Cash flow is the blood supply for your business, without it the whole body (business) stops working. If you don’t have money to pay suppliers or utilities you don’t have a business that can continue to trade, regardless or not if your business is trading at a profit. Yes that’s right you can run out of cash even if your business is making a profit.
How can this be you may ask, well assume you start month one with £1000 in the bank, and all your monthly bills added together amount to £2000 and all fall due during the month, Lets assume you have secured a contract to work all most full time for a large multi-national company photographing products for their website, which amounts to £5000 income per month. But the multi-national company has payment terms of 60 days, which means you won’t get a dime for two months. Now although you have revenue of £5000 a month and your total outgoings are just £2000 per month meaning you are making a profit of £3000 a month, because you are not getting the first months payment for 2 months you have incurred £4000 of costs before you have received any money back. and as you only started with £1000 cash in hand you are £3000 short of paying your bills. Now unless you have access to an overdraft or other funds, you are not able to meet your debt obligations as they fall due, which means you cannot pay your bills and are out of business. The way around this would be to;
• Have additional funds to plug the two month gap before getting your first payment or
• Insist that your customer, in this case the multi-national pays you straight away or use a factoring company as an intermediary
• Arrange to pay your suppliers on 60 days credit terms, so that these bills are only due once you have been paid by your customer.
All of which are easier said than done, but these either done in isolation or together are the only way around your cash flow problem.
Although this simple example has happened at the start of you trading, cash flow problems can hit you at any time. If your company is experiencing rapid growth, cash flow can become a major problem. Suddenly you are paying more for inventory or in wages and bigger contracts / customers are expecting to receive better payment terms from you.
Always keep your eye on your cash cycle. Generally speaking the cash cycle decribes the;
time that elapses between the delivery of inventory and its conversion into sales (1 week)
PLUS time that elapses between the sale of goods and services to customers and receipt of monies due from these accounts receivable (nil – payment terms are cash on delivery)
LESS time that elapses between the receipt of goods and services from suppliers and subsequent payment to these accounts payable (4 weeks)
Cash cycle = 1 week + 0 weeks – 4 weeks = -3 weeks
Your aim as a business owner is to get better terms from suppliers (increase creditor days) and reduce customer payment terms (reduce debtor days)