Cash flow risk and how to reduce it
Cash flow is the lifeblood of any business, but managing it effectively involves understanding and mitigating risks that can threaten the health of the business at large. Here’s everything you need to know about cash flow risk and how to avoid it.
Cash flow, or the flow of money into and out of a business, is a central element of operational health. It determines a business’s ability to pay bills on time, cover unexpected costs, and invest in growth or development – all essential components of a thriving company. But there are a range of cash flow risks that can affect the health of a business’s books, and in turn the amount of available working capital.
Poor cash flow management can expose you to these risks, which is why it’s one of the most common causes behind businesses failing. That makes understanding cash flow risks critical, ensuring you stay in control of your cash flow and avoid it controlling you.
Understanding cash flow
Cash flow is sometimes mistaken as simply being the same as revenue or profit, but it’s actually more of a process than a single figure. Essentially, cash flow is the term used to describe the flow of money into and out of a business in all its forms. Money in can come from revenue, investments, and other operating activities, while money out is the total of all a business’s expenses.
Cash flow is often described as ‘positive’ or ‘negative’, which describes whether more money is flowing into or out of a business in a given time period. If a business is making more money than it is spending, it is cash flow positive. If the opposite is true, it is cash flow negative. Generally, running a negative cash flow poses greater risks, as it highly limits the flexibility with which you can react to adversity, whether from within your organization or in the wider market.
Cash flow risk terminology
There are several commonly used terms that apply to cash flow risk, which it’s helpful to understand. They are:
- Cash flow at risk (CFAR) – A measure that provides information about what portion of future cash flow is at risk from changing market conditions, usually weighted by importance.
- Value at risk (VAR) – A measure of the extent to which an investment could lose value over a given time period, often delivered with a probability of that happening.
- Liquidity risk – A measure of how readily a business can cover its financial obligations or, in other words, how liquid its capital is.
Types of cash flow risk
There are a wide range of cash flow risks to be aware of, posed by a variety of sources. Some cash flow risks are internal, which are generally able to be controlled by operational policy, while others are external and largely out of the control of the business at risk.
The main categories of cash flow risk are:
- Operational risks – Generally coming from within the business, operational supply chain risks are present in the processes, procedures, and policies of internal departments including accounts receivable, procurement, and accounts payable. These departments are responsible for the management of money entering and exiting the business, and so the way they operate has an intrinsic effect on cash flow. Examples of operational cash flow risks include poorly optimized payment terms, unmitigated potential for internal fraud, and inefficient inventory management.
- Macro market condition risks – Cash flow risks are also present on a much more macro scale – particularly from the condition of the global market. Overall global economic conditions, such as interest rates and the availability of finance, affect the ease with which businesses (and particularly SMEs) can access liquidity when needed. Taking an even broader view, global crises such as recessions or pandemics can cause supply chain collapses or demand fluctuations that also pose huge risks to healthy cash flow.
- Industry risks – In a similar way to with macro market conditions, there are a variety of cash flow risks that can be presented due to volatility or adverse events in the specific industry within which a business operates. Whether it’s a change in cost for an essential raw material somewhere in the supply chain or rapid shifts in demand for a certain type of product, industry-based cash flow risks can cause sudden changes in the amount of money coming into or out of a business.
- Supply chain risks – Finally, there are the risks that come as a natural part of having a complex, expansive supply chain. Cash flow risks are abundant in supply chains, especially if you’re reliant on a lot of individual suppliers with moderate to high risk profiles. All it takes is for one supplier (or even one of your suppliers’ suppliers) to fail, and the domino effect that ripples through the supply chain can cause chaos, seriously inhibiting your operational capabilities and damaging cash flow.
Managing cash flow risks
With an understanding of what types of cash flow risk exist, and what kind of threat they pose to your ability to operate healthily or efficiently, we can finally move on to covering how you can go about managing them. These are four of the best methods to consider when you’re trying to minimize cash flow risk.
Improve cash flow forecasting
Cash flow forecasting is a hugely beneficial tool in the battle against cash flow risks. With effective cash flow forecasting software, you can get an accurate prediction of cash flow over extended periods of time, helping you to make better decisions and plan ahead for periods where you predict surplus cash or funding gaps.
Unlock value in your supply chain
Instead of relying purely on external financing to deal with the fallout of cash flow risks, it’s also helpful to create a plan as to how you can access liquidity from within your supply chain. This can be achieved with solutions like dynamic discounting and supply chain finance, which help to speed up cash flow and unlock working capital.
Optimize cash inflow
From a more traditional perspective, you can also help to mitigate cash flow risks by optimizing how money comes into your business. This can include techniques like offering an expanded choice of payment methods, following up quickly on invoices, and working on improving operational margins.
Minimize cash outflow
Finally, you can also minimize the money that flows out of your business by reducing expenses where appropriate, helping to improve margins without increasing sales. This can be achieved in a broad range of ways, including converting short-term debt to long-term debt, eliminating unnecessary expenses, and renegotiating supplier terms.