Cash flow is primarily a factor of accounts receivable, accounts payable, and inventory. By controlling these factors, a company can control its cash flow. In order to avoid getting caught without enough cash to pay your bills, follow these rules:
1. Collect cash as soon as possible: When you make a sale, try to get paid immediately. If you must extend credit, make sure you collect the cash as scheduled.
2. Pay your bills by the due date, not earlier: You do not have to pay a bill the day it arrives. Look for the due date, and send your payment so it arrives by that date. This will conserve precious cash.
3. Check on your available cash every day: Always know how much cash you have on hand. Your cash flow will be reflected in your up-to-date accounting journal. Remember, your true balance takes into account any checks or bank debits outstanding.
4. Lease or finance instead of buying equipment, where practical: Leasing distributes costs over time. Better yet, acquire functional, used equipment rather than new equipment.
5. Avoid buying inventory that you do not need: Find the point at which you stock the minimal inventory necessary to satisfy customer demand. Inventory ties up cash: the cash you use to purchase inventory and the cash you spend storing it.
Noncash Expenses Can Distort the Financial Picture
The income statement is not an accurate reflection of your cash position when it includes noncash expenses, or expenses recorded as adjustments to asset values, such as depreciation. When you depreciate an asset, you are deducting a portion of its cost from your income statement. But you aren’t actually spending that cash; you are reducing the value of the asset.
The Working Capital Cycle
Once a business is operational, an entrepreneur must keep an eye on the working capital, the formula for which is current assets minus current liabilities:
Working Capital = Current Assets – Current Liabilities
Working capital tells you how much cash the company would have if it paid all its short-term debt with the cash it had on hand. What was left over would be cash the company could use to build the business, fund its growth, and produce value for the shareholders.
All other things being equal, a company with positive working capital will always outperform a company with negative working capital. The latter cannot spend the money to bring a new product to market. If a company runs out of working capital, it will still have bills to pay and products to develop; it may not be able to stay afloat. When determining cash requirements for your business, always remember working capital. Learn more about cash flow management at LSBF.