Learn about best practices to manage cash flow.
In its simplest form, cash flow is the movement of money in and out of your business. It is most often described as the process in which your business uses cash to generate goods or services for sales to your customers, collects the cash from the sales, and then completes this cycle all over again.
The two basic elements of your business's cash flow are the cash inflows and cash outflows:
Improving your cash flow means:
Cash inflows represent the movement of money into your business. 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 their purchases of your goods or services to their account, then an inflow occurs as you collect on the customers' accounts.
It should be fairly obvious that accelerating your cash inflows will improve your overall cash flow. The quicker you can collect cash, the faster you can spend it. That may not sound very businesslike, but it's true. Accelerating cash inflows allows your business to pay its own bills and other obligations on time, or even earlier than required.
It may allow your business to take advantage of trade discounts offered by some suppliers if you pay them within a certain period of time. And it will certainly make the other aspects of cash flow management easier. Understanding the cash conversion period is the first step in accelerating your cash inflows. Then, you must streamline:
The cash conversion period measures the amount of time it takes to turn the sale of your product or service into cash available for cash outflows. You might say the cash conversion period looks at the "big picture" by taking into consideration the events that happen before the sale, as well as the events that occur after the sale. How long it takes to complete each event in the conversion period may surprise you.
The graphic below is an illustration of the typical cash conversion period for many businesses.
|The Purchase Decision and Ordering|
|The Credit Decision|
|Order Fulfillment, Shipping, and Handling|
|Billing the Customer|
|The Average Accounts Receivable Collection Period|
|Payment and Deposit|
Each box represents a different event in the cash conversion period. Completing each event takes a certain number of days. The total number of days it takes to go from the "Purchase Decision and Ordering" event to the "Payment and Deposit" event is the cash conversion period. Shortening the cash conversion period is an important step in accelerating your cash inflows.
Your customer's decision to purchase your product or service is the start of the cash conversion period. Allowing your customers to make their purchase decisions, and communicate their decisions to you as quickly as possible, is an important step for shortening the cash conversion period event. Here are two basic tips:
One way to accelerate your customer's decision to purchase your product or service is to make sure they know exactly what you're selling, and at what price. Your customer's purchasing decisions will take longer if they're not exactly sure what you're selling, or what it will cost them. Price lists, catalogs, displays, proposals or quotes are just a few ways you can let your customers know what you're selling.
Think about why you buy most of things from a certain website or store: Because it's easy. Ensuring your order process mimics that of your favorite business' will often accelerate your customer's purchase decision.
Under the best circumstances, relying on the postal service for receiving orders can add anywhere from two to seven days to your cash conversion period. Providing ways for your customers to bypass the postal service with their orders makes it convenient for them, and it reduces your cash conversion period at the same time. Accepting orders at a secure website, over the phone, or via FAX, are just a few ways you can make your customer's ordering task quicker and easier.
The decision to extend credit to your customers is based on your credit policy. Depending on your credit policy, the time involved in the decision making process can add a significant number of days to your cash conversion period.
The call for a credit decision is likely to arise in one of two situations:
In either situation, the key to accelerating the credit decision is to do some of the credit decision work in advance of the customers' orders for your goods or services.
With existing customers or clients, it is best to anticipate a raise in their credit limit whenever possible. This can be accomplished by looking at the customer's current credit limit and comparing it with your expected levels of business with them.
You can avoid delays in fulfilling their order if you can make your credit decision well ahead of the customer's request for a change in their credit limit. Anticipating existing customers' credit needs can significantly reduce your cash conversion period, and impress the customers at the same time with your willingness to extend their credit limit.
This one can be more difficult and time-consuming. The main reason is that you don't have past business relationships with the customers or clients to use as a basis for your decisions. Checking the customers' credit references, obtaining credit reports and checking with the customers' banks can be a monotonous process. Delaying your credit decisions beyond a new customer's expectations increases your chances of losing the sales and the customer.
