What is Good Cash Flow Management?
Efficient cash flow management is one where an organisation is able to invest and manage cash spending while maintaining its operations and liquidity.
This involves:
- shortening cash collection periods
- negotiating with suppliers on favourable terms
- proper planning through cash flow forecasting
With efficient cash flow management comes efficient cash allocation that allows companies to cover operating expenses, utilise investment opportunities, and maintain adequate cash reserves.
For instance, a computer manufacturing company that purchases its core parts from a certain supplier has a policy of providing goods on a 30 day payment term basis. The computer manufacturer has to make a payment of $4 million within 30 days from the purchase date to the supplier.
The company has $20 million of cash available on hand and after 30 days has an investment opportunity of $20 million, which will exhaust all the cash that the company has readily available.
The manufacturing company could negotiate with the supplier to extend the payment term to 60 days instead. This delay will allow the company to use available funds for investment and have an additional 30 days to make the payment to the supplier.
In this way, the company can take advantage of the investment opportunity while maintaining its business operations.
Objectives of Cash Flow Management
Cash flow management has 2 key objectives:
- To closely monitor cash transactions and plan capital expenditures
This can eventually help businesses meet payment due dates.
Firms are required to make regular payments to suppliers for goods purchased, employees for salary payments and other such expenses on a recurring basis. Stringent control and planning of cash transactions helps businesses have adequate cash reserves readily available for use even when the business’s outflows are greater than its inflows.
There are several companies with negative cash flow that have remained profitable.
Maintaining an optimum cash balance is thus essential for companies to meet payment due dates and all other expenses. This can prevent businesses from bankruptcy as it has an impact on its solvency.
It is therefore highly important for firms to have efficient cash flow management to be able to pay for any unexpected expenses easily. The ultimate goal is to maximise liquidity.
- To minimise operating costs while meeting necessary expenses
The above goal of planning and controlling cash to maximise liquidity is so that the company minimises cash outflows and avoids unnecessary expenses.
Any cash surplus should be invested wisely in other profitable ways allowing firms to gain more cash in return. This helps them maintain a healthy cash flow cycle and improve their overall financial position.
Eventually, the aim is to minimise operating costs while performing all cash flow management activities to remain solvent, liquid, and meet all short-term requirements.
Key Functions of Cash Flow Management
To overcome the challenge of maintaining adequate liquidity and remaining profitable, cash flow management should fulfil the following three functions:
- Inventory Management
A key function of cash flow management is to manage a firm’s inventories to maintain low inventory stock on hand.
Cash flow management prevents firms from blocking cash in tangible assets. The greater inventory there is in stock, the more sales is trapped in those assets.
This significantly reduces a company’s liquidity.
Good cash flow management targets at shortening the inventory turnover period which indicates how quickly the company is selling and replacing goods. This can be calculated as follows:
Inventory Turnover Period Formula – Indicates how quickly the company sells and replaces goods
Average Inventory Formula – Determines a firm’s average inventory stock
The number of inventory days can then be calculated as follows:
Number of Inventory Days Formula – An efficiency ratio that tells how long a firm takes to convert inventory into sales
The higher the inventory turnover, the better as this indicates that the company is selling goods quickly. The demand for their products is therefore high.
For example, Walmart reported an annual sales of $559 billion in 2021. Its year-end inventory was $44.9 billion and beginning inventory was $44.4 billion along with a cost of goods sold of $420.315 billion.
Based on the above calculations, its inventory turnover period in days was around 39 days.
- Receivables Management
Receivables comprise of sales that the company has completed but the cash for which has not been received yet. The supplier has sold the goods on credit. This credit term usually varies from 30-90 days, and sometimes is even as long as 120 days.
Businesses should try shortening their revenue collection period.
Companies implement follow-up mechanisms to ensure faster recovery of payments from buyers, preventing them from experiencing bad debts.
- Payables Management
Lastly, cash flow management’s function is to ensure that vendor payments and all other expenses to third parties are paid on time.
Unlike receivables, payables are debts owed by businesses to third parties. This function addresses the above objective of maintaining an optimum cash balance to meet payment due dates.
Hence, firms must analyse their ability to meet current debt obligations regularly. This requires proper planning of cash expenses. These payments should be timed in such a way that a firm’s liquidity is maintained while leaving them with adequate cash reserves to invest in other opportunities.
4 Cash Flow Management Strategies For Small Businesses
SMEs often struggle to manage their cash flow efficiently and cost-effectively due to several cash flow issues. For this reason, this section particularly provides some tips on strategies for cash flow management for small businesses.
Sell or Lease Idle Equipment
SMEs usually tend to have less capital and liquidity on hand due to limited budget.
When tight on cash, an efficient way to generate liquidity is to sell equipment that is not being used or rent it to another party that can put it to use.
This can also make room for space otherwise taken over by such equipment.
Increase Margins
This can help small enterprises generate liquidity to fund other business operations.
Once the business is in its growth stage and demand for its products or services is high, prices can be increased slightly to match the growing demand.
This small increase in price can have a significant impact on a company’s profit if demand is high.
Another way to increase product margin would be to reduce production and delivery costs. These measures can eventually help increase liquidity and balance a company’s cash inflows and outflows.
Even if the equipment is used, it could be rented for much cheaper. Meanwhile, the extra cash could be used to fund other operations of the business.
Invest How Much You Can Afford & Required
This is an easyprinciplebut many times, a difficult means for businesses to improve their cash flow management.
Avoiding unnecessary expenses will certainly help businesses maintain a healthy cash flow.
Do not try to be overambitious and waste resources in deploying a faster but costly success strategy that may harm your business significantly, or lead to risk concentration.
If the expense is really required, opt for cheaper alternativesthat are most suitable for you.
Obtain Financing Through Alternative Financiers
Injecting cash into your business solves most of the cash flow problems faced by companies.
Funding from alternative financiers is one of the best means for SMEs to improve their cash flow management, as most SMEs who try obtaining financing through banks often get rejected. This is because SMEs are often considered as high-risk companies whose credit score may not match banks’ requirements. Moreover, they may not have enough collateral as requested by banks.
Since SMEs often fail to fit these stringent criteria, banks do not consider them reliable enough to provide them financing.
Alternative financiers like Velotrade are a much faster and cost-effective financing solution for SMEs who struggle getting funding from traditional lending institutions. Aside from the receivable or invoice, no additional assets are required as collateral. The entire process is also digital. This accelerates your business’s cash flow and increases liquidity at any time.
Based on your type of business and industry, you can find financing solutions for your needs. Cash obtained from financing can be used to invest in other resources and opportunities that further expand and grow your business. This affects a firm’s working capital.
Funding your business operations can save you from the liquidity shortfall to meet daily expenses. Cash flow management requires constant effort and a thorough understanding of a business’s nature.
Knowing how to improve and manage cash flow is therefore crucial to the successful operation of any business.
