The present economy has created an unfortunate time when it’s easier for companies to fall into cash flow problems and run the risk of going out of business. Cash flow can be an issue for most businesses, but with the unpredictability of the economy, there is less room for error because it is difficult to predict what the future holds. Let’s look at three different scenarios in which cash flow needs to be analyzed.
Scenario 1: Existing Customers
Company A (we’ll call them SMB) needs to pay their vendors, and the checks need to go out today to be on time. However, for the first time in their business life, SMB finds that they do not have the cash to cover these checks. How did this happen?
They did not keep a close eye on their own debtors because they have always had the cash on hand. SMB decides to investigate their cash flow issue and some research uncovers that Company B (let’s call them The Corporation) is currently 45 days past due on their payment. Additionally, because the current economic climate is weak, business in general has slowed for SMB. This is a huge problem because The Corporation makes up the majority of SMB’s business volume. As a result, a few different issues began to develop with SMB’s cash flow. Let’s break it down.
First, SMB should have tracked when their cash receivables were due. When an account is 30 days past due and going into collections, the situation should be dealt with immediately. Collecting your receivables on time is one of the only ways to safeguard against your own company’s payments being late. Two years ago, it was easy to take for granted that receivables were being paid on time or early, but in today’s market, businesses need to keep a closer eye on their financials and know when money is due and when it is paid.
Second, as soon as the debt was in delinquent status, SMB should have contacted The Corporation. The longer they wait to contact them, the less likely they are to see any money. It is not uncommon for a business to have delinquent payments owed to them for up to a year because they are not effectively tracking their receivables. Surprisingly, some of these businesses only realize a customer is late when that person either pays or tries to access additional services!
This sort of situation is preventable. Some accounting software packages include alerts to notify you when a customer owes money, when that money is due, and even when your own business debts are due. If your accounting software does not, you can set your own alerts through your email. Be proactive! Both SMB and The Corporation could also schedule payments to go out electronically so they are not late.
Accounting software packages like Cougar Mountain Software also allow users to track payment trends and restrict accounts once they are past due so that more money is not lost through unguarded credit. Understanding how to use your accounting software to its fullest potential is very important in managing your cash flow effectively.
Another key factor in keeping money liquid within the business is for companies to look inside themselves. Is the company currently doing anything that could potentially jeopardize their cash flow? Companies need to reduce their own bottom line and cut unneeded expenses, especially today, when timely payments can often be unreliable.
Additionally, companies need to stay on top of their own accounts payable and make sure that their company credit is good by paying bills on time or early and taking advantage of early payment discounts such as 2/10 net 30. Reflecting back on our fictitious company, SMB, and their client, The Corporation—if SMB had more liquid capital to weather the poor economy, they might not have to rely on The Corporation as much to pay their own debts. Cougar Mountain Software’s AP module includes several reports, such as the Cash Requirements Report, to help track the financial responsibilities of your company.
Scenario 2: Taking on New Business
Effectively managing your account receivables is always important. Most service businesses perform their due diligence when they take on new clients to ensure they are likely to receive payment back in a timely manner, but taking on new business also implies a level of trust. If a new client, or any business for that matter, decides not to pay you, you can find yourself having performed your services for free. That inherent risk makes accrual-based accounting uncertain. So how do you know if the risk is less than the reward when taking on a new customer?
The best safeguard for your company’s cash flow is to be proactive before new customer billing even begins. When taking on a new customer, always ensure there is a contract in place that sets out the terms of repayment, and make sure you cover all your hard costs before beginning work.
When a company is going to start work with a new customer, they conduct a process of due diligence and ask themselves these five questions to ascertain whether there is any risk involved, and if so, to what degree and how that risk will be handled.
1. Who are they? A company with a reputation for paying late is an instant red flag. You might want to further research why or how they developed this reputation, but ultimately you might find they are just not worth the high risk. It is always a good idea to research a business’ reputation by contacting other companies who have worked with this person or business.
2. What is the volume of business that you will be doing with this customer? Small businesses that take on larger clients who make up over 10% of their revenue might end up sacrificing the needs of their current customers or even put their own resources at risk to fulfill the needs of the larger client. As a small business, you do not want to be at the mercy of this larger client for survival and ability to do good business.