However, anticipating the credit needs of your new customers can significantly reduce the amount of time it takes to make your credit decisions. Starting your credit decision-making processes when first meeting with new customers or clients is one way to reduce the amount of time it takes.
Completing at least some of your credit decision prior to a new customer's order can significantly reduce the amount of time needed after the customer's order is placed. You may even impress the new customer with your commitment to ensuring that their order is not delayed any longer than absolutely necessary!
Accelerating the cash conversion period in this area requires that you use the quickest means of delivering your products or services to your customers. Unnecessary delays in the shipping and handling of your products or services can add a significant number of days to your cash conversion period, not to mention the negative impact this can have on your customer relationships.
The cash conversion period is increased significantly if your business is unable to supply your customers with the products or services they order. For a retail business, or any business that sells products rather than services, this occurs when the business fails to control its inventory. For a service-related business, this occurs when the business cannot provide the services requested by its customers.
In this step of the cash conversion period, you issue an invoice (bill) to your customers or clients for the completed sale of your products or services. An invoice includes the following information:
The completion of the invoice is an important step in the cash conversion period. Your lack of attention in this step can unintentionally lengthen the cash conversion period. Your invoice actually begins the cash collection process for your completed sales. You've probably figured out by now that most customers don't pay without first receiving some form of invoice for the goods or services you sold them. Invoices serve as a reminder to your customers that your goods or services have been delivered. Invoices also serve as a reminder to your customers that they have an obligation to pay you.
The invoices should include the date they were prepared. These dates are important because they serve as the starting date for your credit terms. Customers generally have 20 to 30 days from the date of the invoice to pay the amount listed on their invoice. You can also add a fee for any late payment; while they might not acknowledge it, you might see your invoices being paid faster than without this line.
You can shorten the cash conversion period and improve your overall cash flow by making sure you prepare invoices promptly. If possible, try to prepare invoices immediately after you've delivered your goods or services to each customer. Don't wait until the end of the month to prepare invoices — this could add as many as 30 extra days to your cash conversion period. Don't wait until the end of the week to prepare invoices — this could add as many as 7 extra days to your cash conversion period!
Meet Diggers Plus, a small construction company specializing in excavating, trenching and other building site preparation construction. A typical project for the company takes one to two weeks to complete.
Jim Backhoe, the owner, takes care of the invoicing and the other bookkeeping duties for the company, in addition to actually operating the equipment at many of the project sites. Needless to say, Jim would rather be out operating the equipment instead of sitting in the office preparing invoices.
And it shows: Jim's cash flow has been...well, it's not good. Just last week he received a call from a subcontractor inquiring about the status of the subcontractor's payment for some work completed for Jim. This subcontractor was used at the building site for the Joneses' new home. Jim told the subcontractor he was unable to pay him at that time. You might say Jim is digging an early grave for his own business. Here's why:
Unfortunately, Jim's billing cycle is reminiscent of the way many small business owner's have been doing things for far too long:
|Week 1||The Joneses' new home site construction was completed on Tuesday. Jim packs up his equipment and moves on to the next project. Jim will not prepare the invoice for this completed project until the end of the month (week four).|
|Weeks 2 and 3||Jim completes a couple other projects during these two weeks and moves on to another. Jim dreads the thought of having to sit in his office completing all those invoices for the different jobs completed during this busy month. The Joneses' invoice will not be completed until the end of the fourth week.|
|Week 4||It's the end of the month—and it has been a very busy month for Jim. He spends a full day preparing 16 invoices for all of the projects completed during the month. Included in this group is the invoice for the Joneses' new home site completed four weeks ago. The Joneses and the other customers should receive their invoices within the next day or two. His credit terms call for the full payment of the invoice in 30 days. This makes their accounts due in the eighth week.
