Keep the cash flowing
When the cash stops circulating, businesses – even profitable ones – die.
StubbsGazette offers some pointers on how to make sure it doesn’t happen to you.
Cash is the lifeblood of any business and the length of time between when you have to pay items like your suppliers, interest on you borrowings, employee salaries and the time you collect from your customer can give rise to a thrombosis. Businesses don’t necessarily fail because they are not profitable – most businesses fail quite simply because they run out of cash.
Many more businesses will see their cash flow squeezed as Irish banks are forced to absorb the liquidity and cash flow impact of losses on loans transferred to NAMA and impairment costs. The medication required to keep the blood circulating and prevent the clots is Cash Flow Management.
You can delay some payments beyond the due date but you may not be in a position to delay payments on your bank loan or your tax bill unless you want a visit from the Receiver. You can’t normally delay payment of salaries without industrial unrest and you will run the risk of repossessions if you don’t make leasing repayments on time.
For many organisations, cash flow management simply entails delaying outflows of cash to suppliers until the last possible moment. However, this approach won’t win you many friends with your suppliers who might restrict the amount of credit they will extend to you and it will definitely have an adverse impact on your credit rating.
Hundreds of Irish businesses are members of programmes that provide their accounts receivable files to credit reference agencies that factor the payment habits into their credit rating scorecards. A poor credit rating narrows down the number of suppliers who will deal with you; it might prevent suppliers from obtaining credit insurance on your business and will almost certainly mean you don’t get as a good a deal on your purchases as companies with a good credit rating. It may also have a detrimental effect on your ability to raise short-term finance from banks that often use variants of their own credit scorecards incorporating credit reference agency data.
Effective cash flow management boils down to three key areas: cash flow measurement, preparing cash flow projections; managing your receivables with the objective of encouraging customers who owe money to pay it as soon as it becomes due (earlier if possible); and prudence over the timing and payment of purchases.
All businesses should prepare a cash flow projection on either a weekly or a monthly basis, forecasting for at least six months, preferably a full year in advance, making educated guesses for all of the factors that might affect your cash flow.
These will include: timing of when you will be paid for sales already made; sales you expect to make and all payables including supplier invoices, wages, vehicle expense and location costs etc. Make sure you monitor your actual performance against the forecast cash flow on a regular monthly basis and identify any shortfalls that need attention. Never forget: even profitable new business can cause cash flow problems; profitable companies can and do become insolvent when they have to pay the costs incurred during fulfilment of an order before they receive payment from their customer. This is generally referred to as overtrading and to avoid this threat it may be necessary to either delay some large orders to spread the fulfilment costs over a longer period, or to ask the customer for a deposit.
Most computer spreadsheets and business accounting software offer templates that are either pre-installed or free to download but remember to start with your cash in hand and account for any seasonal variations in income or expenditure. If it looks like you are going to enter periods of negative cash flow, look to find opportunities to reverse the negative cash flows by deferring capital expenditures or offering improved terms that encourage customers to pay more quickly.
If you do need to delay payment to a supplier, make sure you communicate with them and try to gain their consent. A crucial success factor when faced with a cash flow shortfall is acting early: the sooner you act the more options will be open to you. If you go to the bank looking for an emergency overdraft next week, you’ll get a much rougher ride than you will if you are looking for a line of credit that you may not need for another six months. If the Bank won’t help, consider other forms of business finance, such as factoring.
Factoring isn’t cheap. A Factor (invoice discounter) will advance payment on invoices issued today that may not be due for payment for another 30 or 60 days. You can either start with future invoices, or go back over your existing accounts receivable file. Many of the same Factoring companies can also offer payroll funding, which for a fee will provide you between one and two months’ grace on the payroll; they’ll take over the current month’s payroll and you’ll pay them 1 or 2 months in arrears. The cost will hit your profitability and reduce cash flow from operations but it will speed up cash inflows and may prevent a cash flow crisis.
