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A deficit is what you have when you haven't got as much as when you had nothing.
--Gerald F. Lieberman
The law of cash flow: No matter how much cash you have coming in, it never comes in soon enough to cover your expenses.
--Anonymous
Learning Objectives
Students will be able to:
1. Explain the importance of cash management to the success of the small business.
2. Differentiate between cash and profits.
3. Understand the five steps in creating a cash budget and use them to create a cash budget.
4. Describe fundamental principles involved in managing the "Big Three" of cash management: accounts receivable,
accounts payable, and inventory.
5. Explain the techniques for avoiding a cash crunch in a small company.
Instructor’s Outline
I. Introduction
A. Cash
1. A four-letter word that has become a curse for many small businesses.
2. Developing a cash forecast is essential for new businesses because in the early stages businesses usually do
not generate sufficient cash to keep afloat.
3. Controlling the financial aspects of a business with the techniques described in the previous chapter is
immensely important.
4. However, by themselves, those techniques are insufficient to achieve business success. Entrepreneurs are
prone to focus on their companies' income statements--particularly sales and profits.
a) It is entirely possible for a business to have a solid balance sheet and to make a profit and still go out of
business by running out of cash.
Selling globally is an excellent strategy for boosting sales and profits, but only if you get paid for what you sell! Collecting
bills from foreign customers is more difficult than collecting from customers next door. For instance, collecting accounts
receivable from U.S. companies takes an average of 42 days. Collecting payment from foreign customers usually takes a good
deal longer, however.
Uniform laws giving businesses the right to pursue late payers and to add interest charges to their accounts do not exist across
Europe. "U.S. companies make a big mistake when they assume that they can deal with problem foreign accounts the same
way they do [in the United States], says the head of an international collection agency.
Before they send thousands of dollars of merchandise halfway around the world, U.S. entrepreneurs must take some basic
precautions to make sure their foreign customers will pay their bills. The following techniques have worked for many small
businesses:
Rowena Rowdy had been in business for slightly more than two years, but she had never taken the time to develop a cash
budget for her company. The business was growing fast, with sales more than tripling from the previous year, and profits
were rising. However, Rowena often found it difficult to pay all of the company’s bills on time. She didn’t know why
exactly, but she knew that the company’s fast growth was requiring her to incur higher levels of expenses.
The company's wages and salaries (including payroll taxes) estimates are:
April $3,550
May $4,125
June $5,450
July $6,255
August $6,060
6 Section III Building the Business Plan: Marketing and Financial Considerations
September $3,525
The company pays 66 percent of the sales price for the inventory it purchases, an amount that it actually pays in the
following month. (Rowena has negotiated "net 30" credit terms with his suppliers.)
1. Help Rowena put together a cash budget for the six months beginning in April.
Answer: Using an Excel template, the students need to create a cash flow analysis.
2. Does it appear that Rowena’s business will remain solvent, or could the company be heading for a cash crisis?
Answer: Yes – after calculating the cash flow analysis from the sales forecast, the company will be heading for a
cash crisis.
3. What suggestions can you make to help Rowena improve her company's cash flow?
Answer: Student’s answers may vary. Most common answers will be to cut costs and expenses.
f)Take advantage of money-saving opportunities, such as economic order quantities and cash discounts.
g)Make the most efficient use of the cash available.
h)Finance seasonal business needs.
i)Provide funds for expansion.
j)Plan for investing surplus cash.
7. Manage cash flow effectively, and the business works.
B. Accounts Payable
1. The second element of the Big Three of cash management is accounts payable.
2. The timing of payables is just as crucial to proper cash management as the timing of receivables, but the
objective is exactly the opposite.
3. An entrepreneur should strive to stretch out payables as long as possible without damaging the company's
credit rating.
4. A simple five-point accounts payable system.
a) Set scheduling goals.
b) Keep paperwork organized.
c) Prioritize.
d) Be consistent.
e) Look for warning signs.
5. Business owners should verify all invoices before paying them.
6. In general, it is a good idea for owners to take advantage of cash discounts that vendors offer.
a) A clever cash manager also will negotiate the best possible credit terms with his suppliers.
b) Almost all vendors grant their customers trade credit, and the small business owner should take
advantage of it.
7. Favorable credit terms can make a tremendous difference in a firm's cash flow.
a) Table 9.6 shows the same most likely cash budget as that shown in Table 9.2, with one exception:
Instead of purchasing on C.O.D. terms (Table 9.2), the owner has negotiated "net 30" payment terms
(Table 9.6). Notice the drastic improvement in the company's cash flow resulting from improved credit
terms.
