As a small business owner, you need to understand your cash flow and forecast it to ensure your business always has sufficient liquidity. Cash is the lifeblood of business, it doesn't matter if you're a sole trader or a limited company. Even profitable companies that do not manage cash flow can fail, often unexpectedly and with alarming speed.
Without cash and liquidity, eventually, a good business will be starved, fail to meet its commitments, and be forced into liquidation. It may seem paradoxical, but you can be profitable and still go out of business. Or you can make massive ‘bottom line’ losses but be in good fiscal shape. The reason is cash. This is the reason that cash flow management and forecasting are core to our virtual CFO services.
Most businesses focus on turnover. Good businesses focus on profits. High growth businesses may choose to forgo current profits to buy growth, but there should still be an understanding of what the underlying profitability of the business is. The best businesses, whether small or large, also focus on cash flow both now and forecast into the future. In order to successfully forecast cash flow, you need to understand your liquidity.
What is liquidity?
Simply put, liquidity is your company’s ability to satisfy its immediate and short-term debts and obligations. The liquidity of an asset has to do with how quickly it can be turned into cash; therefore, a customer debt to be repaid within 30 days is much more liquid than a property that could take months or even years to sell. So when looking at overall liquidity, we are looking at current assets and current liabilities.
There are measures to track liquidity, such as:
- Current ratio = this is a measure of current assets to current liabilities. Any result over 1 means positive liquidity, and the higher the number, the stronger liquidity is. However, this is a snapshot of assets and liabilities at one point in time, but it can take up to a year to turn all the assets into cash so they can pay the liabilities. What if liabilities come due before assets can be converted?
- Acid test = Stock can take a while to convert to cash as it needs to be sold first, and then could be converted to a receivable before finally being converted to cash. The acid test removes stock from the current assets to then measure against current liabilities. This can give a shorter-term view of liquidity. Is the result still 1 or higher?
Evaluate your current position
Is your cash flow positive or negative? Are you struggling with late payments? If cash flow is negative, is it putting your long-term viability at risk?
Cash is not a particular concern at the moment
If this is the case, then that’s great. You will probably have other issues that require your attention, but it is still important to forecast cash flow to ensure there will be no problems on the horizon. If there are, then you will have plenty of time to address them.
I do struggle with cash
If cash flow is a problem, then there are actions you can take to improve it. As improving liquidity will improve cash flow, you can take action to make assets more liquid. For example, if you offer credit terms to your customers, you can reduce the number of days credit you extend.
You can also offer card payments or Direct Debits to get customer payments faster. If you use Stripe or PayPal for card payments, they will both integrate directly to Xero Accounting for easy and streamlined processing and transaction posting. Similarly, Direct Debit collections can be simple to setup with GoCardless and it also integrates nicely with Xero Accounting. If you have troubles with customers paying on time, you can implement credit control procedures to help get payments in. There are apps that assist with this as well, such as Chaser.
On the flip side of the coin, there are measures you can take to extend the time liabilities are due. For example, you can negotiate extended supplier credit terms that help cover the time of holding stock as well as the time to get paid by your customers.
Cash analysis
Now it's time to get a real understanding of your Cash flow.
Statement of cash flow
Start with this report to see where cash has come in and been used in the past and up to last month. It can give great insights on the current cash position of your business.
Cash flow forecast
From the current position, we look forward using either your budget, or a forecast based on past results. We then create a statement of cash flow using the forecast results to determine your future cash position over time.
Sensitivity analysis
You may be thinking, how can you tell what my future is going to be? In truth, we can’t. The future is unknown, but that does not mean that we should not apply the best knowledge we have about your business to create a likely future outcome. It’s no crystal ball, and will not tell you what your future will be, but it does give an indication of things to come.
The way to help overcome the unknown of the future, is to create scenarios to see what would happen in alternative situations. We tend to look at pessimistic situations as we prefer to hope for the best, but plan for the worst. It is a good idea to create scenarios to show what would happen to cash flow if say sales reduced, or costs increase. That way you can tell how much the situation can change before you have cash flow issues to manage.
Goals and strategy
What are you trying to achieve over the short-term and long-term? Do you have strategies to reach your goals? Is there sufficient capital to carry out the strategies? Does your current financial health enable or restrict reaching your goals?
Once we have prepared cash flow forecasts, we then meet with you to discuss your goals, what strategies to put in place to meet those goals, and the capital requirements to carry out the strategies. It is important to not just blindly rely on your business’ working capital to pay for new strategies. We will create new scenarios to forecast cash flow with the growth plans included, to see how well the business can fund the plan. If there will be a cash shortfall, it is best to know before you start, and we can discuss how to attain the capital your plan needs to be successful.
Depending on the situation and need, there are various ways to provide a capital injection to a business. For grand ambitions, you may need to look at venture capitalists or private equity firms, which will likely mean giving up part of your business to someone else. For smaller requirements, you can look at different types of debt such as an overdraft facility, invoice finance facility, or a bank loan.
Implementation
With your new business plan, it is time to carry out your new strategies, which may include arranging whatever capital you have decided is best for your business.
While carrying out your plan, we continue to monitor your business’ progress by creating a new cash flow statement and updating your cash flow forecast on a monthly basis to ensure everything is going to plan. Where something is not working as you expected, it is important to identify it quickly, so we can come up with a solution to rectify the issue. This may mean making tweaks to your business plan, but it is better to keep a close eye on progress and make necessary amendments, than to just carry out a plan as was originally decided. No plan will be executed flawlessly.
A good adviser
As a small business owner, you may feel like you need to be a jack of all trades, but if you have plans to grow your business, there are areas that really pay to have a good adviser. To carry-out a growth plan, it is very important to understand the financial situation of your business on a regular basis. Our accounting services for small businesses help ensure that not only do they avoid over-trading (growth that uses cash faster than it can produce cash), which can make a business fail, but also help manage cash to ensure the business is able to carry out its plans successfully. If you have ambitions to grow your business, or just struggle with cash, we would be happy to discuss ways in which we could help your business succeed.