Cash Flow - The Oil That Keeps the Small Business Running Smoothly

Before the business day is over, probably a dozen small companies in our nation will declare bankruptcy. The U. S. Small Business Administration (SBA) states that most businesses fail for lack of good management. According to the Bank of America, the history of small business failures reveals that many firms fail because of inadequate working capital and poor cash flow management. As a small business manager, you must always be concerned with your company's day-to-day financial position, as well as its future growth and profitability. It's necessary to ensure that your company is using its assets and liabilities effectively, is able to meet current obligations and borrow funds when necessary, and is financially prepared to support future operations.

A good starting point in an effort to enhance your company's future operations is to plan cash flow and profits period by period, perform cash flow analysis, calculate cash flow from extended data, determine free cash flow and undedicated cash flow and the cash conversion cycle.

Financial Statements
The income statement and the balance sheet, which are the general purpose and generally accepted financial statements, don't answer all questions raised by users of financial statements, but statement of cash flows does. Such questions include: How much cash was generated by the company's operations? How much was spent for equipment and property, and where did the company get the cash for the expenditures? How is the company able to make distributions to the owners when it incurred a net loss for the year?

The main purpose of a cash flow statement is to report a company's cash receipts and cash disbursements for a period. Cash is broadly defined to include both cash and "cash equivalents," such as commercial paper and money market funds. A secondary purpose of the cash flow statement is to report on the firm's investing and financing activities for the period. It also summarizes the effects on each of the operating, financing and investing activities of a company for a period and reports on post management decisions such as expansion and the incurrence of debt. This information is available only in bits and pieces from other financial statements.

The effects of investing and financing activities that don't affect cash are shown on the cash flow statement, and a reconciliation of net income and cash flows from operating activities also is provided by the cash flow statement. Because cash flows are vital to a company's financial health, the cash flow statement provides useful information to management and other interested parties, especially creditors and investors.

Whether a large multi-national corporation or a small independent family business, financial management isn't confined to preparing financial statements, managing the petty cash, paying bills, collecting debts and handing relations with banks. Almost every action and decision made by a small business owner or manager has financial implications.

For the most part, small business owners are concerned with the future. They must make decisions and plan with the flexibility to adopt to every-changing circumstances.

As a small business grows in scale and complexity, so does the area of financial decision making. Accordingly, the five most important responsibilities of small business people are:

1. To ensure that the company always has enough cash to meet its legal obligations.
2. To arrange to obtain whatever funds are required from external sources at the right time, in the right form, and in the best possible terms.
3. To use their knowledge and viewpoint to ensure that the company's assets and liabilities—current and long-term—are used as effectively as possible.
4. To forecast and to plan for the financial requirements of future operations.
5. To perform all the above functions and make all decisions on the basis of one key criterion: maximizing the long-term wealth of the company's owners.

There are two reasons for planning cash flow. First you must ensure that short-term sources of funds are negotiated and arranged well in advance of your having to use them. As cash flows fluctuate there many be a time when cash balances fall below zero. These shortfalls must be anticipated so that the liquidity of the business isn't jeopardized. It's much easier to negotiate a short-term loan in advance, thereby demonstrating good management, than it is to attempt to secure funds at the last moment in a crisis.

Second, planning cash flows during high inflation periods is just as important, if not more important than ensuring short-term sources of funds. As a result of fluctuations cash balances may be much higher than immediate needs. The ideal cash must be invested in short-term money-market instruments as soon as the cash becomes available so as to preserve its purchasing power and contribute to profitability. Whether the business's cash budget indicates a shortfall or a surplus, the manager of the firm must take appropriate action in a timely manner.

Planning for Profits
Although there is a relationship between them profits aren't the same as cash flow. Profit is an accounting concept designed to measure the overall performance of the company. It's a somewhat nebulous concept, open to various measurement techniques and accounting principles, each of which produces somewhat different results and are open to different interpretations.

