How to Avoid a Cashflow Crisis
A six step guide to improving your cashflow for growing and slowing businesses
There are two ways to get into a cashflow crisis; growing or slowing your business.
In fast growing and seasonal businesses (retail or service) increasing sales mean that you need higher stock levels or more work in progress which you will need to fund before getting paid by your customers.
In a slowing business cost-cutting measures such as smaller premises and reducing employee numbers won’t be enough to ride out a cashflow crisis. Your previous cost levels and fees involved in exiting contracts will impact your cash position for a significant time.
The power of this six step guide is illustrated by a Sunnydale Dairy business that found a year’s worth of revenue tied up in their business with the assistance of their local business banker and CashScan (Westpac’s in-bank cash analysis tool).
Working Capital Cycle
If you want to understand how your business is trading from a cashflow perspective it is essential to understand the Working Capital Cycle.
Every business, regardless of what they do, has a working capital cycle (WCC) which ties up available cash.
To start any business, cash is required. This cash is then used to purchase stock or equipment in order to generate a sale. When the stock is sold it is either by way of a cash sale or is charged to an account, creating a debtor. When the debt is collected the WCC continues. In a service industry the stock is ‘work in progress’.
Imagine that the stock a business buys sits on the shelf, on average, for fifty five days before it is sold and that it takes an average of forty five days to collect the debtors. Each dollar tied up in the WCC takes one hundred days before it returns to the cash position where it can be used again to purchase more stock as shown below:
While waiting for that dollar to return, more stock has to be purchased to keep the business operating and to do so, many businesses use their overdraft facility which is costing them money. If there is no overdraft, they are using their credit funds that could be better used elsewhere. The faster you can turn the WCC, the faster the dollar returns and the less overdraft or surplus funds you have to use.
Improperly managed the WCC can be your worst enemy and the cause of a cashflow crisis.
So How Can I Run My Business To Avoid A Cashflow Crisis?
Forecast with a cashflow budget
A cashflow budget is a powerful financial tool to help you predict the availability of cash in your business at any point in time. Using your previous sales and expense records coupled with reasonable assumptions about the year ahead you can quickly determine if there could be any crisis points ahead.
Eliminate cash-draining initiatives
These fall into two categories: unnecessary expenses and incorrect asset finance. Unnecessary expenses are often found by looking at the capacity of the business compared to its current or forecast requirements. Examples include premises space/location, IT maintenance contracts and redundant stock.
The golden rule when financing a business is to match the life of the loan to the life of the asset. You wouldn’t buy a house with your credit card, so why would you use an overdraft facility to buy equipment that you expect to use for the next three years?
Collect debtors and establish appropriate procedures
Asking your customers to pay just a few days earlier could have a dramatic impact on the amount of cash you have in hand.
Some strategies to help achieve this are:
• issue invoices on the first day, not a week later;
• charge an upfront deposit;
• create and communicate a terms of trade policy with customers;
• put credit control procedures in place to minimise bad debts;
• always check credit references; and
• collect your overdue debts and work with customers to avoid the same issue recurring.
Your credit control procedures should monitor debtors and ensure that collecting on accounts is a priority, not a once per month event. Establishing a clear debt collection system will give you the ability to minimise the impact of bad debtors; a $5,000 debt can quickly balloon to $20,000 if proper procedures are not executed.
An example where this strategy was implemented was a regional hardware store that was passed down from father to son. A quick review showed that 90 per cent of sales were on account. This was paralysing their cashflow so with two simple steps they saved time and administration costs:
• small accounts were stopped and all sales to these customers became cash only
• a merchant facility was setup to give customers a more convenient way to pay (instead of cash and cheque being the only options).
Within two months, 40 per cent of sales were on account and average debtor days had reduced by 15. This seemingly simple change greatly reduced the credit requirements for this business.
Control your stock
Increasing stock turnover can rapidly consume cash on hand. To manage this, look into:
• improving stock forecasting;
• sales pipeline management;
• building supplier relationships;
• adjusting your pricing strategy; and
• additional financing.
Decreasing stock turnover can mean that significant amounts of cash are tied up in stock. To manage this, look into:
• sales pipeline management;
• ‘just in time’ ordering systems;
• only ordering when you need to;
• stock management systems; and
• centralised monitoring.
Conducting an inventory review can be one of the easiest ways to liberate cash in your business. Knowing which products are selling and how quickly will enable you to adjust your ordering patterns. You may be able to achieve higher discounts on larger orders of fast-moving stock and you won’t have cash tied up in slower moving items.
Another example is a Queensland saddlery which discovered they had two and a half years of stock on hand. The store was cluttered and unappealing. When they reviewed sales, 80 per cent of sales were from 20 per cent of their range and many items hadn’t sold for over six months. Urgent action was needed so they:
• immediately stopped ordering stock;
• sent some excess stock back to suppliers;
• renegotiated with suppliers to establish smaller, monthly orders for core stock;
• ran clearance sales to sell old and unreturnable stock; and
• donated remaining stock to charities which helped to boost their profile.
Within six months they had reduced stock levels to one year of stock, vastly improving their cash position and the procedures that they established have helped reduce the likelihood of them getting into financial trouble again.
Review your pricing
Many business operators base their prices on the competition. They assume that the competition has their pricing structure right, they are making a profit and they have the same cost structures as themselves. In reality every business has a different cost structure and it is important to understand yours.
Break even analysis is a simple financial tool which uses your fixed costs, variable costs combined with your sales volumes to determine your profit margin. It is easily adjusted to show:
• how many extra sales you have to generate to compensate for reducing your price;
• how much your sales can reduce if you increase your price before impacting your bottom line.
The main impact on cashflow is the time between stock purchases or work in progress and recouping your costs.
Recalculate your cashflow budget (Step 1) with your new scenario to see the effects on your cashflow.
Adjust your financing
Once you have completed the above steps you may identify some short-term financing requirements going forwards. Armed with the above information you will be in a strong position to talk to your banker and explore options for financing to cover these needs.
An appropriate overdraft facility can smooth out periods of high cash demand. You may also be able to refinance your long-term assets with a more appropriately termed loan.
Finally, you will find that the cashflow budget tool may become one of your most important and powerful ongoing financial management tools. By reviewing this monthly, you will stay on top of your finances and may be able to avoid a cashflow crisis.
Ian Watt is the Senior Business Development Manager - Franchising, NSW & ACT Westpac continues their long-term commitment to franchising in Australia.
The bank has a national network of franchise specialist business bankers who are able to deal with the specific needs of the franchise sector.
Contact Ian at:
P: 0419 271 995