Many businesses fail from lack of ready cash, even though their profitability is good. Profits give a business strength and allow it to grow. Cash is the lifeblood of most businesses -- if the flow runs dry, the business dies. This guide explains what cashflow is and how to keep it under control.

Profit vs cash

Profit and cash are related but they are two distinct things. In some ways they represent the difference between the theoretical and the practical sides of business – between the long and the short term. Profit is the balance between sales and expenses, whereas the cash balance is the difference between receipts and payments. There are several reasons why these are not the same.

The first is a question of timing. While you may have sold a widget today, you may not be paid until next month. Conversely, you might have bought a large quantity of widgets yesterday for stock, and to get a better discount, you paid cash. But today, where will you find the money for wages until the rest of the widgets have been sold – and paid for?

Secondly, some things that may cost lots of money do not appear on the profit and loss account (P&L). These include machines and other capital items.

In practice, for a small business, cashflow forecasting is almost more important than planning or budgeting for profit, since cashflow dictates the very survival of the business in the short term.

Why businesses fail

Many businesses fail because they cannot pay their bills, or wages, despite often having full order books. This is almost always down to poor management and, in particular, poor control of cashflow. The main reasons for running out of cash include:

• Allowing too much credit to customers for too long.
  
• Growing too fast, especially in people and sales, in relation to available cash.
  
• Investing too much in stock, especially in slow-moving items.
  
• Spending too much on capital equipment, computer systems or other fixed assets, by doing so depleting cash reserves.
  
• Not planning for seasonal variations where payment or receipts come in short bursts, often far apart.
  
• Over-committing your business with credit from suppliers.
  
• Withdrawing too much salary in good times and not leaving enough for taxes, VAT, rent and so on.

The surest way, if not of avoiding problems, at least of foreseeing them and preparing for them, is to prepare a cashflow forecast. This is simply a chart of what you expect your incomings and outgoings to be over the next year.

Consider what your costs will be. Some things will be precise, such as rent, wages and PAYE. For other items, make your best guess. Most of these receipts and payments will be staggered before or after the actual sale or purchase of items.

You need realistic forecasts of the following things for each month:

• Your opening balance – the money you have in your bank account at the beginning of the period.
  
• Cash sales.
  
• Cash from debtors – payments for items sold on credit last month, and in the previous month. Always over-estimate how long it will take to get paid. If you offer 30-day payment terms to customers, plan for payment within 60 days.
  
• VAT on sales (if you are VAT-registered).
  
• Other income including sponsorship and sale of assets.
  
• Payments to creditors.
  
• Payments to employees, including yourself.
  
• Rent and rates.
  
• Utilities – usually quarterly in arrears. Remember to account for increased heating in winter.
  
• Telephone bills, usually quarterly in arrears.
  
• Postage.
  
• Professional fees – for example, your accountant’s annual bill.
  
• Office running costs, including cleaning.
  
• Capital expenditure – say to buy a new computer – and lease payments.
  
• Bank fees.
  
• VAT on payments, duty on imports, and PAYE payments to the Inland Revenue. If you are self-employed or a partner, you will also have to make payments in January and July. Don’t forget corporation tax nine months after your year-end.
  
• Don’t forget to cost in one-off special items, such as the cost of exhibiting at a trade fair.

Closing balance = opening balance + receipts – payments.

What a cashflow forecast tells you

Cashflow forecasts help you plan ahead. For example, are there any horror months when a group of big payments comes together and wipes out your cash balance? If so, can you reschedule any or negotiate better terms before you buy? If not, it may be time to discuss an overdraft to cover the shortfall.

Shortfalls are common in some types of businesses, especially if they are seasonal or a big project is planned. If your business manager sees you have projected the cash deficit well in advance, and can see exactly how long you expect it to last, they will be much more supportive than if you rush in at the last minute in a panic.

Trends, particularly negative ones, are another thing to look for in your cashflow. Most businesses dip up and down, but if each successive dip is lower than the last, then there are clearly long-term issues to be addressed.

So what can you do to improve cashflow in an otherwise profitable business?

Get the cash in

State your terms clearly before the sale. You cannot be angry with someone who doesn’t pay within 30 days if you didn’t agree this in advance.

Draw up some standard Terms and Conditions (T&Cs) and draw customers’ attention to them before you close the sale. Ideally, ask customers to sign these.

If a customer goes out of business before paying up, you may be able to reclaim your goods if you have a Retention of Title clause in your T&Cs. Include a clause in your terms that states that the goods remain yours until you are paid in full.

Invoice promptly

The best way to be paid earlier is to invoice earlier. Send out your invoice with the goods or in the post the same day. Don’t wait until the weekend – or worse, until the end of the month. That way, it goes into the next month of the customer’s paying cycle.

Chase debtors

Almost all regular income comes from sales. It would be great if they were all cash sales but often they are on credit. In other words, you are lending your customers your precious money, interest-free, with little incentive to pay quickly. Moreover, the longer you leave a debt uncollected, the more chance there is of it becoming a bad debt.

Most customers are honest and well-meaning, but lazy when it comes to paying. Your first duty is to chase all debts promptly and firmly. Set up a procedure that is activated the moment you sell something on credit and tracks the money owed to you until you bank the cheque. Don’t become a nuisance or be aggressive, but make sure that anyone who hasn’t paid on time knows it and knows that you will keep on chasing them. Nobody likes being chased and so they are more likely to pay up if you are efficient about chasing outstanding bills. People respond best to a professional, polite approach.

