A business goes bankrupt when it is unable to meet its payment obligations when they fall due, that is, bankruptcy is caused by a shortage of cash. However, a shortage of cash is not necessarily related to profitability. In fact profitable businesses can go bankrupt, while companies making losses can have substantial cash.
Cash is king, but what is cash flow and what is the difference between profitability and cash flow? What are the sources of cash and how do we improve cash flow?
What is cash flow
Cash flow is the difference between cash coming into the business (cash receipts, inflows or sources of cash) and cash going out of the business (cash payments, outflows or uses of cash). Cash flow is thus positive (a net inflow/ source) if receipts are greater than payments or negative (a net outflow/ use) if receipts are less than payments.
Profit versus cash flow
Sales (selling) less expenses (purchases) = profit or loss.
While, cash receipts less cash payments = cash inflow or outflow.
The difference between a profit or loss and a cash inflow or outflow is essentially a difference in timing.
We will use a simple example to illustrate this concept.
If you buy a cool drink for R7 and sell it for R10 then you have made a profit of R3. If this cool drink was sold for cash then you would receive payment of R10 from the buyer. However, if the cool drink was sold on credit/ account you would not receive any payment at the time of the sale, but would hopefully receive payment sometime in the future. In both cases the profit is the same (R3), but the timing of the receipt of cash is very different.
Sources or uses of cash
There are 4 sources or uses of cash:
Cash inflow or outflow from the primary business operations or trading activities of the business, that is, through the buying and selling of products or services.
2) Changes in working capital
Working capital consists of current assets (stock/ inventory and debtors/ accounts receivable) and current liabilities (creditors/ accounts payable). An increase in stock and receivables is an outflow/ use of cash, while an increase in payables is an inflow/ source of cash and vice versa. When stock/ inventory is paid for, it affects cash flow, but it only affects profits when sold.
3) Investing activities
Here we primarily refer to capital expenditure and investments in operational fixed assets (motor vehicles, equipment, machinery, etc.), although investing can also include investments in shares or other financial assets.
When assets are bought there is an outflow of cash and when the assets are sold there is an inflow. Investing activities affect cash flow when paid for, but are charged against profits over the useful life of the asset in the form of depreciation.
4) Financing activities
Finance or capital is typically raised from a combination of shareholders equity and loans. Raising equity or loans will result in an inflow of cash, while the repayment of equity (including the payment of dividends) and loans (both capital and interest) will result in an outflow of cash.
Cash flow from operations is derived from the income statement, while changes to working capital, and investing and financing activities are reflected in changes in the balance sheet figures from one period to the next.
Improving cash flow
Ironically cash flow is not necessarily improved by an increase in sales. As sales increase a business needs more capital and ties up more cash in inventory and receivables, and often fixed assets. The rate at which a business can grow is largely determined by the amount of capital it has to support this growth. When a business grows too quickly it will burn cash and thus have a negative cash flow
Cash flow can be improved by:
- Reducing costs and expenses → if costs are reduced you pay less and thus use less cash,
- Reducing assets → a source of cash and improves cash flow,
- Improving processes and efficiencies → reduces costs, assets, re-work, waste, scrap and delays/ waiting thereby improving cash flow, and
1) Reducing costs and expenses
Costs can be divided into fixed and variable costs.
Fixed costs remain unchanged irrespective of the level of production. Examples include depreciation (essentially the cost of fixed assets), leases, rental, insurance, rates and taxes, and certain salaries.
Variable costs change in proportion to the level of production. Examples include raw materials, labour and sales commission.
Fixed costs are often linked to the level of fixed assets. Although the level of fixed costs and assets is often a function of the industry, companies can still choose between more capital equipment (fixed cost and asset) or more labour (variable cost). This choice should be based on which option is more productive and has the lowest cost.
It is difficult to reduce fixed costs and assets in the short term, however, since companies with high levels of fixed costs and assets tend to be more risky than those with lower levels, the objective is to keep fixed costs as low as possible.
Purchases of inventory or raw materials
Purchases are the biggest cost for most businesses. Retailers and wholesalers purchase inventory, while manufacturers purchase raw materials.
To reduce the cost of purchases:
- Develop relationships with your key suppliers and discuss your specific needs with them.
- To prevent outages and to test prices, ensure that you have more than one supplier for most items, especially your key and expensive items.
- Regularly test prices to ensure you are getting the best possible price.
- If possible, take advantage of discounts on large purchases and early payment.
Also see Inventory Management and Payables/ Creditor Management below.
Labour is another substantial cost for companies, especially manufacturing companies.
The objective is to increase productivity by:
- Improving business processes,
- Establishing performance and productivity standards,
- Comparing actual performance with the established standards,
- Using bills of materials and job cards,
- Improving quality in order to reduce rework and scrap, and
- Ensuring staff are properly trained and qualified for the position.
The net result is a shorter, more efficient production cycle, which reduces costs, assets, re-work, waste, scrap and waiting thereby improving cash flow.
