Cashflow management - the basics

Overview

Balance sheets, profit and loss accounts, financial forecasts - all terms you will need to understand to run your own business successfully.

Managing the cash in and out of your business is basic but there are principles to follow. Financial and management accounts are more detailed and may require an Accountant.

For both, you still need to understand how much money you have, know how you plan to use it and make sure records are kept for payments in and out.

Cash allows a business to survive and prosper and is the primary indicator of business health.

While a business can survive for a short time without sales or profits, without cash it will die.

For this reason, the inflow and outflow of cash need careful monitoring and management.

This guide:

looks at the key elements of cashflow
looks at at how effective cashflow management will help protect the financial security of your business
outlines the steps that you can take when dealing with your customers, suppliers and stakeholders to improve cashflow
highlights common cashflow problems and how to avoid them

Cashflow

Cashflow is the measure of your ability to pay your bills on a regular basis.

It depends on the timing and amounts of money flowing into and out of the business each week and month.

Good cashflow means that the pattern of income and spending in a business allows it to have cash available to pay bills on time.

Your available cash includes:

Coins and notes
Money in current accounts and short-term deposits
Any unused bank overdraft facility
Foreign currency and deposits that can be quickly converted to your currency

It does not include:

Long-term deposits (if these cannot be withdrawn)
Money owed by customers
Stock

Difference between cash and profit

It is important not to confuse cash balances with profit.

Profit is the difference between the total amount your business earns and all of its costs, usually assessed over a year or other trading period.

You may be able to forecast a good profit for the year, yet still face times when you are strapped for cash.

The importance of cash

To make a profit, most businesses have to produce and deliver goods or services to their customers before being paid.

No matter how profitable the contract, if you don't have enough money to pay your staff and suppliers before receiving payment from your customers, you'll be unable to deliver your side of the bargain or receive any profit.

To trade effectively and be able to grow your business, you need to build up cash balances by making sure that the timing of cash movements puts you in a positive cashflow situation overall.

Bear in mind that having a lot of cash in your bank does not necessarily make good business sense.

If you do not need to use it immediately, put spare cash into an account where it will earn a higher rate of interest, or use it as capital for short-term investments.

Get advice from your bank, accountant or financial adviser.

Cash inflows and cash outflows

Ideally, during the business cycle, you will have more money flowing in than flowing out.

This will allow you to build up cash balances to plug cashflow gaps, look for expansion and reassure lenders and investors about the health of your business.

Income and expenditure cashflows rarely occur together, with inflows often lagging behind.

Your aim must be to speed up the inflows and slow down the outflows.

Cash inflows

Payment for goods or services from your customers
Receipt of a bank loan
Interest on savings and investments
Shareholder investments
Increased bank overdrafts or loans

Cash outflows

Purchase of stock, raw materials or tools
Wages, rents and daily operating expenses
Purchase of fixed assets - PCs, machinery, office furniture, etc
Loan repayments
Dividend payment
Income tax, corporation tax, VAT and other taxes
Reduced overdraft facilities

Many of your regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed dates.

You must always be in a position to meet these payments to avoid large fines or a disgruntled workforce.

Improve cashflow

To improve everyday cashflow you can:

Ask your customers to pay sooner
Chase debts promptly and firmly
Use factoring
Ask for extended credit terms with suppliers
Order less stock but more often
Lease rather than buy equipment
Improve profitability

You can also improve cashflow by increasing borrowing, or putting more money into the business.

This is suitable for coping with short-term downturns or to fund growth in line with your business plan, but shouldn't form the basis of your cash strategy.

The principles of cashflow forecasting

Cashflow forecasting allows you to predict peaks and troughs in your cash balance.

It helps you to plan borrowing and tells you how much surplus cash you're likely to have at a given time.

Many banks require forecasts before considering a loan.

Elements of a cashflow forecast

The cashflow forecast identifies the sources and amounts of cash coming into your business and the destinations and amounts of cash going out over a given period.

There are normally two columns listing forecast and actual amounts respectively.

The forecast is usually done for a year or quarter in advance and divided into weeks or months.

In extremely difficult cashflow situations a daily cashflow forecast might be helpful. It is best to pick periods during which most of your fixed costs, such as salaries, go out.

The forecast lists:

Receipts
Payments
Excess of receipts over payments - with negative figures shown in brackets
Opening bank balance
Closing bank balance

It is important to base initial sales forecasts on realistic estimates

All forecast figures must relate to sums that are due to be collected and paid out, not invoices actually sent and received.