8. Owners who do find themselves financially strapped should discuss openly the situation with the vendor.
9. Small business owners also can improve their firm's cash flow by scheduling controllable cash disbursements
so that they do not come due at the same time.
a) Scheduling insurance premiums monthly or quarterly rather than annually also improves cash flow.
C. Inventory
1. Inventory is a significant investment for many small businesses and can create a severe strain on cash flow.
2. Although inventory represents the largest capital investment for most businesses, few owners use any formal
methods for managing it.
3. Surplus inventory yields a zero rate of return and unnecessarily ties up the firm's cash.
a) A typical manufacturing company pays 25 percent to 30 percent of the value of the inventory for the cost
of borrowed money, warehouse space, materials handling, staff, lift-truck expenses, and fixed costs.
4. Marking down items that don't sell will keep inventory lean and allow it to turn over frequently.
Chapter 9 - Managing Cash Flow 9
a) Even though volume discounts lower inventory costs, large purchases may tie up the company's valuable
cash.
b) Only 20 percent of a typical business's inventory turns over quickly, so the owner must watch constantly
for stale items.
5. Carrying too much inventory increases the chances that a business will run out of cash.
Lance Redmond had this in mind: What should he do with the check he had just received as an up-front payment from a
large customer for a job the customer wanted Redmond’s company to do? In light of the fact that Redmond’s company,
Stallion Manufacturing, a maker of industrial equipment, did not have the cash to meet a payroll due in just 20 days, the
answer seemed simple: Cash the check.
Redmond knew that his company was not capable of doing the job the customer was requesting. The scope of the job
required engineering skills, equipment, and financing that Stallion Manufacturing simply did not have. Redmond called a
meeting to talk about the situation with his top managers. The Chief Financial Officer, Sandy Camanetti, suggested they
cash the check, meet with the managers from the company, and bluff, pretending to consider accepting the job.
Later that evening at dinner, Redmond happened to see an old friend. Redmond explained the scenario, and then asked the
friend, “What should I do?”
1. Assume the role of Lance Redmond’s friend. What advice would you offer him? Explain your reasoning.
Answer: Student’s answers may vary.
3. What other recommendations can you make to Redmond for resolving this problem? Develop a list of at least
three suggestions that would help Redmond manage his company’s cash flow more effectively.
Answer: Student’s answers may vary.
VIII. Conclusion
1. Successful owners-run their businesses "lean and mean." Trimming wasteful expenditures, investing surplus
funds, and carefully planning and managing the company's cash flow enables them to compete effectively in
a hostile market.
2. The simple but effective techniques covered in this chapter can improve every small company's cash
position. One business writer says, "In the day-to-day course of running a company, other people's capital
flows past an imaginative CEO as opportunity."
3. By looking forward and keeping an analytical eye on your cash account as events unfold (remembering that
if there's no real cash there when you need it, you're history), you can generate leverage as surely as if that
capital were yours to keep.
Chapter Summary
Explain the importance of cash management to the success of the small business.
Cash is the most important but least productive asset the small business has. The manager must maintain enough cash
to meet the firm's normal requirements (plus a reserve for emergencies) without retaining excessively large,
unproductive cash balances.
Without adequate cash, a small business will fail.
Understand the five steps in creating a cash budget and use them to create a cash budget.
The cash budgeting procedure tracks the flow of cash through the business and enables the owner to project cash
surpluses and cash deficits at specific intervals.
The five steps in creating a cash budget are determining an adequate minimum cash balance, forecasting sales, and
forecasting cash receipts, forecasting cash disbursements, and determining the end-of-month cash balance.
Describe fundamental principles involved in managing the "Big Three" of cash management: accounts receivable,
accounts payable, and inventory.
Controlling accounts receivable requires business owners to establish clear, firm credit and collection policies and to
screen customers before granting them credit. Sending invoices promptly and acting on past-due accounts quickly also
improve cash flow. The goal is to collect cash from receivables as quickly as possible.
When managing accounts payable, a manager's goal is to stretch out payables as long as possible without damaging
the company's credit rating. Other techniques include verifying invoices before paying them, taking advantage of cash
discounts, and negotiating the best possible credit terms.
Inventory frequently causes cash headaches for small business managers. Excess inventory earns a zero rate of return
and ties up a company's cash unnecessarily. Owners must watch for stale merchandise.
Discussion Questions
1. Why must small business owners concentrate on effective cash flow management?
Answer - Cash is the most important yet least productive asset that a small business owns. A business must have enough
cash to meet its obligations or it will be declared bankrupt. Proper cash management enables the owner to adequately meet
the cash demands of the business, to avoid retaining unnecessarily large cash balances, and to stretch the profit-generating
power of each dollar the business owns.
