Understanding the Cash Balance of a Business

August 30, 2011 by  Filed under: Management 

A dangerous situation occurs when the manager of a business does not understand that the balance of the business bank account is not the cash balance of the business. Even if the financial statements of the business show that the business is profitable, the business still may not have enough cash to continue operations. If a business is making last-minute moves to create more cash, such as emergency loans (usually at a higher interest rate), out of the normal course of business collection efforts, or, worse, laying off employees, there is a good chance the manager is managing cash flow from the business bank account not the actual cash balance of the business.

The bank balance and the cash balance are two different forms of cash. Rarely will the two ever be the same. Reconcile the bank balance, do not manage from it. Cash flow from normal operations is sales revenue less cost of goods sold, other costs and taxes. Knowing the cash balance of the business requires up to date and accurate accounting. Moreover, an effective manager must predict the cash needs of the business in time to prepare for liquidity problems.

Here are some processes to put in place to establish effective cash flow management:

1. Create a cash flow analysis spreadsheet. Set up a spreadsheet to predict potential cash needs in advance. The spreadsheet should have a date for each column, generally the day you plan to pay bills. Dates are typically weekly for the next six weeks and monthly out to 12 months. The rows consist of: beginning balance for the sheet and a formula for each column; an array and total for cash receipts (include revenues and cash from outside sources such as loan proceeds and capital contributions); an array and total for expenditures (expenses, capital expenditures and loan payments); ending balance formula (balance transferred by formula to beginning balance of the following column). Limit the number of rows in major categories to keep making a projection manageable. Typically there are 3 to 5 cash receipts lines and 10 to 20 expenditure lines. Accounts receivable and accounts payable reports are considered with receipts and expenditures that do not go through these systems. This will show the cash balance now and the cash balance projected at milestones out to 12 months.

2. Develop budgets. Under best practices there will be a strategic plan containing projected accounting statements. From these statements and from the operating plans created to realize the goals and mile stones of the strategic plan, there should be budgets based on a realistic review of past performance and reality using the general principle of underestimating revenue and overestimating expense. These budgets, once the cash flow spreadsheet indicates the budget is unrealistic, will need revision as will the strategic plan. The budget must establish the profitability of the business – revenue must exceed expenditures. Having cash on hand does not guarantee profitability. Expenditure decisions should begin with a forecast of profitability – not a quick look at the bank account to see if there is enough cash at that moment.

3. Manage account receivables. Make sure the basic processes are in place: receive payment before or on performance if possible, bill on or before performance, consider discounts for early payment, verify the receipt of billings or invoices (confirming payment will follow), mark a follow-up date if payment is not received and on that date contact the customer for payment arrangements, deposit checks immediately, and be very careful about extending credit to customers (analyze each extension of credit with current information and document contracts against an established credit policy).

4. Manage account payables. Pay bills on time to avoid finance charges or penalties. Ask vendors for terms longer than 30-day terms rather than be late. When cash is tight, weigh each payment’s importance and delay those that are least essential to the business. Examine payment options such as paying at the end of a term with a credit card so that the cash expenditure is delayed for up to 60 days.

5. Manage inventory. To have good cash flow, there must be sufficient products and staff for customers’ needs, but not at excessive levels that consume too much cash. Use vendor and supplier terms and financing (for example, 90-day inventory floor financing). Make informed decisions about how much of a certain item to order – and when. Inventory that is not being transformed into cash is useless. If you have out-of-date inventory, the best strategy is to sell it for the best price you can.

6. Working Capital Cycle. Working capital is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets (including inventory) minus current liabilities. Since the three major elements of working capital, accounts receivable, inventory and accounts payable, can all be expressed in days, they can be collectively expressed as the working capital cycle. The working capital cycle is equal to the average days of an account receivable plus the average days of an inventory item minus the average days of an accounts payable. While the working capital cycle number will varies from industry to industry, it should remain fairly constant within the business and should not vary much seasonally. When business slows, the dollar balances of accounts receivable and accounts payable should drop significantly but inventory dollars may drop more slowly. To keep the working capital cycle constant and cash flow healthy, manage collections aggressively, plan ahead to reduce inventory before a slowdown, and extend payments to offset slower inventory turns.

7. Maintain marketing. Marketing and advertising are the last budget items that should be cut in dire circumstances. Marketing efforts should be a constant of business operations.

8. Establish credit lines. Many business owners underestimate cash needs by assuming future profits will occur. Work with bankers to establish long-term, low-interest loan access for more credit than you need when times are good.

9. Establish a reserve. Prepare for the future with at least three months’ worth of company savings in interest-bearing accounts. Some businesses accomplish this by saving a certain percentage of revenues as a matter of course.

Managing cash flow requires current and accurate accounting information placed in an understandable spreadsheet that allows the business manager to know the current cash balance and projected cash balances. Managing cash flow from the business bank account leads to dangerous, if not fatal, liquidity problems for the business.

Rick Riebesell is the Principal Consultant and Manager of Business Transition Consulting LLC ( http://www.btcllc.net ). Rick finds solutions for the problems of owners of closely-held (owner-managed) businesses. He is experienced in business transactions of all types and understands sophisticated estate planning. Rick was a practicing lawyer for over thirty years.

Business Succession Planning – Forms and Practice Manual published by Data Trace Publishing Company is Rick’s latest book. Rick maintains a blog at http://blog.btcllc.net and conducts presentations concerning business succession issues.

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