Striving towards better cash flow management

The importance of cash flow to the health, resilience, and capabilities of any organization cannot be overstated. Cash flow is the net amount of cash that moves into and out of a company. It can be positive or negative and each state has implications on how effectively the company can operate.

A business that has positive cash flow has more money coming in than leaving, resulting in sufficient funds on hand to meet its liabilities. It is also likely to be more attractive to lenders and investors, and better able to adapt to fluctuating market conditions.

One with negative cash flow, on the other hand, has higher outflows than money coming in. In this condition, a business might be unable to pay costs or creditors without external funding and is vulnerable to sudden threats, such as changes in demand.

Cash flow health drives growth and ensures that bills are paid on time, building resilience against adverse market conditions. Which makes cash flow management one of the most fundamentally important practices in business.

What is cash flow management?

Cash flow management is the process by which a business keeps track of and optimizes the cash coming in and going out. It’s central in working capital management. With better cash flow management capabilities, businesses can control the inflows and outflows of capital more effectively. This allows them to make better use of their capital, giving them the ability to invest in growth or resilience with more confidence.

It’s also an essential component in forecasting. Helping businesses predict future revenue and expenses to identify the amount of cash needed to cover payroll, pay suppliers, and service debt.

Cash flow management involves overseeing and managing cash from all sources. These can generally be divided into three categories:

• Cash flows from operating activities represent the movement of money associated with the ordinary operations of a business – generating revenue and covering costs.
• Cash flows from investing activities include the revenue or spend arising from investments, such as the sale or purchase of long-term assets or securities.
• Cash flows from financing activities are the inflows associated with the funding of a company from external sources and the costs associated with that funding.

Measuring cash flow

The measurement of cash flow is key to efficient cash flow management. With an accurate view of their cash flow performance, businesses are better placed to make effective use of their cash and identify any risks or pain points. Key metrics for measuring cash flow include:

1. Operating cash flow:Calculated by starting with net income, adding back non-cash expenses such as depreciation, and adjusting for changes in working capital.

Operating Cash Flow = Net Income + Non-cash Expenses + Changes in Net Working Capital

2. Free cash flow (FCF): Shows the cash that a company can produce after deducting capital expenditure from its operating cash flow, thereby showing a truer picture of a company’s actual cash flow position.

Free cash flow = Operating cash flow – Capital expenditures

3. The cash conversion cycle (CCC): The time in days that it takes a firm to convert investment in inventory and other resource inputs into cash flows from sales.

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

4. Sustainable growth rate (SGR): The rate of growth that an organization can achieve using its own revenue without taking on additional equity or debt.

SGR = Return on equity (ROE) × Retention ratio (RR)

Common challenges in cash flow management

Several factors can hinder efforts to manage cash flow effectively. For businesses that operate with irregular revenue patterns, such as those that are affected by seasonal or cyclical demand, managing costs in low-revenue periods is a challenge.

Businesses that experience rapid growth can face different cash flow problems as they struggle to balance increasing expenditure – coming from hiring, ramped-up production, and increased inventory carrying costs – with additional revenue, which can take time to be collected.

Other businesses with poor cash flow forecasting capabilities can face challenges related to unpreparedness. Without an accurate projection of future cash flows, they can struggle to know how safely they can invest in growth. This means they can miss out on valuable opportunities, invest unwisely and find themselves vulnerable when market conditions change, or be required to fall back on a business loan, line of credit, or another form of external funding.

How to manage cash flow more effectively

The good news is that there are plenty of steps that can be taken to improve the way cash flow management is approached. These include:

Improving forecasting ability

By improving their ability to analyze current cash flows and forecast future cash flows, companies can greatly improve their overall cash flow management. Carrying out a scenario-based cash flow projection and analysis can help companies evaluate risk and examine the impact of possible events in a systematic way.

Technology can play a key role in driving a more accurate forecasting process. Taulia’s Cash Forecasting solution, for example, combines live data from each ERP instance with historical data, harnessing machine learning to predict future cash flows and drive better decision-making.

Shortening the cash conversion cycle

The shorter a business’s CCC, the less time cash spends tied up in inventory and accounts receivable. CCC is made up of three inputs, and it can be optimized (or shortened) by driving improvements to any one of its components:

• A company can increase its DPO simply by delaying payments. However, this approach can be detrimental to suppliers. Another option is to adopt a solution like supply chain finance that enables both the buyer and supplier to meet their working capital goals.
• Actions that can be taken to optimize DSO include offering early payment discounts and taking advantage of receivables financing solutions, as well as speeding up collections and automating the invoicing process.
• Strategies that companies can use to reduce DIO can include disposing of slow-selling inventory, optimizing stock levels, increasing demand through effective marketing, and adopting a sophisticated inventory management system.

Cutting costs where possible

In order to stay on top of recurring costs, companies should also conduct regular reviews to gauge the suitability of vendors and the value delivered by other expenses. By maintaining low costs, businesses can increase their resilience and improve their ability to withstand future cash flow changes.

Optimizing AP and AR processes

Last but not least, companies can improve cash flow management by driving improvements to their accounts payable (AP) and accounts receivable (AR) processes – thereby ensuring that cash stays in the business for longer.

Benefits of effective cash flow management

With more effective cash flow management, businesses will be more resilient and better prepared for whatever the future brings – whether that’s a changing economic landscape, disruptions to revenue, or unexpected rises in costs. Better cash flow management also makes it easier for companies to identify how they can invest in growth while minimizing the risks – all while ensuring they have the capital they need to fund that growth.