5. Outline the basic principles of managing a small firm's receivables, payables, and inventory.
Answer - Managing receivables. Selling merchandise and services on credit is a necessary evil for most small businesses.
An assertive collection program is essential to managing a company's cash flow. The owner should have a credit and
collection policy. Small business owners can take several steps to encourage prompt payment of invoices.
Ensure that all invoices are clear, accurate, and timely.
State clearly a description of the goods or services purchased and an account number, if possible.
Make sure that prices on invoices agree with the price quotations on purchase orders or contracts.
Highlight the terms of sale (e.g., "net 30") on all invoices and reinforce them, if necessary.
Include a telephone number and a contact person in your organization in case the customer has a question or a dispute.
The second element of the Big Three of cash management is accounts payable. The timing of payables is just as crucial to
proper cash management as the timing of receivables, but the objective is exactly the opposite. An entrepreneur should
strive to stretch out payables as long as possible without damaging the company's credit rating. Business owners should
verify all invoices before paying them. In general, it is a good idea for owners to take advantage of cash discounts that
vendors offer. Small business owners also can improve their firm's cash flow by scheduling controllable cash
disbursements so that they do not come due at the same time.
Inventory is a significant investment for many small businesses and can create a severe strain on cash flow. Surplus
inventory yields a zero rate of return and unnecessarily ties up the firm's cash. A typical manufacturing company pays 25
percent to 30 percent of the value of the inventory for the cost of borrowed money, warehouse space, materials handling,
staff, lift-truck expenses, and fixed costs. Only 20 percent of a typical business's inventory turns over quickly, so the owner
Chapter 9 - Managing Cash Flow 13
must watch constantly for stale items. Carrying too much inventory increases the chances that a business will run out of
cash.
7. What steps should business owners take to conserve cash in their companies?
Answer - Business owners can take a number of steps to conserve cash.
When practical, lease instead of buy.
Avoid nonessential outlays.
Negotiate fixed loan payments to coincide with your company's cash flow cycle.
Buy used or reconditioned equipment, especially if it is "behind-the-scenes" machinery.
Look for simple ways to cut costs.
Hire part-time employees and freelance specialists whenever possible.
Control employee advances and loans.
Establish an internal security and control system.
Develop a system to battle check fraud.
Change shipping terms.
Switch to zero-based budgeting.
8. Alan Ferguson, owner of Nupremis, Inc., a Web-based application service provider, says, “We lease our equipment
and technology because our core business is deploying it, not owning it.” What does he mean? Is leasing a wise cash
management strategy for small businesses? Explain.
Answer: By leasing computers and other assets rather than buying them, an entrepreneur can conserve valuable cash. The
value of such assets is not in owning them but in using them. Approximately 80 percent of U.S. companies use leasing as
a cash management strategy. Although total lease payments typically are greater than those for a conventional loan, most
leases offer 100 percent financing, which means the owner avoids the large capital outlays required as down payments on
most loans. Also, leasing is an "off-the-balance-sheet" method of financing; the lease is considered an operating expense
on the income statement, not a liability on the balance sheet. There are two types of lease: Operating lease at which at the
end of the lease, a business turns the equipment back over to the leasing company with no further obligation. Capital lease
at which at the end of the lease, a business may exercise an option to purchase the equipment, usually for a nominal sum.
9. What should be a small business owner's primary concerns when investing surplus cash?
Answer - Because of the uneven flow of receipts and disbursements, a company will often temporarily have more cash
than it needs a for a week, a month, a quarter, or longer. Entrepreneurs who put surplus cash to work immediately rather
than allowing it to sit idle soon discover that the yield adds up to a significant amount over time. However, when investing
surplus cash, the owner's primary objective should not be to earn the maximum yield (which usually carries with it
maximum risk); instead, the focus should be on the safety and the liquidity of the investments. Asset-management
accounts, which integrate checking, borrowing, and investing services under one umbrella and were once available only to
large businesses, now help small companies conserve cash.
4. Interview several local business owners about their policies on accepting payments by check. How much do they typically
lose in a year's time to bad checks? What safeguards do they use to combat check fraud? Contact the American Collectors
Association at P.O. Box 39106, Minneapolis, MN 55439-0106 or access the ACA's Web site at:
http://www.collector.com/
How prevalent is check fraud? What can business owners do to prevent it? Using these resources and those in your local
library, develop a set of recommendations for the owners you interviewed to reduce their losses to check fraud.