Since I became a practicing accountant my biggest and most challenging aspect regarding clients are Cashflow! The constant question and most difficult question to answer is: The income statement is showing I make money, but where is it? It’s not in my bank account. This is confusing them and then doubt sets in in the competency of the accountant. Clients also have the mindset of: ‘I will pay this bill after my client pays me’. Cashflow seems to be the answer when you’re caught between failure and success.
During my apprenticeship my superior told me that an insolvent business can survive with enough cash flow, but a healthy business can’t survive without it. This made me think and plan for cashflow!
In my opinion a lack of cash flow is, in a big portion, a result of a lack of planning or budgeting based on actual results in the past. Budgeting based on actual results in the past is a feature in cloud-based accounting software like QuickBooks Online. Yes, I know that you can’t plan for a sudden economic downslope, but you can still foresee any issues and start planning to counter it. According to the US Business Administration seven out of the top ten reasons why businesses fail is due to poor cash flow management.
In a successful business, cash is the beginning and the end. You need to plan for the end to make sure there will be another beginning. To be able to plan for the end you must evaluate actual results from the past. The interpretation of these results will be the difference in your cashflow.
The key to managing cash is to evaluate its ability to generate cash from operations. Basically, you want to know if you are selling the product at a profit (Gross profit). This might be a basic concept, but, depending on the industry, this is the start of your cashflow conundrum. In most cases accounting data is being captured and reported on an accrual basis. Accrual basis is a method of recording accounting transactions for revenue when earned and expenses when incurred. A key advantage of the accrual basis is that it matches revenues with related expenses, so that the complete impact of a business transaction can be seen within a single reporting period. However, this does not mean that you received the money, nor that you already paid your supplier.
Cashflow can be evaluated by determining the days from which you buy stock from your suppliers until the day your customers pay you. In other words, how long does it take to buy stock, sell it and collect the money from your debtors. How long does it take for money to run through the entire sales cycle in your business? This is called the cash conversion cycle.
Cash conversion cycle = Days of sales outstanding + days of inventory outstanding – days of payables outstanding
In laymen’s terms it means the amount of days it takes to receive payment from your customers, plus the amount of days it takes to sell your stock, less the amount of days it takes to pay your suppliers. The lesser the days, the more positive the cashflow. In other words, your business needs cash for this amount of days to sustain its sales operations.
Unfortunately, there is other expenses in a business as well that is needed to keep the business afloat, for example overheads and the day-to-day expenses. We need to calculate how fast we spend the gross profit made in the conversion cycle. We do this by calculating the days cash on hand. This is the amount of days a business could survive without doing any sales.
We need this amount of days to be as much as possible, however we also need cash to be working in the business and creating more profit. We want to be safe if business takes a turn for the worst, but we need to do a balancing act to introduce cash into the business activity that creates more potential profit.
In conclusion, get as much information as you can about the actual results of your business. Understand the results and use that results to calculate and plan your cashflow. The saying regarding planning is so true: If you don’t plan for success, you plan to fail!
Louis Aucamp, Professional Accountant (SA)
Certified Fraud Examiner