The biggest mistake most SMEs make is the failure to understand the importance of cash in their business, with many entrepreneurs confusing profitability with cash flow. It is easy to assume that if the business is making a profit there will always be cash available. This is wrong. In fact, 70 per cent of businesses which go bankrupt are profitable when they close their doors.
Furthermore, a study by Geneva Business Bank found that the greatest risk to cash flow occurs when a company is experiencing rapid growth and stock and other costs increase faster than profits can fund them.
These eight key points have been put together to help you manage your cash flow and avoid many pitfalls that even successful companies have to face.
1. Prepare
Benjamin Franklin famously said ‘by failing to prepare, you are preparing to fail’. This has never been truer than in the current economic climate, where traditional sources of finance are simply not available. Look at your order book, levels of stock, debtors and creditors, plan for cash pressure points in advance and make provision accordingly. The figures speak for themselves: businesses that plan their cash flow needs once a year have only a 36 per cent survival rate over five years. Those who plan their cash flow monthly have an 80 per cent survival rate. Regular forecasting will also flag up if you need to look at alternative forms of financing.
2. Know your business
what’s your acid test ratio? How much working capital does your business need to operate? Each business is different and it will be dependent on how well your business can turn stock and debtors into cash. A quick way to measure if you have enough working capital in your business is to calculate your acid test ratio. As a ‘rule of thumb’, most businesses would aim to have a ratio comfortably in excess of 1. If you are unsure of what your ‘acid test’ ratio should be, or have a ratio that is not comfortably in excess of 1, speak to your accountant about ways this can be improved. This may include releasing cash tied up in invoices.
3. Regular invoicing
It may sound simple, but the golden rule for good cash flow management is to invoice more frequently, rather than leaving it to the end of the month. Consider this: if you have £40,000 a week coming in and you leave it for three weeks, that’s £120,000 less to work with. And no business is going to pay you before they receive an invoice. Invoice as soon as the job is done.
4. Be cautious of overtrading
You hit a rich vein of form and the order book is full for the next six months. You have twice the amount of work you were expecting to come in. Surely this can only be a good thing? Wrong. Your business is now at risk of overtrading and in (potentially) a dangerous cash position.
Overtrading is an imbalance between the orders a business accepts and the means it has to fulfil them. Put simply, overtrading happens when a business tries to do too much, too quickly, with too little capital. Where traditional sources of finance are not readily available, failure to plan for cash pressure points caused by overtrading can be serious. Remember: even a profitable business can fail if it runs out of cash.
5. Reduce the credit period you offer customers
By reducing the credit period you offer customers, you help improve your working capital by getting money in for completed projects sooner than you normally would. Whilst this is a great idea, exercise with caution: you may have won some contracts on the basis that you offered the client 30, 60 or even 90 days’ credit. Changing the credit period you offer may result in them ordering less from you or even your business losing the work altogether.
6. Review your contract terms with suppliers
The cost of the goods and services that you utilise in your business and the payment terms should be regularly reviewed. This is to ensure they have remained competitive in the current marketplace, or indeed that they are still required at all. It is all too easy when the business is going well to build in unnecessary costs and to set up standing orders or direct debits to pay for services and then to forget about them. The payment terms that have been agreed may be inconsistent or more favourable than the payment terms that are being demanded by your customers, thus giving you more cashflow issues. Examine your contracts with suppliers, in particular the termination clauses and payment terms, to ensure they remain competitive.
7. Consider selling and leasing back assets
Selling assets and leasing them back is a great way to release tied-up cash. Be warned: this is a short-term fix as assets can only be sold once and can result in the business having a higher cost base and continuing payment obligations.
8. Know your options!
With traditional sources of finance simply not being available, it pays to understand what other options there are out there for your business. You may have heard the Federation of Small Businesses report that 41 per cent of businesses seeking loans in the three months leading up to February 2012 were turned down.
In many cases banks have stopped lending in the form of loans, and are withdrawing unsecured overdraft facilities to SMEs. Factoring is viewed by many as a last resort. This is because you have to factor all of your invoices and make your customers aware that you’ve sold their invoices to a third party. You may be charged high arrangement fees and asked to provide debentures and personal guarantees.
Some are turning to investors for a cash injection. This does not suit all businesses as they may lose control or have performance targets set as a condition of the lending. A new option that has recently come onto the market is Invoice Trading. In short, Invoice Trading allows you to sell as many or as few invoices as you want – for an asking price you believe is fair.