In an absolute emergency, you could also consider raising cash by selling and leasing back assets such as plant and machinery or vehicles in the fleet; again, it isn’t cheap but it might beat the alternative.
Many cash flow problems can be averted by the adoption of robust credit management processes that supervise customer payment habits and prevent bad debts by avoiding customers who are at risk of insolvency.
Good credit management practices will speed up your cash collection, control how much credit you provide and to which customers you grant credit. The golden rule of credit management is never to give any single customer more credit than you could afford to lose if the customer went bust and never paid.
Depending on your margin and bad debt losses, it might be worthwhile considering using either your own internal credit scoring system or a credit rating agency to evaluate your largest customers on a fairly regular basis.
If you process 800 orders a year with an average order value of €800 and 64 customers don’t pay, your credit losses will be €51,200. You might be able to reduce these credit losses with the adoption of an internal expert credit management system but a good credit reference agency will be able to identify between 60 percent and 80 percent of the customers who are unlikely to pay.
If the credit reference agency identified 70 percent of the orders that were likely to default, you could reduce credit losses from €51,200 to €15,360 – a reduction of €35,840. You should be able to easily translate this into impact on bottom line but it would almost certainly be more cost effective to use a credit reference agency in these circumstances. Always remember that your existing customers are statistically almost as likely to result in a bad debt as any new customers you take on, so if you are going to use the services of a credit reference agency, make sure you check all of your larger customer and not just the new customers.
Another popular method of Risk Management is the use of Trade Credit Insurance. Credit Insurance usually covers the whole turnover and pays an agreed percentage of an invoice or receivable that remains unpaid as a result of payment default, insolvency or bankruptcy. Credit insurance premiums are usually charged monthly, and are calculated as a percentage of monthly sales or as a percentage of all outstanding receivables but you can also obtain cover for single transactions, or a single customer for a one-off premium.
However, always remember, credit insurance is no different to any other kind of insurance; all insurers work on profitable loss ratios so, over a period of time, your premiums may well amount to more than your losses.
You are unlikely to get cover on high risk customers and you may not get the credit limits you are looking for on some of your larger customer, which could leave you without cover.
Regardless of whether you use a credit reference agency and/or credit insurance, you should always:
A) Set credit limits for all customers. This can be based on the credit reference agency recommendation if you have requested a credit limit. Other methods include: after obtaining trade references, you can take an average of the high or current credit figure given by other suppliers, or from financial statements by setting the credit limit at anywhere between 5 percent and 15 percent of net worth. You should adjust any credit limit to take account of the golden rule (never to give any single customer more credit than you could afford to lose if the customer became insolvent and was unable to pay) and your own payment experience.
B) Make sure every customer has signed up to your terms and conditions and is in no doubt over the agreed credit terms. Check the paperwork from the sales person and if anything is unclear make it a priority to resolve before the goods are shipped.
C) Send invoices immediately after you have supplied the goods or service; don’t wait until the end of the month. Make a follow-up call to confirm that all the invoice details were correct and that there will be no problem paying it by the due date. If there are any queries over the order or the invoice, notify sales immediately and actively engage them in the resolution process
D) Check later payments daily and chase them up on the day they become overdue, always starting with largest debtors first.
E) Inform late payers that unless payment is received by an agreed date you will charge interest on the overdue amount. All businesses have a statutory right to charge interest on late payments, whether it is in their terms and conditions or not
F) Formalise any revised agreement in writing and confirm to your customer in writing that you will be exercising your statutory right to interest on overdue accounts. Key to success is making sure that overdue customers put payment of your invoice ahead of any other supplier who might be pressing for payment.
G) If you haven’t been paid by 90 days use a debt collection agency. A good debt collection agency will normally embark on an amicable collection phase that will yield favourable results well before you incur any of the costs of going down the legal route.
Finally, if an order looks too good to be true, it almost certainly is.