2) Reducing assets
Assets consist of fixed assets and working capital (current assets less current liabilities). Fixed assets include property, plant, equipment, motor vehicles etc. Current assets include stock/ inventory and debtors/ accounts receivable, while current liabilities include creditors/ accounts payable.
Fixed assets, like fixed costs, are difficult to reduce in the short term and are typically a function of the industry the business operates in.
With a view to reducing your fixed assets:
- Assess your level of vertical and horizontal integration in the value chain.
- Determine where the value is in the value chain.
- What assets in the value chain should you own and how do you control the other assets.
- Are there opportunities for outsourcing or sale and leasebacks?
- Consider leasing instead of buying.
Working capital management
The management of working capital is critical to a business. The objective of working capital management is to reduce the cash cycle.
Reducing the cash cycle is achieved by:
- Reducing inventory/ stock – reducing the time (days) between buying and selling inventory.
- Reducing receivables/ debtors – reducing the time (days) between selling inventory and receiving payment for the sale from your customer.
- Extending payables/ creditors – extending the time (days) between purchasing and paying the supplier for the purchased inventory.
In a best case scenario, you will be able to sell and be paid for the goods you sold, before you have to pay your supplier.
- Inventory management
Here we want to reduce the amount/ quantity and costs of inventory. Inventory costs consist of:
- Carrying or storage costs → rent, insurance, material handling, obsolescence, and
- Ordering and shortage costs → time spent ordering, paying and receiving the goods, transport, and loss of goodwill, sales revenue and production time.
There is an inverse relationship between these costs – carrying costs increase with higher inventory levels, while ordering/ shortage costs decline and vice versa. The goal of inventory management is to minimise the sum of these two costs.
- Sell old or obsolete stock → selling at cost would be great, but the objective is to get rid of the stock, even if that means selling below cost price, and to generate cash while reducing your holding costs.
- Reduce the production cycle → in manufacturing companies reducing the production cycle will reduce inventory levels since the time between purchasing the raw materials and selling the finished product will be shortened.
The ABC inventory management system
Divide all inventory items into 3 or more groups in terms of:
- Inventory value (usage rate x individual value),
- Order lead time, and
- Consequences of shortages
Here the logic is that a small quantity of inventory might represent a large portion of inventory value.
- Group A → consists of all high value inventories. Stock is kept to a minimum and all items are strictly monitored and tightly controlled. Precise ordering is important.
- Group B → items are of medium value and require a medium level of monitoring and control.
- Group C → inventory comprise basic, inexpensive items. These items are ordered in large quantities to ensure continuity of supply, while monitoring and control is not that important.
- Receivables/ debtor control
Controlling receivables (money owed by our customers) is the key to cash flow management in any business. First establish a policy which, amongst other things, covers:
- Who you grant credit to.
- How you assess the granting of credit.
- What your collection policy is.
- Request down and milestone payments.
- Invoice daily instead of weekly or monthly.
- Offer cash discounts to encourage early settlement.
- Closely monitor accounts taking swift action on overdue accounts.
- Payables/ creditor management
Extend payables (money owed to suppliers) by:
- Paying in terms of your payment terms → if terms are 30 days, don’t pay on 15 days.
- Delaying payment without losing supplier goodwill or trade discounts.
- Negotiating better terms with your suppliers.
- Communicating and establishing relationships with your suppliers.
When choosing a supplier → negotiate and base your decision on both the purchase price and the payment terms.
Cash discounts are usually attractive and if possible, it is worth taking advantage of them.
1) Improving processes and efficiencies
Improving processes and efficiencies reduces costs, assets, re-work, waste, scrap and delays/ waiting, thereby improving cash flow.
As mentioned earlier in the article, an increase in sales does not necessarily improve cash flow. This is because, as sales increase a business needs more capital and ties up more cash primarily in inventory and receivables, but often also fixed assets.
However, without sales you don’t have a business, and you definitely won’t have a profitable business, since you will not have any revenues to cover your fixed and variable costs.
So what to do:
- Prepare a forecast of your expected sales and expenses → take into account cyclical trends. Remember that sales are a combination of selling price and the number of units sold.
- From the forecast, project your actual cash flow requirements and ensure that you have sufficient capital (cash) from shareholders and loans to meet your requirements.
- Target sustainable growth levels.
- Check your pricing and margins → how do your prices compare with your competitors and have your prices kept pace with your increasing costs?
- Implement regular price adjustments → especially if you are an importer and your input costs vary with the exchange rate.
- Ensure that you know:
} The cost of manufacturing or purchasing a product.
} The gross profit of each product.
} How many of each product is being sold.
} How much effort (time) is required to sell a product.
} Your top customers by sales and profits.
While each of these elements has been discussed individually, they are all intertwined and woven together so reducing or increasing one element will often impact on the other elements and have a ripple effect throughout the company.