The forecast is a live entity. It will need adjusting in line with long-term changes to actual performance or market trends.

Free guides to managing your cashflow are available at GOV.UK: Guide to managing cashflow.

Accounting software

Accounting software will help you prepare your cashflow forecast, allowing you to update your projections if there's a change in market trends or your business fortunes.

Planning for seasonal peaks and troughs is simplified and you can also make 'what if' calculations.

Most banks require profit and balance sheet forecasts as well as cashflow.

Many accounting packages will assist with preparing these documents.

Manage income and expenditure

Effective cashflow management is as critical to business survival as providing services or products.

Below are some of the key methods to help reduce the time gap between expenditure and receipt of income.

Customer management

Define a credit policy that clearly sets out your standard payment terms
Issue invoices promptly and regularly chase outstanding payments. Use an aged debtor list to keep track of invoices that are overdue and monitor your performance in getting paid
Consider exercising your right to charge penalty interest for late payment
Consider offering discounts for prompt payment
Negotiate deposits or staged payments for large contracts. It's in your customers' interests that you don't go out of business trying to meet their demands
Consider using a third party to buy your invoices in return for a percentage of the total

Supplier management

Ask for extended credit terms.

Giving your suppliers incentives such as large or regular orders may help, but make sure you have a market for the orders you're placing.

Alternatively, consider reducing stock levels and using just-in-time systems.

Taxation

You may be liable for several different taxes including income tax, corporation tax, VAT, business rates and stamp duty.

It is important to keep good records to help you calculate your liability and complete your returns accurately.

If you are registered for VAT, it makes sense to buy major items at the end rather than the start of a VAT period.

This can often improve your cashflow, because you can set the VAT on the purchase off against the VAT you charge on sales.

This may help plug a temporary cashflow gap.

HM Revenue & Customs (HMRC) has launched a support service to help businesses struggling to meet tax, National Insurance or other payments owed to HMRC.

If you are concerned that you may not be able to pay amounts that are owed or will soon be owed to HMRC, you can contact the HMRC Business Payment Support Service (BPSS). HMRC staff will review your situation and discuss temporary payment arrangements tailored to your business' circumstances.

You can contact the HMRC Business Payment Support Service Helpline on Tel 0845 302 1435 or visit HMRC: Starting up - Help & support.

Asset management

Consider leasing fixed assets like equipment, or buying them on hire purchase.

Buying outright can result in a huge drain on cash in the first year of business.

Using your cashflow forecast as a business tool

A cashflow forecast can be an invaluable business tool if it is used effectively.

Bear in mind that it is dynamic - you will need to change and adjust it frequently depending on business activity, payment patterns and supplier demands.

It's helpful to set up a regular review of the forecast, changing the figures in light of your sales, purchases and staff costs.

Legislation, interest rates and tax changes will also impact on the forecast.

Having a regular review of your cashflow forecast will allow you to:

See when problems are likely to occur and sort them out in advance
Identify any potential cash shortfalls and take appropriate action
Make sure you have sufficient cashflow before you take on any major financial commitment

Using a cashflow forecast to avoid overtrading

Having an accurate cashflow forecast will help make sure that you can achieve steady growth without overtrading.

You will know when you have sufficient assets to take on additional business - and, just as importantly, when you need to consolidate.

This will allow you to keep staff, customers and suppliers happy.

It is important that you incorporate warning signals into your cashflow forecast.

For example, if predicted cash levels come close to your overdraft limits, this should sound an alarm and trigger action to bring cash back to an acceptable level.

Ideally, you should always have a contingency plan, such as retaining a minimum amount of cash in the business, perhaps in an interest-earning account.

This money can be used to meet short-term cash shortages.

Refinements to a simple cashflow forecast

There is no single best way to set out a cashflow forecast.

However, some refinements to the most basic ways of setting out the information will give you a more sophisticated view of your business' situation.

You could separate cashflow for business operations from funding cashflow.

This gives a clearer picture of the actual performance of your business and is a format that many accountants prefer.

Cashflow from operations

Includes inflows such as:

cash sales
receipts from credit sales in earlier periods
interest on savings

Includes outflows such as:

payments to suppliers
hire purchase and lease payments
expenses - rent, rates, insurance, utilities, telephone, etc
wages
taxes and National Insurance contributions
interest on loans and bank charges

Funding cashflows