However, the concept of cash isn't nebulous. Either the company has a certain amount of cash or it doesn't. And a lack of cash is critical. A company can sustain losses for a time without suffering permanent damage, but a company that has no cash is insolvent and in imminent danger of bankruptcy, no matter what its profit picture may be. Thus, many financial transactions that don't enter into the calculation of profit—such as buying new operating assets, getting additional financing, and making distributions to owners—enter into cash flows. Similarly some transactions that enter into the determination of profit—notably, the deduction of depreciation expense—don't enter into cash flows because they are non-cash transactions with no effect on cash balances.

Planning Periods
Cash flow planning consists of both sort and long-term forecasts. The principal purpose of a short-term forecast is to identify temporary cash shortages or surpluses and to deal with them. The primary purpose of a long-term forecast is to establish long-term goals and objectives and provide a financial plan to meet the desired target.

Short-term forecasts are often prepared on a receipts minus disbursements basis, while longer term forecasts are usually based on an adjusted new income approach. The short-term forecast is focused on the timing of cash flows and on the availability of cash to meet bills as they come due. An insufficient level of cash on hand can cause the business to pass up valuable trade discounts, and, at the extreme, can cause the business to file for bankruptcy. Thus, the short-term forecast concentrates on the actual receipt and disbursement of cash.

In times of high inflation, a business's cash position should be actively managed because it's very expensive to borrow short-term funds and there may be periods when no funds are available at any price. A business that hasn't secured a commitment in advance will be unable to meet its cash requirements. Excess cash must be invested as soon as it becomes available, so as to avoid erosion in purchasing power. Making a cash budget also allows the financial manager to see the impact of various decisions on speeding up or slowing down cash flows.

Since cash flow planning is concerned with fluctuations in cash balances, the interval of time used in planning is a more important consideration than the length of the whole planning period. The most common interval is one month. That is to say, a financial manager forecasts cash inflows and out flows over one month and then calculates beginning and end-of-month balances. The procedure is repeated for the other 11 month balances. The procedure is repeated for the other 11 months of the year, if the overall planning horizon is one year. The one month time period likely coincides with the accounting period of most companies and also with their official period for collecting receivables.

Many companies use a shorter interval of time, and some companies forecast by the day. Why such a short interval? If the company forecasts by the month and shows adequate balances at the end of each month, isn't it a waste of time to use a shorter interval?

Suppose a company uses a planning interval of one month. Although the monthly cash flow forecast looks fine, the weekly forecast shows that the company will be in considerable trouble before the first week is over. Such a company would do well to choose a planning period not longer than one week and possibly shorter.

Usually, the size of cash inflows and outflows is much more predictable than their timing. But when it isn't, unexpectedly small inflows combined with unexpectedly large outflows can create a serious cash shortage over a sort time. To avoid this scenario, the business must carry large balances to provide a margin of safety or maintain a very short planning interval and a continuous watch on how actual events are conforming to plan. The alternative adopted depends on the size of the balances needed and the management time available for short-interval cash planning.

If cash balances are large, temporary variations within a long planning interval, such as a month, are unlikely to place them in jeopardy. But if the company is operating on inadequate balances, a strong net cash outflow over only a few days may bring balances down to dangerously low levels. In such circumstances a short planning interval is better, even if it can't be economically justified on any other grounds. For this reason, a company that normally uses a planning interval of one month may switch to weekly planning when its cash balances are dangerously low.

References

1. luxury hotels in ParisFASB, "Statement of Cash Flows," Statement of Financial Accounting Standards No. 95, Stamford, CT, 1987.
2. SBA: What it is...What it does, Publication OPI-6 Washington, D.C.,: Small Business administration, Office of Public Information, August 1988, p. 25.
3. Steps to Starting a Business, Small Business Reporter, Vol. 10, No. 3, 1986.

For further assistance, contact a consultant at a Small Business Development Center near you.

> See also: Starting a Business

Torquay Alojamientos baratosAuthor: Andrew J. Potts, Ed.D., C.P.A.
Dr. Potts is Professor of Accounting at the University of Southern Maine in Portland, Maine. He has served as an international consultant to Eastern Europe in cost accounting systems and was a Visiting Professor at the American University in Bulgaria in the Spring of 1993.
Source: Central Ohio Small Business Development Center, Document #5000
Description: Seven rules that will help lead to success under a small budget.

This article is reprinted from Small Business Institute Directors' Association, "SBIDA 1993 National Conference Proceedings."