A successful business is not only having the right product or leading the market, there is also a lot going on behind the scenes and a great part of it is having a rigorous recordkeeping practice and a very solid cash flow. A healthy cash flow is not only a sign of a profitable business, but also businesses (especially smaller ones) need to prepare for future events; market changes and meet tax and other obligations. However, history has shown us that the lack of understanding of basic accounting principles have made small businesses fail. So here is a brief introduction on how to keep track of your cash flow.
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First, let’s define an operating cycle. It is the complete loop through which cash flows, from purchase of inventory through the collection of accounts receivable. It measures the flow of assets into cash and tells you the amount of time you should be able to finance, according to your operating cycle from purchase to receivables. This period of time should be carefully taken into account, especially since capital providers (most likely lenders) require a return on their investment; hence the longer the operating cycle, the more cash you need to minimize the amount to be financed without actually running out of cash.
Another reason for analyzing your cash flow is that it will show whether your daily operations generate enough cash to meet your obligations and if the more cash outflows actually mean major cash inflows from sales. In turn, these movements will determine if your whole operation cycle result in a positive cash flow or in a net drain. To avoid the latter, here are some recommendations to have a healthy cash flow to help make your company profitable, sustainable and, if it’s in your plans, bigger.
1. Plan ahead. Make sure you are aware and have an updated list of your financial requirements such as premises, equipment, staff and working capital. It is always safer to have enough cash at hand to meet next month’s cash obligations. That way you will ensure you can meet such obligations, and an accurate cash flow projection will help you identify and eliminate deficiencies or surpluses in cash and compare figures to those of past months.
2. For most startups and small businesses you will not need certified financial statement, compiled statements, which an accountant prepares with a letter stating that the numbers are based on the information you have provided, will be just fine. Keep frequent financial statements at least on a monthly basis in order to compare your income to that of previous periods. The ultimate objective will be to design a plan to provide a well-balanced cash flow, so when excess cash is revealed it could be that there is excessive borrowing or idle money that could be invested; or if on the contrary cash-flow deficiencies are found, business plans could be implemented to provide more cash.
3. Always keep an eye on key income statement percentages. For example if you are in the manufacturing business, the cost of your goods sold percentage should be more or less the same as the competitor’s.
4. Do not delegate the authority of signing checks or purchase orders. Always keep track of the cash outflow. And never use the money that you have withheld for payroll, sales or for other taxes. This money belongs to the Internal Revenue Service, Social Security Administration and your state’s sales tax authority and you will need it to pay your obligations to them.
5. Try to collect your receivables as quickly as possible. The longer it takes a firm to collect a customer’s unpaid balance, the more revenues it loses because it is less likely that you will receive full payment. But the faster you collect them, the shorter your operating cycle will be.
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6. Apply stricter credit policies to make more customers pay their purchases in cash to increase your cash on hand and reduce uncorrectable accounts. However, bear in mind that the tighter the credit, the less opportunity for clients to purchase your products or services; so keep an eye on how tight the rope must be to allow some room for adjustments.
7. One of the biggest weaknesses of small businesses is setting the price of their products or services. Pricing is the key element to getting a profit and having a good cash flow; so have a clear and complete knowledge of your product’s market, distribution costs and competition and monitor them frequently to make adjustments when necessary.
8. If necessary, take out short term loans such as revolving credit lines and equity loans to cover your cash flow problems.
9. Not all increase in sales actually means more cash flow. You may have sold on credit, meaning that your accounts receivable would increase but not your cash. It will take up to 30 days or more for receivables to be collected, and in the meanwhile your inventory will have depleted and will need to be replaced, leaving your company’s cash reserves quickly drained. Use a computer to help you track this critical data and give you time to consider those situations and be prepared.
10. And finally watch what you spend and why. Expenses should be carefully analyzed to make sure they are necessary and reasonable. When it comes to accounts payable, if a supplier offers you a discount for early payment, take it; but if there is no discount and you have 30 days to pay do not pay in a week. And whatever you do, always be aware of penalties for late payments and keep your credit record as clean as possible.