In this article you will learn:

  • The difference between cashflow and profit
  • Why managing cashflow is critical for your business
  • Ways to manage cashflow

Prelude

When I worked in the Banking industry in the 1990’s, a lot of my time involved interacting with and supporting small to medium sized businesses. Quite often I’d come across businesses with decent profit margins that were struggling to survive without access to high cost cashflow funding, commonly known as an ‘overdraft’. The cash flow problem was due to the fact the timing of ‘cash in’ versus ‘cash out’ worked against these business, not for them.

Cashflow -v- Profit… and why managing cashflow is critical

Let’s use the the example of Sam, the small manufacturer of ‘marine grade rubber seals’ to help explain this; Sam can manufacture 1,000 rubber seals for $1,000. The $1,000 cost is made up from raw materials ($500) labour ($400) and electricity/rent ($100). Sam sells the rubber seals to his customers for $2,000. This means his profit is $1,000. Pretty good, right? Well, lets consider Sam’s cashflow during this process:
  1. Sam buys the raw materials on ‘payment within 30 days’ terms from his supplier.
  2. Sam pays his staff salaries on a weekly basis
  3. Sam pays his rent and electricity on a monthly basis.
  4. Sam’s customers have requested payment terms of ‘within 90 days’ which means they always pay 3 months after receiving the rubber seals.
So at the end of the first month, Sam is $1,000 in the red and has to wait another 2 months for his $1,000 profit! On this basis Sam is unlikely to survive… so what can he do?

Ways to Manage Cashflow.

  Careful use of Credit Cards: A usual ‘go to’ solution is to pay major bills (suppliers, rent, electricity) via credit card and utilize the ‘55 day interest free’ period (depends on the bank, but it's usually 55 days). For example, if Sam pays the suppliers on ‘Day 30’ via credit card, he has an additional 55 days to pay off the credit card debt . This gives Sam a total of 85 days cashflow coverage for no additional cost. Of course, it is critical that Sam pays off that debt as soon as his customer payments come through!   Obtain more formal ‘cashflow finance’ from a bank, commonly known as an Overdraft: Providing the bank with copies of the Customer and the Supplier Contracts, along with the salary, rent and electricity details should be enough evidence to show that Sam has a profitable business, but an unhealthy cashflow. As the months and years roll on, Sam should build up enough cash reserves to reduce the need for cashflow finance.   Renegotiate Terms with Suppliers and Customers: Imagine how good it would be if Sam could be paying his Suppliers on 90 day terms and his Customers were paying on 30 day terms? His Suppliers and Customers might consider renegotiating Terms if Sam offered some incentives, such as slightly higher payment to Suppliers and price discounts to Customers. It would be critical for Sam to understand what type of incentives are important to his Suppliers and Customers prior to commencing negotiations… knowledge is power!   In summary, it is critical that a business accurately forecasts the ‘cash in-out' cycles. The cycle can be weekly or monthly, whatever cycle that suits your type of business . This information will help you keep your business healthy and help you build a war chest for future investment opportunities!