Importance of cashflow management when a business is growing

16th February 2016

Cash flow is the lifeblood of all businesses and is the primary indicator of business health. It is generally acknowledged as the single most pressing concern of most small and medium-sized enterprises (SMEs), although even finance directors of the largest organisations emphasise the importance of cash, and cash flow modelling is a fundamental part of any private equity buy-out.

Cash needs to be monitored, protected, controlled and put to work. There are four principles regarding cash management:

  1. Cash is not given. It is not the passive, inevitable outcome of your business endeavours. It does not arrive in your bank account willingly. Rather it has to be tracked, chased and captured. You need to control the process and there is always scope for improvement.
  2. Cash management is as much an integral part of your business cycle as, for example, making and shipping widgets or preparing and providing detailed consultancy services.
  3. Good cash ow management requires information. For example, you need immediate access to data on:
    • your customers’ creditworthiness
    • your customers’ current track record on payments
    • outstanding receipts
    • your suppliers’ payment terms
    • short-term cash demands
    • short-term surpluses
    • investment options
    • current debt capacity and maturity of facilities
    • longer-term projections.
  4. You must be masterful. Managing cash flow is a skill and having a grip on the cash conversion process will yield results.

Cash management, credit and overtrading

During a credit crunch and recession, every business needs to monitor cash flow. Where it is poorly managed, even a company’s successes can lead to its own downfall. Simply put, big new orders require you to pay for new plant, extra workers and additional stock before your brilliant new customer settles their invoice, resulting in you running out of cash. Hence the term ‘insolvency by overtrading’. It is surprisingly common to hear people say, `everything was all right until we got that large order’ or, having just suffered insolvency, `next time I will keep the business small’.

Working capital

Working Capital relates to the amount of cash tied up in the business’ trading assets. It is usually calculated as: stock (including finished goods, work in progress and raw materials) + trade debtors – trade creditors. It is made up of three components:

  1. Days sales outstanding (DSO, or `debtor days’) is an expression of the amount of cash you have tied up in unpaid invoices from customers. Most businesses offer credit in order to help customers manage their own cash flow cycle (more on that shortly) and that uncollected cash is a cost to the business. DSO = 65 x accounts receivable balance/annual sales.
  2. Days payable outstanding (DPO or creditor days) tells you how you’re doing with suppliers. The aim here is a higher number, if your suppliers are effectively lending you money to buy their services, that’s cash you can use elsewhere in the business. DPO = 65 x accounts payable balance/annual cost of goods sold.
  3. Finally, your days of inventory (DI). This is tells you how much cash you have tied up in stock and raw materials. Like DSO, a lower number is better. DI = 365 x inventory balance/annual sales.

Cash conversion period

The cash conversion period measures the amount of time it takes to convert your product or service into cash in flows. There are three key components, which will be familiar as constituents of working capital.

  1. Inventory conversion – the time taken to transform raw materials into a state where they are ready to fulfill customers’ requirements. A manufacturer will have funds tied up in physical stocks while service organisations will have funds tied up in work-in-progress that has not been invoiced to the customer.
  2. Receivables conversion – the time taken to convert sales into cash.
  3. Payable deferment – the time between taking delivery of input goods and services and paying for them.The net period of (1+2)-3 gives the cash conversion period (or working capital cycle). The trick is to minimise (1) and (2) and maximise (3), but it is essential to consider the overall needs of the business.

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