Cash is King: Managing Cash Flow for Business Survival and Growth

Cash is King: Managing Cash Flow for Business Survival and Growth

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Part 1

Description of Cash Cycle Analysis

The cash cycle represents the use of cash in the day-to-day operations of the business. A cash cycle analysis is a process of looking at how cash might be unnecessarily locked up in the workings of the business. Within any business, there are three areas where cash may be getting unnecessarily ‘trapped’:

1. Accounts receivable

What customers owe for what you’ve sold on credit. This represents money that ‘belongs’ to your business but is currently inaccessible for operating the business.

2. Inventory

Materials, work-in-process, and finished goods on hand for manufacturing and distribution companies or unbilled services for work already performed but not yet invoiced for service firms.

3. Accounts payable

What you owe suppliers for what you’ve bought on credit. This is an area where, if you fully utilise the credit given to you by suppliers, you can release extra cash into your business.

In doing a cash cycle analysis one carefully analyses how much cash is locked up in each of these elements of the business and then works to unlock this cash in a safe and responsible way. How do you perform a cash cycle analysis to unlock cash within your business?

Step 1

Calculate the cash days for each element of the cash cycle

The first step is to understand how many days’ worth of cash are locked up in each element of the cash cycle. The cash locked up in accounts receivable is calculated as the accounts receivable balance divided by the average sales per day. The cash locked up in inventory is calculated as the inventory balance, divided by the average daily cost of sales; and the cash days in accounts payable is the accounts payable balance divided by the average daily cost of sales (see the equations below for the calculation of these amounts). The total days in the cash cycle can then be calculated as accounts receivable days, plus the inventory days less the accounts payable days.

Step 2

Assess whether the number of days’ cash in each element of the cash cycle is reasonable

All businesses need to have some cash tied up in the cash cycle but the key to effective financial management is to reduce the overall days tied up in the cash cycle to a competitive level. Therefore to have more cash to grow the business you need to try to reduce the number of days in accounts receivable and inventory and to increase the number of days in accounts payable within a range that is reasonable and sensible.

Having calculated the number of days in each element of the cash cycle in step 1, the next step is to assess your business days in each element of the cash cycle in relation to:

  • The number of days in prior periods to see if cash management is improving or declining
  • The number of days provided for in firm policies (the policies of your firm for accounts receivable and inventory and the policies of your suppliers for accounts payable)
  • The number of days of other firms in the industry  (see alongside)

By comparing the days in each element of the cash cycle over time, one can see whether you have been more or less effective at managing your cash over time. By comparing days to firm policies you can assess if firm policies are actually being implemented and by assessing the days’ cash in comparison to others in the industry you can assess whether you are competitive compared to other firms.

Step 3

Set targets for managing each element of the cash cycle

Most people discover that there is room for improvement with respect to the amount of cash tied up in accounts receivable, accounts payable or inventory. The next step is to set targets to improve these balances. The targets for these amounts should be reasonable within the industry in which the firm operates. You should set targets that are ambitious but not so unreasonable that you are unable to operate effectively. For example it may be an industry norm to expect customers to pay invoices on 30 days. It is then unreasonable to set a target of 15 days for accounts receivable. You may need to keep a certain amount of inventory on hand to maintain customer service levels; it is then destructive to set targets that reduce inventory levels to levels that are dangerously low. It is also unwise to set a target to pay accounts payable on 50 days if your supplier’s policy is 30 days; you will just develop poor relations with your supplier.

Step 4

Start managing each element of the cash cycle

Having set targets for improvement, it is time to go to work on managing these balances to achieve the targets that you have set for your business.

To reduce accounts receivable you could:

  • Look to get invoices out more efficiently (eg by email). Incentivise the people in accounts to send out invoices as quickly as possible.
  • Adjust the credit policy to reduce the number of days’ credit allowed to customers (but only do this if it will not have a significant negative effect on sales).
  • Actively follow-up with customers to collect receivables within the credit terms that you have given them.
  • Incentivise customers to pay early (eg by offering discounts or rewards).

To manage the inventory levels downward you could:

  • Identify what inventory you need regularly and what you need less regularly and manage it accordingly, with lower inventory balances for stock that you seldom need.
  • Keep smaller amounts of stock on hand and set up relationships with suppliers where they agree to provide goods more regularly in smaller batches.
  • Identify slow moving and obsolete stock and provide incentives to move it off the floor.

To release cash within the accounts receivable balance, you could:

  • Ensure that you are using the credit terms that customers provide.
  • Negotiate longer credit terms with customers.

If the targets that you set are reasonable and you implement these tactics in a reasonable and responsible way, over time you should be able to reduce the amount of cash tied up in the cash cycle to achieve your goals and have more cash to build the business.

Step 5

Review progress

The cash cycle needs to be reviewed and managed on an ongoing basis. It is amazing how easy it is for the accounts receivable and inventory balance to creep up if unchecked, thereby sucking cash out of the business. The cash cycle numbers — accounts receivable days, inventory days and accounts payable days — should become part of the monthly management dashboard for any business. Managers who observe that these numbers are moving in the wrong direction should immediately investigate and take action to rectify the situation. In this way you can ensure that the business has as much cash as possible to continually fuel growth. »Many times managers think that a cash injection into a business must come from outside the organisation — they desperately apply for bank loans or try to contact a long lost rich uncle to invest in the business. The reality is that you can often engineer extra cash from inside your business if you just manage your finances more effectively. What can you do to ensure that you have adequate cash to keep your business alive? In this article we will highlight a specific process for managing and unlocking cash in your business.

