Managing Cash Flow

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Copyright © 2016 Pearson Education Ltd

Section 3: Launching the Business
12
Managing Cash
Flow
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Learning Objectives
 Explain the importance of cash management to a small company’s

success.
 Differentiate between cash and profits.
 Understand the five steps in creating a cash budget.
 Describe fundamental principles involved in managing the “big three” of
cash management: accounts receivable, accounts payable, and inventory.
 Explain the techniques for avoiding a cash crunch in a small company.
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The Importance of Cash
 “Everything is about cash – raising it, conserving it, collecting it.” ~ Guy
Kawasaki
 Common cause of business failure: Cash crisis!
 Cash is the most important, yet least productive, asset that a small
business owns.
 Businesses must have enough cash to meet their obligations or run the
risk of declaring bankruptcy.
 It is entirely possible for a business to earn a profit and still go out of
business by running out of cash.
 Disruption to cash flow is most often caused by customers paying their
bills late or not at all.
 Valley of death
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The Valley of Death
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Cash Management
 The process of forecasting, collecting, disbursing, investing,
and planning for the cash a company needs to operate
smoothly.
 Young and growing companies are “cash sponges.”
Cash management enables a business owner to :

 Adequately meet the cash demands of the business
 Avoid retaining unnecessarily large cash balances
 Stretch the profit-generating power of each dollar the business
owns
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Cash and Profits
 The first step in managing cash more effectively is to
know the company’s cash flow cycle.
 Cash ≠ profits.
 Profit is the difference between a company’s total
revenue and total expenses.
 Cash is the money that is free and readily available to
use.
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Cash Flow
Cash flow is a method of tracking
a company’s liquidity and its
ability to pay its bills ( tracking
the flow of cash into and out of
the business over a period of time.
)an accounting period.
Cash flow measures a

company’s liquidity and its
ability to pay it bills.
Purchases typically lead(s) sales;
Collections typically lag(s)
sales.
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The Cash Budget
 Is a “cash map” showing the amount and the timing of cash receipts
and cash disbursements on a daily, weekly, or monthly basis.
 It is used to predict the amount of cash needed to operate smoothly

over a period of time( anticipate cash crunches )
 Must take into consideration seasonal fluctuations in sales
 Predicts the amount of cash a company will need to operate

smoothly.
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Preparing a Cash Budget
Five steps:
1. Determining an adequate minimum balance
2. Forecasting sales.
3. Forecasting cash receipts.
4. Forecasting cash disbursements.
5. Estimating the end-of-the-month cash balance.
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Determine an Adequate Minimum
Cash Balance
Step 1:
 Deciding the right minimum cash balance is
based on past experience
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Forecast Sales
 Step 2:
 The heart of the cash budget.
 Sales are ultimately transformed into cash receipts and cash
disbursements.
 Cash forecast is only as accurate as the sales forecast from which it is
derived.
 Be careful not to be excessively optimistic — consider economic swings,

increased competition, fluctuations in demand, normal seasonal
variations, and other factors that can have a dramatic effect on sales
 Prepare three sales forecasts:

 Pessimistic
 Optimistic
 Most Likely
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Example
 Robert Adler wants to open a repair shop for imported cars. The trade
association for automotive garages estimates that the owner of an imported
car spends an average of $485 per year on repairs and maintenance.
 The typical garage attracts its clientele from a trading zone (the area from
which a businessdraws its customers) with a 20-mile radius. Census reports
show that the families within a 20-mi leradius of Robert's proposed location
own 84,000 cars, of which 24 % are imports. Based on a local consultant
 's market research, Robert believes he can capture 9.9 percent of the market
this year. Robert 's estimate of his company's first year's sales are as follows:
Ch. 12: Managing Cash Flow

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Sales Forecast for a Start-Up
Example:
Number of cars in trading zone 84,000

x Percent of imports x 24%
= Number of imported cars in trading zone 20,160
Number of imports in trading zone 20,160

x Average expenditure on repairs x $485
= Total import repair sales potential $9,777,600
Total import repair sales potential $9,777,600

x Estimated market share x 9.9%
= Sales estimate $967,982
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Forecast Cash Receipts
Step 3:
 Record all cash receipts when the cash is actually
received (i.e. the cash method of accounting).
 Determine the collection pattern for credit sales; then
add cash sales.
 Monitor closely: Slow and non-payers.
 To predict accurately the firm's cash receipts, the

owner must analyze the accounts receivable to
determine the collection pattern.
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Forecast Cash Disbursements
 Step 4:
 Record disbursements when you expect to make them.
 Start with those disbursements that are fixed amounts

due on certain dates.
 Review the business checkbook to ensure accurate

estimates.
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Cash Flow Concerns among
Small Business Owners
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Estimate
End-of-Month Balance
Step 5:
Take Beginning Cash Balance ...
Add Cash Receipts ...
Subtract Cash Disbursements
Result Is Cash Surplus or Cash Shortage
(Repay or Borrow?)
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Benefits of Cash Management
 Increase amount and speed of cash flowing into the company

