Overcoming cash flow problems

By Wendy Skinner - 1 October 2017, Build 162

Professional advisors are often asked one question: ‘i have made a profit this year, so why do i have cash flow problems?’ If you can relate to this, read on for some advice.

MAKING A POSITIVE net profit doesn’t necessarily mean you will have a positive cash flow.

As the saying goes, ‘cash is king’, so while making a profit is good, it is irrelevant if you have insufficient cash to pay your debts when due. In the building industry this can be particularly relevant as suppliers and staff may need to be paid before customers’ pay you.

Profit is different from cash

What are some of the reasons that profit is different from cash?

Accrual versus cash

Net profit is based on accrual accounting, not cash. Included in the profit and loss are transactions not yet recorded in your accounts. For example, this includes jobs that have been invoiced to customers but you haven’t yet received payment for and invoices for expenses incurred that are still owing to your suppliers. These transactions are recorded in your profit and loss, but no cash transaction has yet happened.

Asset purchases

When cash is used to purchase assets for a business during the year, it is not recorded in the profit and loss. Instead, it will be recorded in the balance sheet as an asset. These types of transactions have been through your bank account but not the profit and loss.

Loan payments

Cash is also used to pay business loans. There are two components to loan repayments – principal and interest. While the interest portion of the loan repayment is recorded in the profit and loss as an interest expense, the principal portion is offset against the loan liability recorded in the balance sheet.

Drawings

Drawings are cash withdrawals from the business bank account during the year by the owner. This reduces your cash in the bank but is not recorded in the profit and loss.

Effective cash flow management

These types of transactions show the difference between the net profit result and cash on hand. Understanding the difference between the two is the first step to managing and ultimately improving your cash flow.

A three-step sequential process can help develop effective cash flow management.

Step 1 – monitor cash flow

To effectively monitor cash flow, you need access to up-to-date reliable information.

Accounting systems are accessible and responsive, with many available, making it easy to keep business transactions up to date regularly and monitor cash flow and profit.

We assist clients to monitor cash flow by using reporting dashboards. These reports pinpoint key performance indicators specific to the business.

Key performance indicators for cash flow may include:

debtor days – the average time to collect payment from customers
inventory days – the average number of days it takes to sell an item of inventory
accounts payable days – the average number of days it takes to pay suppliers
cash conversion days – a product of all the above that determines how many days during the sales process you will be required to fund working capital. It measures the number of days it takes to convert initial cash out to purchase inventory to final cash collected from the customer.

Step 2 – manage your cash flow

Once cash flow is being monitored on a regular basis, you will begin to understand the factors that impact positively and negatively on your cash flow, identifying trends and patterns. Only then can you start to manage and take action to turn around the negative impacts on your cash flow.

For example, if you notice that debtor days (a key indicator highlighted by the dashboard) have increased over the last couple of months, question why this has changed.

Why are customers not paying on time?
Is anyone following up to request payment or ask the reason why they haven’t paid?
What are your terms of trade?
Are your terms of trade being ignored by your customers or by you? Let’s say, for example, your terms of trade state payment 20th of the month following with interest on non-paid work. If you’re not following up unpaid work after the 20th or not charging interest, the customer is taking advantage of your lack of process for follow-up and using your business as a bank.

Step 3 – make improvements

Once you are monitoring cash flow and identifying areas that need closer management, improvements should naturally follow.

A key way to improve cash flow is to minimise the time that cash is tied up in your working capital.

Small changes can make a difference

With a plan in place to regularly monitor, manage and then take steps to improve cash flow, problems can be quickly identified and rectified. It all begins with understanding what the root of the problem is, and this is done by monitoring.

Remember that even a small change can result in material positive outcomes for your business.