Accessing financial data on other firms in your industry

The easiest place to find financial information about other firms in your industry is to look at the financial statements of firms that are listed on the JSE or AltX exchange.

These firms are required to publish their annual financial statements so their financial information can be accessed via one of the following sources:

  • The company website — usually under the investor relations section
  • The Moneyweb website — go to the website (www.moneyweb.co.za); in the top right corner go to “CLICK-A-COMPANY”; click on the names of the companies that you are interested in and then look for SENS announcements further down the page that contain financial results for the company. From these announcements you can get information required to calculate the number of days in accounts recievable, inventory and/or accounts payable.

Part 2

Case Study

Presto Print

Presto Print is a local printing business doing bulk printing jobs for small and medium size businesses. Samantha Graham, the manager of Presto Print, wants to expand the business but to do so she needs to buy two new printing machines valued at R110 000. She was convinced that she would need to get a bank loan to buy the additional machines but her corporate banker was not getting back to her with an answer on her request for finance.

Getting frustrated she wondered whether there was another option. An examination of her recent set of financial statements reveals that there may be.

Step 2

Assess whether the number of days’ cash in each element of the cash cycle is reasonable

Based on the table of comparisons, it is evident that Samantha Graham needs to implement better accounts receivable management practices at Presto Print. The number of days’ cash in accounts receivable is creeping up over time and it is much higher than the firm policy and the industry average. It also appears that there is room for improvement in her inventory management practices.

She has too many days’ worth of cash tied up in inventory compared to the industry average and she has never established an inventory management policy specifying how much inventory she intends to keep on hand. There appears to be less opportunity to release cash through the accounts payable balance. It would be irresponsible to extend it much higher than its current level as her suppliers credit policy is for outstanding invoices to be paid on 30 days.

Step 3

Set targets for managing each element of the cash cycle

The next step is to set targets for how many days’ cash Presto Print should aim to have tied up in each element of the cash cycle. Based on the assessment of the industry averages and the firm policies and after consultation with the other employees in her business, Samantha Graham decided to set the following targets:

  • Accounts receivable days:  36 days
  • Inventory days: 30 days
  • Accounts payable days: 35 days

To achieve these targets she would need to reduce accounts receivable by 11,93 days, which would result in (R2 101 085 /365 days) x 11,93 days = R68 673 extra cash. If she reduced inventory down to 30 days she would release another (R845 095/365 days) x 38,92 days = R90 113 worth of cash into the business. Therefore, through careful management of the accounts receivable and inventory balance there is the potential to release more than R150 000 worth of cash into the business at current business levels.

Step 4

Go to work at managing each element of the cash cycle

Having established reasonable targets for each element of the cash cycle, the next step is to aggressively manage these elements of the business to achieve the targets.

To do this, Samantha Graham first shared the targets with all her staff and explained why and how the management of these elements of the business would have a significant positive impact on the business. Furthermore, she promised that if they achieved the targets and maintained them for six months she would take them and their partners out for a dinner at a fancy restaurant and grant each of them two extra days of paid leave in the following year.

Thereafter, she worked with her accountant to put more processes in place to get invoices out quicker and to follow up on payments five days before they are due, on the day they are due and every two days after they are overdue. She also reviewed her debtors book over the last two years and identified the clients that were most guilty of paying very late. She called each one up and had a friendly but firm conversation with them saying that she was thrilled to have their business but then reminding them of the policies and asking them in a nice way to please try to comply.

Furthermore, she reviewed the inventory balances for the past two years and discovered that they were keeping large amounts of paper on hand that was very seldom requested by clients. She identified all the paper that fell into this category and called her supplier asking if they would be willing to take some of it back at a discount as payment for some of Presto Print’s recent purchases. They agreed! She then categorised all the paper and ink that they stored on hand according to how regularly it was used. She set targets for the amount of each category of inventory

they would keep on hand. She then called Presto Print’s suppliers to confirm how long it would take them to deliver paper and ink from the time of order. Using this information she set reorder levels for each category of inventory. She made the reorder levels clear to all her staff and instructed them to inform her when they reached the reorder levels. After seven months of implementing these simple but effective tactics, the accounts receivable and inventory levels were nearing their targets and Samantha had much more free cash flow in the business to fund growth and capital acquisitions.

Step 5

Review progress

After a few months, Samantha asked her accountant to create a simple weekly report that would give her the weekly sales, the number and amount of invoices sent out that week, the accounts receivable balance, the inventory balances by category and the accounts payable balance. This information gave her much richer insight into her business and allowed her to make highly informed management decisions. She put the targets for accounts receivable days, inventory days and accounts payable days up on a large whiteboard in the office. Each month she filled in the actual balance next to the target so that all employees could see how close they were to achieving the target.

Greg Fisher
Greg Fisher, PhD, is an Assistant Professor in the Management & Entrepreneurship Department at the Kelley School of Business, Indiana University. He teaches courses on Strategy, Entrepreneurship, and Turnaround Management. He has a PhD in Strategy and Entrepreneurship from the Foster School of Business at the University of Washington in Seattle and an MBA from the Gordon Institute of Business Science (GIBS). He is also a visiting lecturer at GIBS.