Cash flows in a cycle into and out of a business. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire. This is probably the most misunderstood topic in business accounting i.e. profit does not always equal cash, and confusing the two can strangle a growing business.

The faster a business expands, the more cash it will need for working capital and for capital investment.  Working capital inside the business is usually your first and cheapest option. Good management of working capital will generate cash which will help improve profits and reduce risks. Remember that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.

Cash Cycle in Action

Lets’s construct a simple cash flow model. A distributor buys $10,000 of inventory for sale on Day 1, and the vendor provides terms of 45 days. On Day 30 a credit sale occurs for $20,000 - receivable in 30 days. On day 45 the company pays the vendor $10,000 and receives $20,000 from the customer on day 60.
The cash flow cycle is 15 days: i.e. 30 days in Inventory + 30 days in AR less 45 days credit from vendor. So the Distributor has to finance $10,000 for 15 days – not bad. Plus, of course, finance the company overhead for 60 days (from Day 1 to Day 60 when your cash comes in).

Now lets look at different situation where the distributor has sloppy financial management, and receives a new order. The company buys $20,000 of inventory (just because it has no clue what it really needs), but vendor terms are 30 days. It gets a sale of $20,000 on Day 30 from a large company – who rarely pays within 60 days. Now the cash flow cycle is 90 days: 60 days Inventory (includes inventory that is gathering dust) + 60 days AR less 30 days AP credit. So now the company has to finance $10,000 for 90 days, plus the overhead. Quite a difference - the cash cycle is 6 times longer.

By computing your cycle days for each cash element it is possible to estimate working capital needs, and make funding projections. This is critical for determining a line of credit, or deciding whether you can afford to accept that big order from Walmart.

Managing Cash

It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc. If you do pay cash, remember that this is now longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment - loans, equity, leasing etc. Similarly, if you pay dividends or increase drawings, these are cash outflows - and like a drainhole - they remove liquidity from the business.

Sources of additional working capital can include existing cash reserves, profits (when they are turned into cash), credit from suppliers – which is not to be abused, equity or loans from the owner or shareholders, bank overdrafts or lines of credit and long-term loans.

Warning Signs of Working Capital Shortage
Often when a company has insufficient working capital and tries to increase sales, it can easily out run the financial resources of the business. This is sometimes called over-trading. Early warning signs include:

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  • Constant pressure on existing cash
  • Exceptional cash generating activities e.g. offering high discounts for early cash payment
  •  Bank overdraft exceeds authorized limit
  • Seeking greater overdrafts or lines of credit
  • Juggling supplier bills or part-paying creditors
  • Paying bills COD to secure additional supplies
  • Management pre-occupation with surviving rather than managing
  • Frequent short-term emergency requests to the bank (to help meet payroll, pending receipt of a cheque)

In the next article on this subject we will discuss ways to straighten out the working capital picture, which will include the need for planning, active working capital management and working with your banker.