Business Opportunities: On-Line Articles - Effective Cash Flow Management Is Essential to Business Success

Effective Cash Flow Management Is Essential to Business Success
By Michael J. McDermott

Brad Farley, president of a $62 million-a-year building supplies business with two locations in the Southwest, got the best-and shortest-cash flow lesson of his life some 30 years ago.

Not long out of college, he was intent on dazzling his new employer, the company's founder, with an intricate, chart-filled presentation of his cash flow projections for the company. The founder sat through the presentation attentively, then offered Farley a succinct bit of advice: "Just remember one thing, son. If more money comes in than goes out, we're going to be successful."

That might be the Occam's Razor approach to cash flow modeling, but as the owner of nine successful businesses, Farley's then-employer is well qualified to wield it. As Farley, now a partner in the business, puts it, "It's a one-liner, but it's the theory we've embraced ever since, and it's paid off."

Business gurus keep trying to outdo each other in coming up with colorful ways to characterize cash flow's importance. The Department of Applied Economics and Management at Cornell University, for example, maintains a Web site called "Cash Flow Is More Important Than Your Mother."

Hyperbole aside, it's almost impossible to overstate the importance of a healthy cash flow to any successful business. "It is the lifeblood of most businesses," says Marty Grace, a senior vice president in loan administration for a leading commercial bank in the South. "Without adequate cash flow, no business can function efficiently."

The cash flow cycle is the process by which money moves into and out of a business. The business expends cash to create goods or generate services which are then sold to customers. In turn, the business collects cash for the sales from its customers and uses it to create more goods or services, starting the cycle all over again.

"Just remember, if more money comes in than goes out, we're going to be successful."

The primary inflow of cash for most businesses comes from the sale of goods or services, but inflows can also come from other sources. Proceeds from a bank loan or line of credit and collections on the accounts of customers to whom the business has extended credit are examples of other sources of cash inflow.

Cash outflow, the movement of money out of a business, most often results from paying expenses, such as the purchase of raw materials, finished goods for inventory and fixed assets. Salaries, tax payments and loan repayments are other forms of cash outflow.

Cash flow management is critical to the health of any business and, collectively, to the economy as a whole. U.S. companies forego the use of $460 billion a year as a result of inefficient receivables, payables and inventory practices, according to REL Consultancy Group.

HUGE IMPACT

It calculates that capturing the value of that enormous sum through improved cash flow management would reduce total net debt by 29%, increase net profit by as much as 6.3% and improve return on capital employed from less than 14% to more than 15%.

Volumes have been written on the subject of cash flow management, but the collective body of work boils down to a few key points. Business owners have to understand their cash flow as the first step towards effectively managing it. Analysis can help identify potential problem areas in a company's cash flow cycle, and preparing a cash flow budget can help predict cash flow needs in the future.

Analysis of the components that affect the timing of cash inflows and outflows generally includes accounts receivable, credit terms and policy, inventory and accounts payable. A typical cash flow budget projects anticipated inflows and outflows on a monthly basis, but the process can be applied to virtually any time frame-daily, weekly, semiannually, annually or longer.

"Six months to a year is about the ideal time frame for many businesses," Grace says. "That minimizes the level of uncertainty in the projections but is forward-looking enough to allow companies to take corrective action if needed."

He adds that companies may need to prepare longer-term models, looking several years into the future, when preparing loan applications.

Farley's company routinely models its cash flow to project its needs a full year out. Farley and his two partners start working with the company controller at the end of the current third quarter to make projections for the next fiscal year.

It's almost impossible to overstate the importance of cash flow to a healthy business.

"We use the projections to make decisions on what equipment we're going to buy, what our labor needs will be, what our costs will be like," Farley says. "We build out the model so we can work with our bank and determine what months we anticipate our inventory buying will be highest. We like to practice just-in-time inventory management to the greatest extent possible."

While there are many ways companies can improve their cash flow (some of which are unique to the type of business or industry they are in), most fall into one of three general categories: accelerating cash inflow, delaying cash outflow and reducing cash outflow by minimizing expenses.

"Companies can maximize their cash flow by improving their receivables terms, working to get extended payables terms from vendors and being as restrictive as possible when it comes to spending on capital items," Grace says. "They can subsidize working capital with short-term borrowings, but they have to have cash flow sufficient to amortize or pay back the debt."

A big stumbling block that keeps many companies, especially smaller ones, from being able to maximize their cash flow is lack of appropriate financial recordkeeping, Grace says. "We advise all our clients to get a good accountant to set their books up so they have access to interim financial information throughout the year, not just at tax time," he explains.

The key to maximizing cash flow in the retail automobile business is simple, according to one Michigan entrepreneur who owns multiple car dealerships: "Collect receivables as fast as you can."

