Cash flow is vitally important to any business. Rory MccGwire, founder of the Donut websites, looks at why cash flow matters and the different ways you can improve it
Why is cash flow important?
A simple way to illustrate the importance of cash flow is to imagine two different shops. Both sell things for twice the price that they pay for them. Both are profitable.
One is a beach kiosk on a popular beach. It buys ice cream and pays its supplier 30 days after delivery. It sells the ice cream almost immediately, generating the cash to buy more. The owner has more than enough money each month to pay staff, pay the rent, and invest in improving the business.
The second shop is a yacht chandlery. It stocks a vast array of expensive things that are used on yachts, such as special ropes, waterproof clothes, and navigation equipment. It too pays its suppliers 30 days after delivery, but many items do not get sold for months and months. So the owner has to borrow money to buy the stock. He struggles to find the cash each month to pay the staff, the rent and the interest payments. Nor is there any money left to spend on improving the business. The money is tied up in the stock, which makes it a more difficult business to run.
A business that generates positive cash flow can focus on its customers. It can pay its staff and suppliers on time. It can afford to hire the best employees. It can invest in better systems and products. All of which means that it can become more successful.
A business that has negative cash flow has to get money from an investor or a bank in the first place, in order to fund things like premises, stock and payroll. If sales drop off for any reason, the business can suddenly find that it is unable to pay its suppliers or even its own payroll, in which case it will usually go out of business.
The world is littered with profitable businesses that went bust. For example, property developers who ran out of money before the property could be finished and sold at a handsome profit. Or engineering companies that ran out of money before a customer paid for a big contract that was not yet completed. Or cafes that spent too much on fixtures and fittings and were then unable to make the payments on time from their modest monthly revenues.
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How to improve cash flow
You can improve cash flow by ensuring you make enough sales in the first place.
Small businesses often overlook the opportunities to use their pricing to increase sales and margins.
- Test the price points after which sales drop off, such as £9.99 or £79.
- Use popular low-priced products to capture the attention of buyers who may then buy more profitable items from you.
- Offer bulk discounts for large orders, as these cost little more than small orders to administer and deliver.
- Use clearance discounts to sell off old or hard-to-shift stock.
- Think about how you can upsell customers, from a single item to a discounted ‘package’ of some kind.
- Rebates are retrospective discounts that encourage customers to buy more from you. Some coffee shops and fast food outlets use this approach, eg ‘Get your 10th coffee on us’.
Avoid giving away things that customers would be happy to pay for. Rather than charging £400 to build a website, perhaps you can charge £600 if you spell out all the stages involved, including all the pre-build work.
When agreeing contract terms, make sure that it is cash positive. So, using the website example, charge 50% up front, to cover your own costs. Or, if it’s a long project, schedule monthly payments or other ‘milestone’ payments. Otherwise the more work you win, the more money you have to borrow to fund the work (‘working capital’). Another tactic is to raise your prices and offer a discount for prompt payment.
Use budgets. Even the simplest budget is an extremely useful benchmark for any business to measure its performance against. Based on the previous year, estimate the amount and timings of both your costs and your revenues.
Holidays, VAT payments and large contract renewals are often key factors that lead to peaks and troughs in your cash flow.
You can then forecast what you think will actually happen. Will the next three months and six months be better than the budget, or worse?
Knowing these numbers allows you to plan. For example, if December is always a poor sales month, and your invoices are paid after 30 days, you may need to reduce your spending in January. If you then lose a big customer, you may need to take further action to cut your costs in order to remain in business.
Four more ways to improve cash flow
1. Use the latest accounting software
Modern small business accounting software is remarkably easy to use and can free up an enormous amount of time.
Importantly, it also gives you real-time reporting on your cash flow, using a series of dashboards.
You can see who owes you money, check your bank account balance or how much VAT you owe, generate cash flow reports, and view performance against budget.
2. Credit control
Collecting money that is owed to you comes down to good systems and a lot of persistence.
If you are paid by invoicing your customers, start by getting the invoice details right. Does the customer require a Purchase Order number from its finance department? Have the payment terms and other details been agreed?
Issue invoices promptly and follow up on them regularly, before they are due, especially for large amounts and poor payers.
The person who does the credit control for your business really needs to care about getting invoices paid on time. That is why many small businesses have a family member in this role.
3. Stock control
If you sell products, you may have to spend heavily on stocks of the items you sell. Set up appropriate stock control systems to limit the cash requirement.
Are you attempting to sell too many products? Would customers be happy with a choice of 10 colours instead of 25?
4. Build up a cash reserve
We all know that businesses have ups and downs. You might lose a major customer. Another customer may delay payment. Another may go out of business, owing you money.
Similarly, you might lose a key member of staff, or your IT system may go down.
Any one of these things can lead to a sudden, unforeseen need for cash. So, if possible, keep putting a little cash aside every month, just as you do when saving for old age. Prioritise this ahead of any non-vital expenditure.
Solutions to cash flow problems
The other solutions to cash flow problems are the various types of finance.
Working capital is usually provided through an overdraft facility. Asset purchases such as vehicles, IT, machinery and equipment can be done using asset finance. Property purchases (including moves and refurbishment costs) and business acquisitions are funded using traditional business loans.
In each case, the lender requires some form of security — an asset that can be sold in the event that the borrowing is not repaid. In the case of an overdraft, the security is often a personal guarantee given by the business owner.
Growing businesses, in particular, often find that invoice discounting is a more flexible source of working capital than overdrafts or loans.
An overdraft secured against your outstanding invoices (‘debtors’) would typically raise up to 50% of their value. Whereas invoice discounting enables you to raise up to 85% or more.
This is called trade finance. Put simply, it comes in two forms – invoice factoring, where you sell invoices to the funder and your customers then pay them directly; or confidential invoice discounting, where your customers are unaware of the funder and continue to pay you.
The key point is that you get paid as soon as you issue the invoice, so every sale generates immediate cash flow.
The factoring agency will be the one taking care of collection when it's time to pay, so you avoid having to chase customers for payment.
Invoice financing has lower fees, but you will have to be the one to collect the outstanding debts. However, some small businesses prefer this approach, because they want to have a strong relationship with their clients.
When each invoice is paid, you receive the balance, less interest and the fee — both of which reflect the perceived riskiness of lending to your business.
Invoice discounting ‘with recourse’ is an arrangement whereby the lender has the right to be paid their fee even if the customer defaults on their invoice. In other words, your company remains liable for any bad debts, rather than the lender.