow Tutor2u

What is a cash flow problem and what do they happen so often in all types of business?

A cash flow problem can be defined as:

When a business does not have enough cash to be able to pay its liabilities

The main causes of cash flow problems are:

• Low profits or (worse) losses
• Over-investment in capacity
• Too much stock
• Allowing customers too much credit
• Overtrading
• Unexpected changes
• Seasonal demand

Let's look at these in a little more detail.

Cash flow problems arise frequently in business, although less often when a business has strong cash flow forecasting processes.

The keys to the ability of a business to handle cash flow problems are:

• Have a reliable cash flow forecasting system
• Actively manage working capital
• Choose the right sources of finance for the business needs

Good cash flow forecasting is at the heart of cash flow management. The key is having good information and using it! A good cash flow forecast:

• Is updated regularly
• Makes sensible assumptions
• Allows for unexpected changes
• Is reviewed regularly by senior management

Working capital management focuses on:

• Striking the right balance between offering customers credit and ensuring that they pay on time
• Holding an appropriate level of stocks in the business
• Managing relationships with suppliers so that the maximum amount of trade credit can be obtained without damaging supplies to the business

Managing Debtors (credit control)

This isn't easy. Credit control covers areas such as

• Policies on how much credit to give and repayment terms and conditions
• Measures to control doubtful debtors (chasing, threatening legal action etc)
• Credit checking (only allowing credit to customers who can afford to pay!
• Selling off debts to debt factors
• Cash discounts and other incentives for prompt payment
• Improved record keeping – e.g. accurate and timely invoicing

One area you should be aware of is factoring. This involves the selling of debtors (money owned to the business) to a third party. This generates cash and it guarantees the firm a percentage of money owed to it. The downside to factoring is that it reduces income and profit margin made on sales. The costs involved in factoring can be high!

Managing Suppliers (trade credit)

Suppliers are important sources of finance for a business and key part of managing cash flow. "Trade credit" refers to amounts owed to suppliers for goods supplied on credit and not yet paid for. Delaying payment means that the business retains cash longer.

However, by delaying payment, the business has to be careful not to damage its credit reputation and rating. Trade creditors are seen (wrongly) as a "free" source of capital. Some firms habitually delay payment to creditors in order to enhance their cash flow - a short sighted policy which also raises ethical issues.

Managing Stocks (stock control)

Stock refers to goods purchased and awaiting use or produced and awaiting sale. Stocks take the form of raw materials, work-in-progress and finished goods.

Stockholding is costly and therefore it is sound business to:

• keep smaller balances (just in time stocks)
• computerise ordering to improve efficiency
• improve stock control

This will cut down the spending on stock but may leave the business vulnerable to "stock-out" (i.e. no stocks available to meet demand – which is bad news!)

The best way to improve cash flow is to have a reliable and up-to-date cash flow forecast. This provides the information which highlights the main cash flow issues.

In terms of actions which management can take, here are the main options:

Cut costs – by far the most important method of improving cash flow. Every business can identify savings in non-essential costs if it looks hard enough. The recent credit crunch and recession has proved that businesses can take drastic actions to cut overheads and other costs, which immediately reduces cash outflows.

Cut stocks: reduce the amount of cash tied up by buying and holding raw materials or goods for resale. This can be done by (a) ordering less stock from suppliers and/or (b) offering discounts on stocks held to encourage customers to buy (ideally for cash).

Delay payments to suppliers – a dangerous game, but widely used in business. By taking longer to pay bills owed, a business can reduce cash outflows (at the risk of damaging relationships with suppliers though).

Reduce the credit period offered to customers – this is easier said than done. By asking customers to pay for their purchases quicker, a business can accelerate cash inflows. However, there is no guarantee that customers will agree. They may need to be given a financial incentive, such as a prompt-payment discount.

Cut back or delay expansion plans – many of the biggest cash outflows occur when a business is expanding (e.g. opening new offices or shops, adding a production line or factory). By delaying this expansion, cash can be conserved in the short-term.