One of the biggest factors dictating cash flow in that business is the status of contracts in transit (CITs). "Every sale of a new vehicle that is done with any type of financing-whether it's from the manufacturer, a bank, a credit union or a specialty lender-involves a CIT," he says.

LOST PROFIT

"If you sell 40 cars over a weekend at an average price of $25,000 apiece, you've got a million dollars in unpaid sheet metal rolling across the curb. A big dealership could do 100 cars on a busy weekend. Every day that goes by without turning those CITs into cash is lost profit, straight off the bottom line."

While banks, credit unions and the car manufacturers' financing arms generally pay off CITs quickly, some other lenders are not so forthcoming. Even with good lenders, a mistake in the paperwork can delay payment of a CIT.

"Sometimes your own people screw up the paperwork, missing a signature or something else the lender wants," the dealer says. "If the package is not complete, the lender's going to send it back. It is critically important that your finance department-and anyone involved in this part of the deal-is meticulous about sweating the small stuff. You as the owner have a responsibility to stay on top of them to make sure they do."

While the CIT issue might be unique to car dealerships, the focus on receivables is not. A 2005 Visa USA survey found that both small and large businesses share the same attitudes, opinions and concerns about cash management and cash flow. The issue they find most challenging is receiving and collecting payments, cited by 50% of respondents.

A big stumbling block to cash flow management is lack of financial recordkeeping.

"These findings indicate that small businesses have similar goals as their large-market counterparts-efficiency, integration and information handling-in their cash flow management," says David Cramer, senior vice president, commercial solutions, at Visa USA.

Sluggish cash flow and an inability to accurately estimate the timing of payables and receivables on a consistent basis were cited as major concerns in the survey, and improving efficiency in receiving and collecting payments was identified as a top priority.

One strategy that has helped Farley's company maximize its cash flow is invoicing and billing every day rather than waiting until the end of the month. Now on its fourth generation of computer systems, the company has consistently improved its ability to process that paperwork over the years, Farley says.

That kind of expedited approach to billing could help improve cash flow at just about any type of business, but Farley also employs some strategies unique to his industry and location. One is designed to blunt the impact of uncollectible debt, a persistent obstacle to healthy cash flow for many businesses.

Each day that goes by without turning outstanding receivables into cash is lost profit.

Contractors account for 90% to 95% of Farley's business, and almost half of them specialize in building custom homes. When there is a financial dispute between a builder and a customer, it is common industry practice for suppliers to file liens against the property to cover the cost of unpaid bills for materials. However, local law stipulates that only a party that has a direct contract with the owner of a custom home is allowed to file a lien against that property.

To protect its ability to collect on receivables, Farley has all his custom home builders fill out a contractor form. Information required for the form includes the property owner of record, address and/or plat number and location of the property, name of the financial institution that will be financing the deal, name and license number of the general contractor, name of the title company that is handling the property and more.

"We then request what we call a wraparound agreement, which ties us to the owner of record. It has to be signed by the property owner or owners, and we verify everything-including the signatures-against the documentation we've already compiled." Farley explains.

The wraparound agreement states that the general contractor has elected to have Farley's company supply the materials for this project and what its terms are. It also explains the state's lien laws, the ability to file a lien that the agreement gives to Farley and the company's policy of pre-notifying property owners with a 20-day preliminary notice before taking such action. "We have these agreements all completed and signed before we ship out the first stick," Farley says.

This strategy has also helped Farley's company cement its relationships with contractors. "It protects the builder as well as ourselves," he explains. "If there is ever a hiccup with the homeowner, we go ahead and notify them that we plan to file a lien. Because of the wraparound agreement, they almost always come back and sit down with the builder to get the problem solved. A lot of builders don't have the office staff or infrastructure to do this on their own, so not only are we creating leverage to protect our own cash flow position, we're helping out the contractor."

EFFECTIVE STRATEGIES

Farley's company employs several other strategies to maximize its cash flow position:

It starts calling accounts 30 days after invoicing if it has not received payment or had any correspondence with the customer. At 60 days it sends a letter of intent to lien, and at 90 days it files a lien. "But it rarely goes that far," Farley says. "Our process not only helps cash flow, it saves us administrative money. I use my legal counsel strictly for writing the letters and if we have to go to court, but the less I have to use that, the better for the company."

It consistently cross-checks receipts of materials using its sophisticated computer system and contacts vendors immediately if there are discrepancies in pricing or what was shipped.

It takes all discounts offered by vendors and pays invoices promptly, which Farley says also results in increased vendor responsiveness.

When disputes arise, it continues to pay its bills while the issue is negotiated to increase its leverage and bargaining position.

It pre-projects the margins it wants to achieve in each of its five business segments (lumber, doors, millwork, trusses, windows and insulation) and uses those numbers to guide its buying decisions. "One of my partners works with the buyers every day to get the best price, and that is critical," Farley says. "We hit that side of the business as hard as we work customers and contractors on the other end."