Solvency: Managing cash in small and medium businesses

The Australian Institute of Company Directors defines a business as solvent when its current assets equal its current liabilities, or when current assets, minus inventory, are at least half of current liabilities. Unfortunately, many businesses I visit sail very close to the wind, and some are in real trouble without fully understanding why.

A shortage in working capital becomes apparent when it’s difficult to pay employees and suppliers on time, or even maintaining good supplier relationships to preserve raw material supply for the business. The key is to maintain proper and planned cash management where cash outlays are delayed up to the maximum possible duration.

Concept: Cash Flow = Cash inflows – Cash outflows

Cash flow simply means the amount of cash remaining after all outbound payments are made from monies received. Positive cash-flow means that the cash received from sales is more that spent on salaries, expenses, and materials. Negative cash-flow is the opposite and often indicates some underlying problem, or could be a temporary setback.

Even profitable businesses can show negative cash-flows. Simply reviewing profit and loss statements is not enough, businesses need to consider several factors such as accounts receivable, inventory, accounts payable, capital expenditures, and taxation. A sound financial strategy involves regularly reviewing all of these factors along with the profit and loss statement.

To do’s for effective cash flow management

1. Always measure working capital. The key metrics are: the amount of inventory needed for safety stock, overdue invoices, tied-up cash in work in progress, and the time gap between collection and payment. An accountant will be invaluable in setting up a system and helping with reviews, but accounting software or the use of spreadsheets can assist tracking of cash-flows over set periods.
2. Financing assets. Using financial options comes at a cost but it does help keep cash within the business. There are two types of finance. Short-term financing can help with emergency purchases or minimise the gap between payables and receivables. Long-term loans should be strategic and used for such things as key equipment or real estate purchases.
3. Collect receivables early. A common mistake is to wait until end of month before having an invoice working bee. Invoices should be detailed, clear, and raised as soon as products are delivered. Progressive invoicing can be useful to some; the agreed terms include a deposit on signing a contract with progressive payments through manufacture to delivery. Waiting a long time for payment eliminates the time value of money and can risk default. Providing online links on invoices provides convenient options; offering early payment discounts may reduce collection times overall.
4. Manage inventory. Inventory takes up space and ties up cash, and if not effectively managed will result in a build-up of non-value stock (obsolete, bits and pieces, and damaged stock). A basic, but useful, tactic is to identify stocks that are unlikely to sell within the next 12-month period and gradually write them down, so spreading the expense over a longer timeframe. At low holding value any sales will translate to higher profit, or any liquidation of idle equipment and slow stock will not entail a once off high write off.
5. Be risk ready. For each business period a budget should be set and a cash-flow budget set up from it. Risks such as defaulters, cancellation of large orders (accounts), or receipt of a very large order should be considered. Conducting a simple risk analysis early will help guide a business as to the amount of buffer cash needed.
6. Keep personal and business affairs separate. It is unfortunately not uncommon that business owners treat their business as another credit card and many non-business-related assets are purchased through it. Maintaining a personal and business divide will make the business finances more transparent and this will assist if the business is to be sold; it also clears the way for much better business decision making.
7. Cut costs and grow cash. All variable costs can drift if not supervised, especially discretionary spending, and a firm stance on all supplier and employee negotiations is needed to ensure fair outcomes. The strategic purchase of equipment that drive cost savings with reasonable pay back times should be front and centre. Invest surplus cash in interest bearing short-term accounts.
8. Maximise cash inflows – minimise cash outflows. There are various methods used to maximise cash-flow: subscription models (prepayments), layby (receive goods only after full payment made), direct sales from stock (a credit card option is increasingly needed). But for most manufacturers it comes down to having well-managed and supervised accounts receivable and accounts payable procedures.

Profit has no meaning if the business has no available cash. Saving an adequate cash buffer helps the business stay flexible and open to opportunities as they present themselves. Lack of cash-flow management can see businesses borrowing just to maintain business functions where they should be on the lookout for competitive investments. Good cash-flow management provides the coverage that directors have done everything reasonably practicable ensuring their enterprise will not operate while insolvent.

Rob Murphy is a Business Adviser with AMTIL for the Federal Government’s Entrepreneurs’ Programme. To find out what the Entrepreneurs’ Programme can do for you, call 13 28 46 or visit www.business.gov.au/EP, or contact Greg Chalker on 03 9800 3666 or email gchalker@amtil.com.au.