“Hope is not a strategy” – Various
There’s one thing about simple truths. The ones that really ring true have a resonance in more than one field of human endeavor. And when we consider the problems, misconceptions and frankly, wishful thinking, that surround the topic of cash flow, it’s no wonder some businesses wind up in a place more identified with an altogether different saying; “Abandon all hope, ye who enter here.”
While big businesses have the luxury of running on credit, small businesses run on cash. When cash position can be accurately projected and cash is plentiful, they run well. When cash is tight and projections are wishful thinking, then challenges can compound like a perverse form of interest.
Business owners and their CFOs or financial managers are tempted to believe if a business is profitable, then cash flow is assured. And yet, profitability is a snapshot in time, while cash flow describes the predicted movement of cash over a period of time.
As a result, improving cash flow must take into account several variables and requires some specific tools.
On-boarding: getting proactive about cash flow
You’ve heard the old saying: “Until the customer pays, a sale looks a lot like a gift.” Keeping your sales looking and, more importantly, acting more like sales and less like temporary gifts requires a functioning strategy for managing your Accounts Receivable and Accounts Payable cycles.
On the A/R side, proactive management begins with the installation of each new account. If you haven’t already set down a documented policy for establishing the creditworthiness of a new customer, you need to. Everything flows from this. It’s tempting to allow sales people to use their own judgment in on-boarding new accounts, just as it’s tempting to bend or break the rules “just this once.” It’s also a slippery slope and, in many cases, a long and painful one.
Get serious about this. At a minimum, your standard application for new accounts should contain your terms and conditions, a credit reference sheet and a request for contact information for key financial personnel. Actually checking the credit references should be standard procedure, especially the bank reference.
In today’s fast and loose economy, even companies that struggle to pay their bills can generally come up with several references that will vouch for their creditworthiness. This makes digging deeper all that much more imperative. Verify bank balances and length of accounts opened. Check the number of NSFs. Being systematic about the details will help you avoid failed expectations later on.
?On the A/P side of the ledger, set up a purchasing program that exudes professionalism while providing your suppliers with every bit of information they need to establish your company as a customer. The quality of your effort can make the difference between getting more favorable terms and being placed on pre-payment!
We strongly suggest developing a professional-looking credit package for potential suppliers that can be accessed at a moment’s notice. Your package should contain your credit reference sheet, including each of the following:
1. Bank and trade references
2. Dun & Bradstreet number
3. Key company personnel
4. Federal Employer Identification Number (FEIN)
In addition, you should be able to supply a W-9 and a sales tax exemption certificate. Next, draft a brief – preferably one-page – listing of your expectations of suppliers. This way, your vendors will know precisely what is expected of them regarding delivery, invoicing requirements, price discrepancies, order confirmations and any other item you deem critical to timely purchases.
A sound purchasing program also requires your company’s credit rating to be monitored though the major bureaus with corrective action taken if negative conditions appear.
Cruising: managing payments and collections
With sound A/R and A/P principles in place, now it’s time to switch to active management. How you answer the following questions will determine your effectiveness at being able to rein in cash flow problems.
• Do you extend to all customers the same terms, without opportunities for early payment discounts?
• Are your receivable terms typically longer than payable terms?
• Do you ever approach vendors about pushing for extended terms?
If you answered “no” to any of these questions, you’re likely missing an opportunity to positively affect your cash flow.
Proactive management means offering customers an incentive for early payment – maybe a 2% to 3% discount, provided they pay within 15 days. Yes, of course you are giving up a sliver of profit if they take advantage of the discount. But time is money. What you sacrifice on the top line will be outweighed by improved cash flow and less downtime accrued by your collections staff in calling overdue accounts. Likewise, consider using credit cards to extend the payment cycle for expenses and purchases. Suppliers may charge a nominal fee for this, but it can add 20 to 50 days to the payment cycle. That’s huge, not to mention the points you can earn and redeem. Finally, if you have suppliers with whom you’ve established credibility and have long-lasting good- standing relationships, simply ask them to consider granting another 15 to 20 days to current terms. After all, they know you’re good for it.
