Understanding How Cash Flow Works

Source: Business Owners ToolKit

In its simplest form, cash flow is the movement of money in and out of your business. It could be described as the process in which your business uses cash to generate goods or services for the sale to your customers, collects the cash from the sales, and then completes this cycle all over again.

Inflows. Inflows are the movement of money into your cash flow. Inflows are most likely from the sale of your goods or services to your customers. If you extend credit to your customers and allow them to charge the sale of the goods or services to their account, then an inflow occurs as you collect on the customers' accounts. The proceeds from a bank loan is also a cash inflow.

Outflows. Outflows are the movement of money out of your business. Outflows are generally the result of paying expenses. If your business involves reselling goods, then your largest outflow is most likely to be for the purchase of retail inventory. A manufacturing business's largest outflows will mostly likely be for the purchases of raw materials and other components needed for the manufacturing of the final product. Purchasing fixed assets, paying back loans, and paying accounts payableare also cash outflows.

It is important to manage your cash flow because:

• Smart cash flow management is vital to the health of your business. Hopefully, each time through the cycle, a little more money is put back into the cash flow cycle than flows out.
• Our case study illustrates what can happen to your business if you don't carefully monitor your cash flow, and take corrective action when necessary.
• Your profit is not the same as your cash flow. It's possible to show a healthy profit at the end of the year, and yet face a significant money squeeze at various points during the year.

What Is Cash Flow Management?

If you were able to do business in a perfect world, you'd probably like to have a cash inflow (a cash sale) occur every time you experience a cash outflow (pay an expense). But you know all too well that business takes place in the real world, and things just don't happen like that.

Instead, cash outflows and inflows occur at different times, and never actually occur together. More often than not, cash inflows lag behind your cash outflows, leaving your business short of money. Think of this money shortage as your cash flow gap. The cash flow gap represents an excessive outflow of cash that may not be covered by a cash inflow for weeks, months, or even years.

Managing your cash flow allows you to narrow or completely close your cash flow gap. It does this by examining the different items that affect the cash flow of your business. Examining your cash inflows and outflows, and looking at the different components that have a direct effect on your cash flow, allows you to answer the following questions:

• How much cash does my business have?
• How much cash does my business need to operate, and when is it needed?
• Where does my business get its cash, and spend its cash?
• How do my income and expenses affect the amount of cash I need to expand my business?

If you can answer these questions, you're managing your cash flow!

If you need any more convincing that cash flow management deserves your utmost attention, consider our case study illustrating what can happen if you have a cash flow gap.

Case Study: The Cash Flow Gap

This example shows how easily a cash flow gap can occur in a small business. A cash flow gap is a shortage of cash caused by the mismatching of cash outflows and cash inflows.

John makes custom furniture for professional decorators and furniture retail shops. In addition to himself, John has two other employees. John pays himself and his employees every other week (bi-weekly). When a customer places an order for a piece of furniture, John receives a 10 percent down payment of the total sales price. The customer is then billed for the remainder of the sale after the furniture is completed and delivered.

The total sales price of a recently ordered dining room set is $10,000. The material needed for this job is priced at $2,500 and will come from one supplier. This supplier offers a 2 percent discount if John pays for the supplies within 10 days after receiving them. John always takes advantage of early payment discounts.

The following graphic, illustrating the cash flow effects of the sale from start to finish, will help you identify John's cash flow gap. (Click on each of the blue or yellow bars to see a detailed explanation of business events affecting John's cash flow each week.)

Breaking down the sale of the dining room set, and tracing it step-by-step through the cash flow, identifies John's cash flow gap. In John's case, a cash flow gap starts on day 13 and continues to grow, reaching $4,450 just prior to collecting the customer's account. Although this example has been simplified, it's typical of the cash flow gap that occurs in many small businesses.

The cash flow gap creates the need for effective cash flow management. Effective cash flow management can help reduce the amount of time between John's cash inflows and cash outflows. This in turn, will help reduce or close John's cash flow gaps.

Profit vs. Cash Flow

A good way to learn respect for the concept of cash flow is to compare it to the idea of profit. As a business owner, you understand and strive to make a profit. If a retail business is able to buy a retail item for $1,000 and sell it for $2,000, then it has made a $1,000 profit. But what if the buyer of the retail item is slow to pay his or her bill, and six months pass before the bill is paid? Using accrual accounting, the retail business still shows a profit, but what about the bills it has to pay during the six months that pass? It will not have the cash to pay them, despite the profit earned on the sale.

As you can see, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat narrow, and only looks at income and expenses at a certain point in time. Cash flow, on the other hand, is more dynamic. It is concerned with the movement of money in and out of a business. More importantly, it is concerned with the time at which the movement of the money takes place. You might even say the concept of cash flow is more in line with reality! If you use the accrual accounting method, it is helpful to know how to convert your accrual profit to your cash flow profit.