 Reduce the amount and speed of cash flowing out
 Make the most efficient use of available cash
 Take advantage of money-saving opportunities such as cash
discounts
 Finance seasonal business needs
 Develop a sound borrowing and repayment program
 Impress lenders and investors
 Provide funds for expansion
 Plan for investing surplus cash
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Amazon’s Cash
Conversion Cycle
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Cash Conversion Cycle
 The cash conversion cycle is a cash flow calculation that attempts to

measure the time it takes a company to convert its investment in inventory
and other resource inputs into cash.
 The cash conversion cycle calculation measures how long cash is tied up in
inventory before the inventory is sold and cash is collected from customers.
 Cash Conversion Cycle = DIO + DSO – DPO

 DIO stands for Days Inventory Outstanding
 DSO stands for Days Sales Outstanding
 DPO stands for Days Payable Outstanding

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What is Days Inventory Outstanding
(DIO)?
Is the number of days, on average, it takes a

company to turn its inventory into sales.

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Days Inventory Outstanding
Example
Company A reported a $1,000 beginning inventory and $3,000
ending inventory for the fiscal year ended 2018 with $40,000 cost of
goods sold. The DIO for Company A would be:
It takes this company approximately 18 days to turn its inventory into

sales.

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What is Days Sales Outstanding
(DSO)?
Is the number of days, on average, it takes a

company to collect its receivables.

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Days Sales Outstanding
Example
 Company A reported a $4,000 beginning accounts receivable and
$6,000 ending accounts receivable for the fiscal year ended 2018
with credit sales of $120,000. The DSO for Company A would be:
 Therefore, it takes this company approximately 15 days to collect a

typical invoice.

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What is Days Payable Outstanding
(DPO)?
Is the number of days, on average, it takes a company to

pay back its payables.

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Days Payable Outstanding
Example
Company A posted a $1,000 beginning accounts payable and $2,000 ending
accounts payable for the fiscal year ended 2018 with $40,000 cost of goods
sold. The DSO for Company A would be:
It takes this company approximately 13 days to pay for its invoices.

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The “Big Three” of Cash Management
Accounts Receivable
 Accounts receivable – Extending credit to customers.

About 90% of industrial and wholesale sales are on credit,
and 40% of retail sales are on account.
 Survey of small companies: 74% have accounts receivable
outstanding for 60 or more days.
 Remember: “A sale is not a sale until you collect the
money.”
 Accounts receivable goal: Collect your company’s cash as
fast as you can.
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Establish a Credit and Collection Policy
Screen credit customers carefully.

Establish a firm credit-granting policy.
Send invoices promptly.
Cycle billing is a method in which a company bills a

portion of its credit customers each day of the month to
smooth out the uneven cash receipts.
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Accelerating
Accounts Receivable
 Ensure that invoices are accurate and timely.

 Include a description of the goods or services purchased.
 Ensure that invoices match purchase orders or contracts.
 Highlight the balance dues and due date.
 Include contact information in case customers have questions.
 Use a security agreement. a contract in which a business selling an
asset on credit gets a collateral, protecting its legal rights in case the
buyer fails to pay.
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Accounts Payable
 Suppliers and others extend credit to you

 Stretch out payment times as long as possible without
damaging your credit rating.
 Verify all invoices before paying them.
 Negotiate the best possible terms with your suppliers.
 Be honest with creditors; avoid the “the check is in the
mail” syndrome.
 Schedule controllable cash disbursements to come due at
different times.
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Inventory
 The largest expense for retail and manufacturing
businesses.
 Monitor inventory closely; it can drain a company’s cash.
 Avoid inventory “overbuying.”
It ties up valuable cash at a zero rate of return.
 Arrange for inventory deliveries at the latest possible date.
 Take advantage of discounts:
Quantity discounts
Cash discounts
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Cash Discount Terms
Typically, a cash discount is offered as a reward

for paying sooner rather than later.
For example, a merchant's terms might offer 3
percent 10 / 60, which means you get a 3 percent
discount if you pay within 10 days and the full
amount is due within 60 days.
Merchants may offer a cash discount to give
customers an incentive to pay sooner, often
because they are short on cash or trying
minimize the amount of accounts receivable.
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Calculating APR
Example
 Say you have a merchant offer you a 3 percent discount if you pay
within 5 days or full price if you pay within 40 days.
 First, subtract 5 from 40 to get 35 days.

