Business finance has many common sayings. "Cash is king" is one that is heard the most. Surveys indicate that most businesses fail due to cash flow problems. It is nice to make a profit, but cash flow is necessary to continue operating.
Start-up businesses often find it difficult to generate and hold on to cash. This is often due to the debt that is incurred and the cash that is needed to fund operations and pay off debts.
An understanding of free cash flow and some ratios can help owners get a grasp on their cash and debt. Also important to understand are cash budgeting, managing cash flow and the relationship between cash and profit.
Free Cash Flow
Free cash flow is the amount of cash a business generates after accounting for operating cash flow (cash generated from operating), capital expenditures (money spent on your fixed assets), changes in working capital (the difference in working capital between periods), and dividends (shareholder payments, if any). What this means is free cash is the cash you have leftover that you could do something with.
Consider the concept of the time value of money. A dollar today is worth less tomorrow, and worth more if you do something to make it work for you. This is the purpose of free cash concept—to find a way to make your unused cash work for you.
Free Cash Flow = Operating Cash Flow - Working Capital - Capital Expenditures - Dividends
Financial ratio analysis will help you determine how liquid your firm is or how successful it will be in meeting its short-term debt obligations. Liquidity is a firm's ability to pay its short-term debt obligations.
The current ratio and quick ratio are two of the most commonly used ratios when determining liquidity. The current ratio will help you determine the ratio of your current assets to your current liabilities. Current assets include cash, accounts receivable, and inventory while current liabilities are bills you owe generally within 90 days.
Current Ratio = Current Assets ÷ Current Liabilities
The quick ratio will allow you to determine if you can pay your short-term debt obligations, or current liabilities, without having to sell any inventory.
Quick Ratio = (Cash + Marketable + Securities + Accounts Receivable) ÷ Current Liabilities
You can use accounts receivables turnover to view how well you turn inventory into accounts receivables. Beginning and ending account receivable refer to the value of these accounts at the beginning and end of the period.
Accounts Receivable Turnover Ratio = Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2)
You might consider preparing monthly cash budgets to keep track of your cash. Statements of cash flows can be done in regular intervals to analyze your cash flow. This will help you budget the amount of cash you can use for the various activities in your business
The purpose of the cash budget is not to set targets for cash but to anticipate needs. If you prepare cash budgets 6 - 12 months in advance and your needs change, you can change your cash budgets.
Cash budgets can address "what-if" scenarios. For example, what if you changed the speed of your collections or the timing of your inventory purchases? This technique could allow you to predict the general outcome of a change related to cash collection or generation.
How to Maximize Your Cash Flow
Two of your current asset accounts, inventory and accounts receivable can influence cash greatly. Inventory is usually the products you sell. Accounts receivable are the accounts that represent the credit you extend to customers. Selling inventory and collecting your receivables quicker can boost you cash flow.
Another short-term strategy is to time your accounts payable. Pay your accounts payable on the day they are due, not before. This gives you the ability to use your cash while you have it.
Caution should be taken while using this technique, however. Some consideration of your suppliers is warranted. They have to pay bills as well. To maximize your cash usage and boost your supplier relationships, negotiate your payment dates with them to allow you to hang on to your cash as long as you can and make your payments on time.
Cash and Profit
Cash flow and profit are not the same. Financial accounting, one of the three main types of accounting, is not focused on cash flow. It is focused on net income or profit. Profit and cash flow are related in that profit is part of your cash flow, and it is what is left over after paying your obligations.
For example, when you make a sale to a credit customer, you recognize that sale immediately in your accounts. You enter a debit for your inventory and a credit for your receivables. You may not receive cash immediately.
According to your accounts, you have made a profit. However, you do not have the cash for the sale yet.
You can see how the gap between profit and cash flow could be very large. If you have rapid growth in credit sales, for example, profit could far exceed cash received.
Keys to Good Cash Management
The bottom line to good cash management is keeping yourself informed by using the tools available to you. Develop an understanding of how your cash flows in your business, and create a cash budget to give you a healthy cash balance.