Charge interest

By law, all businesses may now charge interest on overdue accounts. Make it clear that you intend to exercise this right by putting a suitable clause in your terms and conditions. The threat of having to pay interest is often enough to prompt payment.

Offer discounts

There is no obligation to offer credit to customers, though this may be the accepted norm in many industries. Consider offering a small discount for cash on delivery or even payment within, say, seven days. For a customer, this is well worth taking if they have the cash. And it saves you the cost of sending statements and chasing the debt.

Encourage part payments

For larger orders or projects, negotiate stage payments – say a third on acceptance of an order, a third on delivery, and a third within 30 days. This has two main benefits: you get more of your money sooner, and the first part goes a long way towards paying for the materials or other external expenses.

Pay out

The reverse of these tactics applies when it comes to paying out – you need to play the system to your advantage.

Order tactically

Find reliable suppliers and operate ‘just-in-time’ ordering practices.

Negotiate hard

Negotiate longer credit terms. Alternatively, when you have a cash surplus, ask for a discount for early payment. Or agree stage payments to smooth out your cashflow.

Planning for the inevitable

There are certain creditors whose demands are predictable and cannot be delayed. These include the Inland Revenue, Customs & Excise and your staff. So be sure you set aside enough each month to pay these bills promptly.

Seasonal woes

Many businesses are seasonal. This creates real cashflow problems because stock must be bought in long before it is sold. Also, expensive staff may be under-used in off-season periods. Plan what you will do to fill these gaps. Think laterally about what other markets you could tap with your same skills. For example, one landscape gardener found winter to be a dead period, until he expanded into woodland management. He realised that trees are planted in winter.

On the other hand, when you have a glut of income, transfer your surplus into a high-interest savings account until it is needed.

Increasing working capital

Working capital is the day-to-day pool of money available to run your business. This comprises debtors, creditors and cash in hand. To get your business started you, and any fellow investors, put in some cash and hopefully the pool grows from profits.

Working capital is one step back from cash but still a measure of the health of the business. There are several ways to increase it:

Overdrafts

An overdraft is often the easiest way to meet a temporary deficit. These are easier to obtain if you have planned for them in advance, and can show your bank how you will repay the money.

Factoring

This is where you ‘sell’ your invoices to a factor, which pays you a large proportion of the face value in cash immediately, with the balance (less charges and interest) when the bill is paid. This means you get rapid access to the cash and someone else manages your debt collection.

Leasing

Buying equipment ties up capital. However, you can lease almost anything from desks to computers and vehicles. While this may be more expensive, it does not cause a sudden drain of capital and your outgoings are predictable. It may be better to pay the extra money on leasing equipment, and use that working capital on marketing.

Profits

Profits are an obvious source of capital and are interest-free. Avoid the temptation to spend all your profit on new equipment or other assets. Equally, don’t remove too much as drawings or dividends.

Equity capital

You may be able to raise additional capital from the original investors, or find new shareholders among friends or family.

Alternatively, looking for a professional investor such as a venture capitalist or a business angel may be the answer, especially if you can show your business will grow rapidly and healthily. Equity investors expect a large and fast return on their money, however, and this does not suit many ‘lifestyle businesses’. The catch with major investors is that they may also want a say in the management, if not the actual control, of the business.

The causes of cashflow problems

If cashflow remains a problem after you have addressed the basics outlined above, your business may have a more serious underlying problem…

Low margins

It is all very well selling large volumes, but if you’re pricing your products too low – and hence not producing significant profit margins – your business will always bump along the runway without ever taking off. And eventually you’ll run out of runway. Moreover, with low margins you have to sell much higher volumes to make healthy profits. Hence it is almost always better to sell less at a higher margin.

Low sales

Low sales are clearly going to have a negative impact on your cashflow. Apart from ensuring you do enough marketing, look at strengthening your sales force, possibly by using an external agent on commission.

Rather than taking the obvious route of dropping prices, and hence margins, to encourage more people to buy, revisit your marketing strategy and look where you can add value. This may cost you little in real terms but can have a high impact. For example, you may find that offering free delivery and installation, which may cost you some hard cash, is highly valued by your customers, so you land more sales that far outweigh the additional costs incurred.

Too high costs early on

A high break-even point can sometimes prove too much to overcome. It is all too easy in the early days to set up a structure that you ‘plan to grow into’. Say, for example, you acquire expensive offices, hire lots of staff, contract with various professional advisers and so on. When the sales are slower to come in than expected (as they often are) you still need to pay the overheads and all the camp followers.

If that is your situation it’s never too late to cut back on all extras, slim down, outsource functions, sub-let space – whatever it takes – to reduce costs.

Overspending

Overspending on capital items is another way to run through working capital fast. Buying a smart car or expensive furniture because ‘it impresses the clients’ is not nearly as impressive as being successful. Equally, splashing out on state-of-the-art computer systems or machines can be premature. It may be better to start with simple ones while you build up experience and revenues.

Growing too fast

Fast growth seems a strange complaint but it has caused the death of many an apparently good venture. Like an over-fertilised plant, it does not have the core strength to carry its own weight or withstand a breeze. When orders rush in early, precious cash has to go on buying and making stock. Then inexperience causes delays in delivery and, with no reserves of cash, the money runs out before enough clients have been satisfied and have paid. A rapid, early growth may be very flattering and exciting, but proceed with caution and plan your cashflow very carefully.

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