Understanding the ebbs and flows of cash in your business is critical to scouting for warning signs of impending cash crunches. Bookkeeping software like QuickBooks can tell you that you will be getting money in the door, but without knowing when, you’re going to be left not knowing if you can pay the bills on time.
The activities that your business carries out can be broken down into several key events. For example in a manufacturing business, these main events would be:
- Buy the raw materials
- Pay for the raw materials
- Manufacture the product
- Sell the product
- Collect payment from the customer
The actions for businesses that provide a service are quite similar. For ease of presentation, we will use a manufacturing business in our example.
Let’s Have a Look at a Simple Example
You purchase inventory for your company for $1000. You pay the bill to the supplier 30 days later. After 15 more days, a customer buys the product for $2500. Your customer buys on credit so she does not actually pay you for another 45 days.
So, you know you’re making a profit on the sale, which is great. However, you may miss the fact in this example that it is a total of 90 days between the inventory coming in the door and going out the door (the inventory holding period) and it is a 60-day span between cash going out the door and cash coming in the door (the cash float).
Why do we need to know the inventory holding period and the cash float? Because, we need to make sure that we can pay for the inventory when it’s due. There’s a 60-day cash flow gap between us paying suppliers and customers paying us. Now that we have that information, we need to ensure that we have the financial resources to “float” that inventory.
The Cash Flow Report
One way to pull all this information together is to prepare a monthly Cash Flow Report. This will let us predict the times when we will be short on cash and times when we will have extra cash that we will need to invest. If you have a bookkeeping program like QuickBooks, this will be an easier exercise.
The Cash Flow Report looks much like a budget, with the exception that it only cares about which period we will collect and disburse money.
Many growing companies find themselves facing a cash flow gap and turn to invoice factoring for immediate access to capital. When you sell your invoices to a factoring company, they now collect payment from your customers for the invoices you factor alleviating one more administrative task.
Let’s just look at the revenue side for a moment. Our Monthly Budget Report shows us this information:
Jan Feb Mar Apr May June
1,250 1,095 2,470 1,750 975 1,645
So we know that we should be able to bill our customers these amounts. But what do we know about when we’re going to get the money? We already know our average receivable turnaround time (refer to last month’s column). If we get the money in on average in 37 days, is that enough information? Not quite.
We need to have an accounting of the percent of revenue we will receive in each month. We can do that by looking at our historical cash receipts and seeing what the patterns look like.
Let’s assume the following: If we’re looking at the month of March, we know that we will probably collect 15% of the March billings in that month. This tells us that 85% of all of our March revenues will be collected in the future. We know that we’ll probably get 63% in the following month, in this case, April. This makes sense considering that on average we collect in 37 days. We have now collected 78% of all our March billings. A further 18% will be collected in May, and, assuming that we have no bad debts, the rest (4%) will be collected in June. Therefore, in June, we will be collecting 4% of March’s billings, 18% of April’s billings, 63% of May’s billings and 15% of June’s billings. We have now determined our expected cash inflows.
So, in May, even though we are billing $975, we are expecting to collect $1,737. You can also predict that June will have a significant bite out of its cash flow. Even though we billed a lot in June, we didn’t in May and we are collecting 63% of May’s billings in June. This is much more useful information for us as we now know what we expect to be in our bank account in any given month.
The expense side of the Cash Flow Report is similar to the revenue side. When it comes to cash flow, we want to put expenses into the periods we expect to pay them, not the period in which they were incurred. For example, if we buy new materials from our supplier for $1,500 in May, but we don’t pay them until June, that expense would be in May on the Monthly Budget Report and recorded in June on the Cash Flow Report.
Although, at first glance, it would seem onerous to track all of this information regularly, it is actually quite easy once you set up the initial format. If you don’t have QuickBooks, you can use an Excel spreadsheet to calculate your cash flows. Divvy also has a handy online tool for managing expense reports. Having an understanding of the money coming in and going out will give you better control over your business.
Your Questions Answered Quickly
Whether your business is thriving and you can’t keep up, or you are waiting on clients to pay, Universal Funding can help your growing company. Call us at 800.405.6035 or complete our rate form today to learn more about invoice factoring and how it can improve your company’s cash flow.
About Universal Funding
Universal Funding is a private funding source that has funded thousands of businesses and more than $2 billion since 1998. We turn your accounts receivable into the funding you need through invoice factoring and can have capital in your hands in a matter of days.