(If you see Jim, tell him he forgot to include the extra work he completed around the Joneses' new home site. Jim's original proposal didn't include this work. The Joneses did agree to Jim performing this extra work. But since Jim didn't make a note to himself, he has long since forgotten about this extra work.)
|Week 5||The subcontractor used on the Joneses' new home project calls late in the week inquiring about the payment of their bill. TheJoneses' account is not due for three weeks, and Jim's broke. Care to guess why?|
|Weeks 6 and 7||At this point, Jim's cash flow gap is bigger than the Grand Canyon. He heads to the bank on the Monday morning of week six. Luckily, he's granted a short-term loan to get him through this cash flow crisis. Jim hand delivers a check to the subcontractor he used on the Joneses' new home project. Think that subcontractor will work with him again?|
|Week 8||The Joneses' check, made out for the full amount of their account, arrives during the week. Their account was paid on time since Jim allows his customers 30 days from the date of the invoice to pay their accounts. It has now been eight weeks since Jim did the work for their new home site.
Jim takes the Joneses' check to the bank Tuesday morning. Unfortunately, he is unable to pay back the entire loan because other bills have come due that require immediate payment.
As you can see, the old way is not worth hanging on to.
By focusing on cash flow and being more willing to tackle paperwork up front, Jim's new way means more money in the bank, literally.
|Week 1||The Joneses' new home site construction was completed on Tuesday. Jim packs up his equipment and moves on to the next project. Before driving to the site of the next project on Wednesday morning, Jim prepares the invoice for the work completed at the Joneses' new home site.
While preparing the invoice, he recalls some extra work that he completed around the new home site that was not included in his original proposal to the Joneses. The Joneses did agree to Jim performing this extra work. Without preparing the invoice immediately, he would have completely forgotten about the extra work he performed. He drops the completed invoice in the mailbox on the way to his new project site. The Joneses should receive the invoice within the next day or two. His credit terms call for the full payment of the invoice in 30 days. This makes the payment due in the fifth week.
If Jim would have prepared the Joneses' invoices according to his old way of doing business, their invoice would not have been prepared until week four—the end of the month. The old method added three additional weeks to his cash conversion period, slowed his cash inflows and created a cash flow nightmare for Jim.
|Weeks 2 and 3||Jim completes a couple other projects during these two weeks and moves on to another. He expects payment from the Joneses sometime within the next two weeks. Jim has been preparing the invoices for all completed jobs the morning after the project is finished. He drops the invoices in the mailbox that very same day, and his customer's receive their invoices within just a few days.
Jim has found it much easier to prepare his invoices while the completed project is still fresh in his memory. He also recalls having to prepare as many as five to 15 invoices at once, depending on how busy the month was.
|Week 4||It's the end of the month—and it has been a very good month for Jim. He is all caught up with his invoicing and in between projects, so he spends the morning fishing and the afternoon golfing. The Joneses' payment should be arriving sometime next week. Who knows, it might even be in Jim's mailbox when he gets home.
If Jim prepared the Joneses' invoice according to his old way of doing business, he would have spent his afternoon in the cooped up in the office, not on the links. And that check would still be four weeks away.
|Week 5||The Joneses' check is in Jim's mailbox when he gets home Monday night. Jim drops the check off at the bank Tuesday morning and mails a check to the subcontractor he used on the Joneses' new home project.
Compared to his old way of preparing invoices, Jim has reduced his cash conversion period by almost three weeks and accelerated his cash inflows. Accelerating cash inflows is a major step for improving a business's cash flow.
|Weeks 6 and 7||Jim's cash flow is better than ever since he started preparing invoices the day after he completes each project. Preparing invoices the day after a job is completed provides Jim with a steady stream of cash inflows throughout the year. The payments from the projects completed during the second and third weeks are arriving during these two weeks.
Had Jim not adapted this new method of preparing invoices? He'd still have another week of waiting for the Joneses' check.
|Week 8||Jim's cash flow is still going strong. Jim is continuing to prepare invoices for his customers as he completes their projects. Amounts due from the invoices he prepared during the fourth week should be arriving some time this week.|
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