To fully understand the difference, you need to become familiar with:

• accrual accounting vs. cash accounting
• converting accrual profit to cash flow profit
• changes in accounts receivable
• changes in inventory
• changes in accounts payable
• changes in notes payable
• case study — profit vs. cash flow

Selecting clients

Did you realize that just as your clients select you, you should also select your clients? Its true and just like you may occasionally have a bad employee (a poor investment) so might you have a bad client (also a poor investment) whose relationship needs to be terminated.

Any relationship is an investment of your time, intellect, mental, spiritual and financial resources and just like any other investment you want it to grow and mature. Any investment starting out needs you to grow and nurture and pay special attention to it yet over time as they mature this relationship should grow into one that benefits both parties not just the client. In cases where the relationship remains excessively one sided, reverses, or become a drain to your resources then like any good broker you have to make a call as to whether the investment was a wise decision and in some cases it is not.

There are some tell tail signs you can look for when make your decision as to whether to do business with a person or a company

• How do they speak of their other vendors?
• How do they treat their employees?
• What do their employees say about them?
• Do they treat others as if they are beneath them?
• How is their business organized?
• How do they make business decision?
• What sort of ethics do they use?
• What does your gut tell you?

Fact is while it is more the exception then the rule some business just is not worth it or the price – taking a job for example that pays $140 when you cost if $200 does not make sense and this too is a factor. So you must also have a great working understanding of your business

• What are your margins?
• What is your rate?
• What is your per job break even point?
• How mature is your business?
• What sort of reputation do you have?
• Do you have the intellectual or financial capital and/or good will to perform the job?

Running a business is not for everyone especially the delusional or the faint of heart. You must know yourself well, understand your business and know what your strengths and weakness are – only when you have a high level working understanding of these things can you make educated business decisions.

With that in mind are you ready to manage your investments properly?

Your role as a consultant

As a consultant the first rule to remember is that your opinion does not matter never had, never will. It is not and never should be about making you look of feel good it is all about the client and what value you bring to them.

You should listen to what they are doing now, what they want to do and then find a solution that bridges that gap. If they are looking for a solution to their cabling trying to sell them candy is a waste of time and at best will only annoy them. Now that said if you help them solve their problem with the cable and in the process see that they have a lot of children that come in and them having candy for the children available would be nice, now you have something.

Communication in this day and time is a lost art. Listening and being non judgmental, which is why so many people go into and back out of business – why truly were not satisfying a need or listening to clients, they actually believed they were in business to make money and learned the hard way that if no one will do business with you there is no business.

So what is the secret? It is simple – all business is personal because you deal with people, their issues, their problems and their challenges. They do no go away once they start work they bring them with them. Your job is to listen to all of their problems until you get to the one’s that you can help resolve. When you hear them it is not your job to point out what they did wrong and how stupid they are – quickest way to loose a client. Once I was so caught up in what I knew and so insecure I actually thought that was what makes a great consultant and learned it makes a bad one the hard way, I lost that client. Your job is simple, listen and help. Help them accomplish their goal and help them see what they need to do to help themselves. Answer the value proposition – let them know what is in it for them and how this benefits them both now and in the future and often when you are real good you will have them fully buy in to the idea because they understand how it will make what they do better and more cost effective. Money is a tool and it represent the time people spend so they are hesitant to part with it unless they see the value of what they are investing in because just like your employees, your clients are an investment, in fact all relationships are an investment and you are the commodity manager – your job is to help that investment grow.

Ok, great words but how – step by step it is easy – the hard part is first getting the client – that is a whole other topic so am going to deal with once you have made contact and developed initial relationship

1) Listen to client as they tell you what they want

2) Do a site assessment to see what they need and can support

3) Do a GAP analysis to see where there is a difference between what they want, what they need and what you think they need

4) Create a unique solution to address their concerns

5) Make sure the solution integrates the KISS approach

6) Determine dependencies required for this solution

7) Report to client the custom solution proposal which addresses the want they mentioned while taking care of a known need and making provisions for scalability

8) Listen to client’s input which will be either proceed or revise

9) Repeat steps 2-7 until approved.

Sounds simple enough – right – wrong. See so many people hear what they want to hear instead of what the person is saying – this is a bad thing. Never forget you cannot separate people from the equation – ever. Never forget that your loyalty is to them and no they are not always right and they know that –which is why they are doing business with you or considering it, so telling them there is a problem – stupid – offering a value-added solution to protect asset, increase productivity, increase gross revenue or decrease expense – now we are talking something worthwhile. My final piece of advice is honest, admit your own shortcomings – that is not a sign of weakness rather one of integrity and strength which shows the character of your firm.