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Part 3: Cash Flow vs. Income and the Working Capital Cycle

22 May

Often when discussing their finances, small business owners regard income and cash flows as one in the same.  In many cases this is true just by the nature of how they collect payment for a sale.  The difference is really about timing. The important factor is that sales revenue is the actual sale or provisioning of goods and services that is recognized as the exchange happens.  Cash for that revenue may or may not be exchanged at the same time the goods and services are given to your customer.

So, for instance, you made that great sale to the giant media company today for $100.  Today you have sales of $100. The invoice for that sale says payable in 30 days. You will have cash flow 30 days from now for $100, today your cash flow is 0$.  However, if you own a coffee shop and get cash every time you hand out a cup of coffee, your sales will equal cash inflow.

Yes, cash flow and income are different. Cash flow is the money that flows in and out of the firm. While income or profit, is what remains from sales revenue after all the firm’s expenses are subtracted.

It’s important to realize that you can show a nice net profit today, but can’t pay your employees because your cash flow is negative.  Not recognizing this difference is one of the biggest mistakes a small business owner can make.

This leads us to the most important thing every business manager should understand: The Working Capital Cycle.

Working Capital CycleCash flows in a company are best described as a cycle.  Sales beget cash to pay employees and buy materials to create more products to get more sales to generate more cash.  The better you are at keeping this pin wheel turning, the faster your business grows.  Consequently, the faster your business expands, the more cash it will need.

The cheapest and best sources of cash exist as working capital right within your business.

Managing the amount of time between the moment when your business begins investing money in a product or service, and the moment the business receives payment for that product or service is the working capital cycle. For instance, inventory can be looked at as potential energy stored in your company. The cash used to buy or make the inventory is stored until it eventually converts into product sales.

The cycle balances two halves: cash absorbing elements such as inventory (stocks and work-in-progress) and receivables (debtors owing you money); and cash releasing elements like payables (your creditors) and financing (equity or debt). If you collect payments later, more cash is locked up in receivables, paying your suppliers later frees up cash, collecting receivables faster releases cash from the cycle.

Good cash flow comes from a short working capital cycle. For example, if you pay your contractors every 30 days but takes 60 days to collect from your customers; you have 30 days of working capital to fund.  Business growth is dependent on cash, or access to cash.  If a company can’t free up the cash from its working capital it will have to pursue other sources of finance, such as loans.

None of this is really ground breaking stuff, but those that can manage this cycle well, especially the early days of a business, increase their of success chances tenfold.

Bilbus is a working capital hub that enables small businesses to invoice, collect and connect with commercial lenders via a single dashboard.

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Cash Flow Series Part 2: Cash Flow Model

15 May

Cash Flow modeling is pretty much another way of measuring different scenarios to estimate cash flows.  It’s an important tool for investigating whether a project or business is viable. It’s as simple as sitting at the table with paper and a calculator and going through your lists of income and expense.  However, you will want to have a tool that is flexible enough to allow you to experiment with different factors so you can make decisions quickly.  The common method today is using a spreadsheet like excel, that lets you input different variables quickly.  This works pretty well when your information is relatively static and you don’t have to recalculate new inputs every time. Later we’ll discuss more about automated tools.

But let’s go over the basics first, below is an example of a cash flow forecast table from Bilbus.

The model is straightforward and can be copied on a spreadsheet.  The basic factors are capturing timing, income and expenses and placing them in manageable groups.

Cash Flow Forecasts can be setup with the following elements:

  1. Column headings for periods to measure (months or years).
  2. Rows grouped to cover:
    1. Inflows:  expected collections of invoices, spot sales, credit card receipts, and sources of finance, Inflow subtotal
    2. Operating Outflows: costs that are due to be paid in the future, including:  payroll, rent, utilities, suppliers, etc.
    3. Debt service and other capital changes such loan principle and interest payments or owner’s draw on equity or dividends.
    4. Calculation of the net cash flow for the period  (Inflows-Outflows)

An additional view is looking at the cumulative cash to show whether your total cash is decreasing or increasing over time.  That’s done by starting with the previous periods ending bank balance and adding the current periods ending cash flow.  Models are simple enough, but now you need to understand what they are saying.

Next: Cash flow versus Income and the Working Capital Cycle.

Bilbus is a working capital hub that enables small businesses to invoice, collect and connect with commercial lenders via a single dashboard.

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Part 1: Cash Flow Forecasting, big or small it still works the same

8 May

When I was young, I asked a mentor about some advice for starting a business. He started out with usual the romantic view of entrepreneurship and its rewards, but quickly, he brought it all down to a simple phrase: “sign every check”. Emphasizing an important fact of life for every business owner: you have to know your cash flow.  The challenge of knowing your cash is in the timeliness and accuracy of the data you use to forecast cash flows. Visibility of that data will directly affect the outcomes of your business.

In a basic sense, the process of cash forecasting is simple.  Figure out when cash is coming in and plan for when to pay your suppliers.  Mostly this is done with a spreadsheet with some sort of back of the envelope calculation. Depending on your business, this is done daily, weekly or monthly.  Getting the details right is what allows you to make good decisions or bad guesses.

In managing my own small business, I surprisingly found that the processes for managing cash I followed as treasurer in a large company were easily applied to my daily activity.  The routine can be broken down into a few steps:

  1. Check your bank balances everyday; see what payments have come in, verify what payments have gone out.
  2. Review the latest account receivable report to see what is due and reconcile with what came in.
  3. Talk to your customers. Verify that they got the invoice, its approved, and when the payment is going to be made.  Or, many cases, ask them to take it out of the desk drawer and submit it to Accounts Payable.
  4. Adjust your cash flow model (spreadsheet or back of the envelope)
  5. Plan when and what you need to pay to your suppliers.  No worries about forgetting payments because most likely, your vendors have already called to remind you.

As the organization becomes more complex, you’ll have to worry about additional things like currency exposure, cash pooling, and the effects of the capital markets.  But for now, how frequently you are able to perform the process above helps you stay in control and avoid the many cash emergencies that plague small and medium sized businesses everyday. In my next post I will discuss more about how to build your cash flow model.

 

Bilbus is a working capital hub that enables small businesses to invoice, collect and connect with commercial lenders via a single dashboard.

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