Now, inspect your company’s A/R collections policy. A good one has the following attributes:
Consistency. It’s either method or madness. Are your invoices followed up on in a manner that is both consistent and documented? For example, 1st notice by email after seven days; 2nd by phone call after 15 days; 3rd by credit hold after 30 days. Whatever process you establish, follow it.
Commitment. When collection problems appear, always get the customer to commit to a schedule or timeline. The payments can be small at first. But getting them back to the cycle of paying your company on a regular basis is imperative. Creditors that are heard from are creditors that get paid.
Discipline. Your charges should be in the terms and conditions you extended originally. Assess these charges and late payment fees for past due balances. Just do it.
Involvement. Get the service team involved. After all, it’s their customer. They have the relationship; they get the commissions; they have a vested interest in collecting the A/R. In addition, paying commissions and bonuses on paid sales only is a policy that focuses on a team-based and company-first culture.
Now, regarding payment. Still accepting just paper checks? There are a number of alternatives to paper that can speed up A/R. Consider switching to an invoicing or accounting program that allows customers to click on a link for an emailed invoice. This way, they can schedule payment via direct deposit or credit card. Offer a customer portal on your website that accepts bank or credit card payments. Any account that pays late should be placed on credit card-only terms to assure prompt payment.
Forecasting: using results to predict the future.
Accurate forecasting is a function of the frequency with which both A/R and A/P are reviewed by your team. If you review cash flow less frequently than twice monthly, you’re likely missing the opportunity to avoid a cash crunch before it happens. Again, an old adage holds true: “What gets measured, gets changed.” And what gets measured depends on the Key Performance Indicators (KPIs) you deem critically important.
Pick three to four KPIs, set benchmarks and be vigilant. Here are two that should be almost automatic:
1. Days Sales Outstanding (DSO). DSO = AR / last 12 months of sales x 365.
2. Days Payable Outstanding (DPO). DPO = AP / last 12 months of purchases x 365.
You should be able to see the relationship intuitively. If you can float your bills longer than your customers (DPO > DSO), cash will accumulate in your business. If your customers are dragging their feet, cash is flowing out the door. The bigger the difference, the faster cash is flowing either positively or negatively.
Your income statement can also provide some insight. If it shows reasonably high profits but you’re always pressed for cash, it’s a sign you have too much debt. You can verify this by calculating the following ratios:
1. Debt to Asset Ratio. Total debt / Total assets, should be below 40%
2. Debt to Income Ratio. Annual debt service payments / Total income, should be below 40%
If your company’s ratios exceed 40% in both cases, consider asking your creditors for more loan favorable terms, such as a lower interest rate, longer repayment terms or interest only payments. The key here is advanced and proactive communication with your creditors.
Navigating: avoiding the rocks and shoals
Accurate forecasting requires departments to collaborate to overcome challenges and boost cash flow. When addressed in a timely and systematic fashion, it facilitates planning for anticipated cash crunches so you can address the problem before it reaches you.
Too often businesses fail to look ahead using the proper instruments and tools for the task. Looking at the P&L statement, they wonder why they have no cash. The truth is, history cannot be relied upon as a valid guide for the future or even the present! A wise manager will solicit input from all departments, so he or she can forecast when a cash crunch is coming. It is much more difficult to navigate a cash flow problem once you are in its grip. Many of the reasons have to do with human nature. Employees, suppliers and customer are adept at detecting duress. People get nervous. In lieu of cash, rumors flow.
One last saying: “Cash is king.” Its proper management will pay off in preferred pricing and terms, bigger discounts and improved profits. Develop your strategies for cash flow management and follow them rigorously. Project from actual data. Your forecast is as good as, and only as good as, the data inputs you are using as sound predictive indicators on a timely basis.
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