Before you enter into this type of work relationship, you should carefully examine your own resources, and certainly have a plan of action should that larger business ever default. This one large client, if late on payments, could have a dramatic and negative impact on your business. Explore, if possible, the pursuit of other new business so that your client base is diversified. Alternatively, look at your own expenses because you may find areas that can be reduced or streamlined.
3. When were the business and their credit established? If the company or customer is new, or has less than stellar credit, be creative about extending credit to them. ALWAYS make sure you cover your hard costs before taking on any type of payment schedule with them, if you choose to take the risk at all.
4. Where have they taken current loans? ALWAYS check references and their credit rating. Do not be afraid to ask. This is your money. Get the answers you need to make educated decisions.
5. When does the benefit of working with the new person/company outweigh the risk of taking them on? That is a difficult question because even if you did your due diligence, the future is still unknown. In the end, it is your decision to make.
Scenario 3: Small Businesses Who Sell Retail
The biggest challenge for retail businesses in managing cash flow is the time between paying for inventory and selling it. If a company purchases too much inventory and sales drop, they could be stuck in a negative cash position with no way out. However, if they are watching their sales, their inventory, and other factors closely, the ability to make quick adjustments can happen if downward trends develop. In other words, you might be able to prevent being stuck with unsold inventory and tying up cash.
To manage inventory effectively, businesses need to be able to analyze sales trends, seasonal variances in inventory, and the lead-time and terms of their major suppliers to make better purchasing decisions. This allows them to keep the right levels of inventory in stock to meet daily sales needs. Businesses dealing with inventory should also have POS software that gives them information about price adjustments from their suppliers so they can react more quickly to price changes that impact profitability.
For retailers with multiple locations, a good POS software product should also allow them to manage inventory levels at all locations and move it between locations to quickly free up needed capital to reinvest in new products or other areas of the business.
If you are a business with inventory that you cannot sell right away, you might have to resort to terms. In this case, even though you are still making the sale, you have to wait months or years to get the cash. Are you in business to make money or are you in business to be a bank? If you are not a bank, don’t think like one. Examine your own terms and try not to extend credit if you don’t have to. However, if you do find yourself in a position where you will allow an extension of credit, know that there are several types of credit and find the one that works best for you.
Contract of sale – the standard payment we have been referring to throughout this paper. Ensure your own expenses are covered and define a schedule for repayment when you create a contract.
Capital Lease – This lease is very similar to a contract of sale and requires that one of four criteria be met.
The lease is classified as a purchase.
The lease is worth more than 75% of the products estimated worth.
The lease contains the option to purchase for less than market value.
The value of the lease payment at the beginning of the lease is at least equal to 90% of the fair value of the leased product.
Operating Lease (true lease) – This lease allows the lessee to use the product but not own the product. At the end of the lease term, the lessee can choose to purchase the product or return it.
Layaway – The customer can purchase the product without paying the entire amount but does not take the item home with them until the product is paid in full. This repayment option has not been practiced as frequently in recent years but is making a comeback as Americans are rethinking the use of their credit cards for purchases.
The Bottom Line
Businesses have choices when it comes to extending credit terms, so know your options and the guidelines of those options to find the best way to maintain your cash flow. Stay on top of your payables and receivables without causing any undue stress on your business’ finances. In short, make sure you have covered your bases so that all your hard costs are always covered—your suppliers/vendors, overhead, payroll, etc. You need to know when your receivables are due, and if necessary, ensure that you have written contracts. Both the money and the contract are economic resources for your company. If you make good decisions and plan correctly, your business should be able to weather an economic storm and cover the majority of the loss with minimal damage.
Finding good accounting software that is fully integrated, like Cougar Mountain Software, is best because its single-entry integration cuts down on user error. Nevertheless, accounting software cannot do it all. Small business owners need to prepare for, and expect, the worst in these uncertain times. Through preparedness, which includes the implementation of the right software, they will have the tools to stay afloat in the turbulent economy.