How To Improve Cash Flow Management In Businesses
Cash management may not be the most exciting part of running a company, but it is a powerful practice that can make or break a business. Company chiefs, financial managers, and accounting teams must have a strong grasp of cash management principles and must always maintain an awareness of the business’ cash flow.
Cash flow reflects the net amount of money coming in or going out of a business. Businesses must balance their operating, investing and financing activities to keep their company afloat. Cash shortage, after all, can hamper business operations and hinder growth. It can cause business owners to make short-sighted decisions and hurt the business in the long term.
To improve cash flow management, business leaders can:
- Digitalise their accounting process
- Keep an eye on their cash conversion cycle
- Reduce the risk of credit sales
- Strategically assess potential investments
- Measure their liquidity position.
Tech to Automate Accounting
Whatever the scenario, businesses should get started by analysing their cash flow statement. If their accounting system still involves plenty of paperwork and manual processes, they should consider investing in cloud-based software that gives them broader, real-time visibility into their finances across all departments.
Modern types of cloud-based accounting software come with interfaces that allow them to interact with other applications. These include software for banking, payroll, sales, and even project management for specific industries. They also feature business intelligence tools, allowing companies to analyse their financial position in detail and identify trends in their cash flow.
Businesses can analyse the cash flow by highlighting the items that show large cash outflow and determine their reasons. For example, if they see a large cash outflow on increased inventory purchase, they must check whether the money spent on increased inventory is linked to an expected increase in sales or not. If it’s not the case, then it could suggest that they are overspending on stocks.
Maintain Visibility with the Cash Conversion Cycle
The cash conversion cycle is the time taken by a business to convert the money spent to create inventories to cash received from sales. Businesses should closely track their account receivables, account payables, and inventories to keep track of cash going out and coming in.
One common cash flow problem lies in the gap between selling products on credit and having to pay suppliers immediately for the goods. If debtors’ credit term is longer than suppliers’, businesses may have to match the balance by cashing out their reserve. This may possibly lead to poor cash flow.
Companies can use accounting software to generate accounts receivable and payable aging reports that give them a better visibility on their collection timeframe. This can help them strategically negotiate transactions terms to have a greater cash efficiency.
Reduce the Risk of Credit Sales
If the nature of the business involves selling goods and services on credit terms, it must bear the risk of debts not being paid. Some debtors also aim to overextend their credit period, leading to a shortage of cash. To beat these odds, one ideal solution is invoice factoring.
Businesses can sell their invoices to a factoring company to raise cash. The factoring companies will pay 80 to 90 percent of their invoices up front. The business can use this immediate cash to pay their suppliers, accommodate business expenses, and keep the rest on reserve. As a whole, their cash conversion cycle will be shorter, allowing their new inventories to turn to cash more quickly.
Factoring can also have a non-negligible impact on the balance sheet. Non-recourse factoring could be considered as a true sell depending on the applicable accounting rules the company follows. A true sell transaction could then be regarded as “off-balance sheet financing” meaning the seller can remove the receivable sold from his balance sheet and can book the cash received from the payment as cash. The advantage of this accounting treatment is an improvement in liquidity while not adding liabilities on the balance sheet.
As opposed to non-recourse factoring, full recourse should be considered as a loan because the seller keeps the ownership of the invoice. The company will still benefit from an increase in cash and a new liability after the transaction is financed.
Moreover, factoring is often offered with the added benefit of credit insurance. Credit insurance not only mitigates the debtor’s credit risk but also works as a deterrent to delay payments: corporates do not want their credit rating tarnished by a delayed payment reporting to the insurance company.
Apart from invoice factoring, businesses can raise more funds to fill the gap of credit sales by using debt financing tools such as a line of credit. Outside of debt, another way to raise funds is through equity by selling new shares to new or existing shareholders. A business can also look internally to raise cash by lowering expenses through cutting non-vital charges and trying to raise revenue with a pricing audit.
Consider Investments’ Net Present Value & Payback Period
The correct way for a company to increase its earnings is to make investments that have a Net Present Value (NPV) greater than zero. To calculate NPV, subtract the amount of the initial capital required for the project from the value of net cash inflows. (This would be based on the cash inflows that the project is expected to generate.)
Based on the NPV principles, businesses should make investment decisions depending on how much profit they will yield, as well as on the cost of capital. However, the payback period of the project is also an important factor.
The cash going out should be recovered within a reasonable amount of time that allows the business to reduce their risk of cash flow shortage. A long payback period means it will take time for the money going out to bring in profit. In the meantime, the business will have to resort to other alternatives to generate cash for everyday expenses.
Check on the Firm’s Liquidity Position
Liquidity ratio refer to the speed the firm can turn its current assets to cash to meet short-term debt. If businesses have a healthy liquidity position, they have a higher chance of avoiding a cash flow shortage. It is thus crucial for businesses to keep an eye on their liquidity level to prepare for possible adverse conditions such as a labour strike or an economic recession.
One sure way to measure liquidity is to calculate the following three ratios and assess their results.
1. Current Ratio
It reflects whether the business has enough current asset to cover its current debts by dividing all current assets with its current liabilities.
2. Quick Ratio
Quick ratio also known as “acid test ratio”, as it evaluates the business’s ability to cover its short-term debts with its most liquid assets. The calculation for this ratio is the same as the current ratio, the only difference being that they exclude inventory while calculating current assets as they are not as easily cashable as other current assets.
3. Cash Ratio
Cash ratio gives the ultimate picture of liquid cash in the business to cover the debts. Hence, this ratio takes only cash and cash equivalents such as bonds and marketable securities when calculating current assets. The business then divides the current assets with the current liabilities to see whether it has enough cash to pay off its short-term debts.
For all three ratios above, the higher the ratio, the better their liquidity. That means the business has increased assurance that it has enough liquid assets to cover its short-term debt liabilities. Too high liquidity may also show that the firm don’t use efficiently it’s current asset to generate revenue. A business should therefore compare his ratio with his industry average and taking in account the economic cycle.
Know What Businesses Can Leverage
The first step for businesses to improve their cash flow is to leverage technology to have visibility on their cash movements. This will enable them to manage their cash conversion cycle by taking relevant actions to turn faster their inventory into revenue. This increase in cash will help them consider new ventures. While taking on new investments, they must evaluate the project’s worthiness by looking at the NPV and payback period of the projects.
Finally, as businesses have constant streams of cash going in and out, they must measure their liquidity at frequent intervals to keep informed of their liquidity position. This will place them in a strategic position to maintain a healthy cash flow.