 Second, divide 365 by 35 to get 10.429.
 Third, subtract 0.03 from 1 to get 0.97 divide 1 by 0.97 to get
1.0309.
 Fourth, raise 1.0309 to the 10.429th power to get 1.3738.
 Finally, subtract 1 from 1.3738 to find the APR of forgoing the cash
discount is 0.3738, or 37.38 percent.

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A Cash Discount
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Lawrence Industries Ltd purchases $1,000
worth of merchandise on 27 February from a
supplier extending terms of 2/10 net 30 End of
Month (EOM).
If the firm takes the cash discount, it will have to
pay $980 [$1,000 – (0.02 × $1,000)] on 10
March, thereby saving $20.

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Analysing credit terms
 Mason Products has four possible suppliers, each
offering different credit terms. Except for the
differences in credit terms, their products and services
are identical. Table 15.1 presents the credit terms
offered by suppliers A, B, C and D, respectively, and the
cost of forgoing the cash discounts in each transaction.
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Avoiding the Cash Crunch
 Barter exchanging goods and services for other goods and services, to
conserve cash.
 Trim overhead costs: Ask for discounts and “freebies” ,conduct periodic
expense audits, lease rather than buy
 Operating lease is a lease at the end of which a company turns the
equipment back to the leasing company and has no further obligation.
 Capital lease is a lease at the end of which a company may exercise an
option to purchase the equipment, usually for a nominal sum
 Hire part-time employees and freelancers
 Outsource
 Negotiate fixed loan payments to coincide with your company’s cash
flow
 Build a cash cushion
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Invest surplus cash
 Money market account is an interest-bearing account that allows

depositors to write checks without tying up their money for a specific period
of time.
 Zero-balance account (ZBA) is a checking account that never has any

funds in it. A company keeps its money in an interest-bearing master
account tied to the ZBA; when a check is drawn on the ZBA, the bank
withdraws enough money from the master account to cover it.
 Sweep account is a checking account that automatically sweeps all funds

in a company’s checking account above a predetermined minimum into an
interest-bearing account.

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Conclusion
“Cash is King”
Cash and profits are not the same.
Entrepreneurial success means operating a company
“lean and mean.”
Trim wasteful expenditures.
Invest surplus funds.
Plan and manage cash flow.
12 - 40

Managing Cash Flow

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Copyright © 2016 Pearson Education Ltd

 Explain the importance of cash management to a small company’s

Cash management enables a business owner to :

Cash flow measures a

 It is used to predict the amount of cash needed to operate smoothly

 Must take into consideration seasonal fluctuations in sales

 Predicts the amount of cash a company will need to operate

 Be careful not to be excessively optimistic — consider economic swings,

 Prepare three sales forecasts:

Ch. 12: Managing Cash Flow

Number of cars in trading zone 84,000

Number of imports in trading zone 20,160

Total import repair sales potential $9,777,600

 To predict accurately the firm's cash receipts, the

 Record disbursements when you expect to make them.

 Start with those disbursements that are fixed amounts

 Review the business checkbook to ensure accurate

 Increase amount and speed of cash flowing into the company

 The cash conversion cycle is a cash flow calculation that attempts to

 Cash Conversion Cycle = DIO + DSO – DPO

Ch. 12: Managing Cash Flow

Is the number of days, on average, it takes a

Ch. 12: Managing Cash Flow

It takes this company approximately 18 days to turn its inventory into

Ch. 12: Managing Cash Flow

Is the number of days, on average, it takes a

Ch. 12: Managing Cash Flow

 Therefore, it takes this company approximately 15 days to collect a

Ch. 12: Managing Cash Flow

Is the number of days, on average, it takes a company to

Ch. 12: Managing Cash Flow

It takes this company approximately 13 days to pay for its invoices.

Ch. 12: Managing Cash Flow

 Accounts receivable – Extending credit to customers.

Screen credit customers carefully.

Cycle billing is a method in which a company bills a

 Ensure that invoices are accurate and timely.

 Suppliers and others extend credit to you

Typically, a cash discount is offered as a reward

 First, subtract 5 from 40 to get 35 days.

Ch. 12: Managing Cash Flow

Ch. 12: Managing Cash Flow

 Money market account is an interest-bearing account that allows

 Zero-balance account (ZBA) is a checking account that never has any

 Sweep account is a checking account that automatically sweeps all funds

Ch. 12: Managing Cash Flow

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