There’s a common saying in finance that goes, “Revenue is vanity, profit is sanity, but cash flow is reality.” As with many such sayings, there is a lot of wisdom behind this seemingly simplistic phrase. Cash is the reason many companies fail. Younger and growing companies, yes, but also sometimes large and established companies.
All businesses aim for profit, but one good month is never enough. Having consistent cash flow and the ability to cope with fluctuations in payments and expenses is what makes a business financially healthy. Cash flow is therefore more important than profitability.
The good news is that you can solve cash flow problems by planning ahead and managing them. When you know in advance that you will have a requirement for cash, you can weigh your options and get that provision in a calm and organised way. What’s not so easy, and in fact can be impossible, is managing issues at the last minute. Trying to find enough liquidity for Friday’s payroll on a Monday morning, for example.
How much liquid reserve should a company hold?
At this point, you may be wondering ‘Yes, but how much do I need?’ My recommendation is that at any point in time you have a liquid reserve that’s equal to six months’ worth of costs. This means that even if you fail to make a single sale, you could survive for six months. Let’s say your costs for one year are €300,000. That would translate into a reserve of €150,000.
This reserve can be in different forms. You might have just €50,000 in actual cash and €100,000 as an overdraft facility. You might have investments that can easily be converted to cash if needed. However, I do realise that for some businesses six months in reserve would be quite a challenge and that three months may be better suited to your needs.
How to build a liquid reserve for a business
Like I said, it’s a good idea to think ahead. It’s much easier to put solutions in place while your business is financially healthy. Two key things you can do within the business are credit control and stock management. Embrace technology to be efficient about the amount of credit you’re giving, such as collecting payment by direct debit, setting up automatic reminders for invoices, and automatic invoices. Read my in-depth advice about the good cash habits to adopt in your business.
Next, you can look outside the business to options such as bank loans, overdrafts, and investment. So, as well as talking to your bank, go to agencies such as the Local Enterprise Office or Enterprise Ireland to see what you might qualify for. You can also explore schemes available from the SCBI (they offer loans, asset finance, and invoice finance) or a Microfinance Ireland loan – both of these are state-backed and aimed at SMEs. In the private sector, you have peer-to-peer (P2P) lending, investment, and crowdfunding options.
Don’t allow cash flow issues to creep up on you
Every business that intends to grow should have a three-year business plan that they review and update regularly. As a business owner, you need solid projections to help you asses the health of the business at any point. If you have a business plan, it will be clear when there will be a requirement for cash. It will show you when the right time to invest in new people or resources is. Where there is a requirement for cash, you can go out explore options to fund that.
If keeping cash reserves is too big a challenge
If the thought of keeping cash in reserve seems impossible and you feel the need to monitor every expense in detail, you may have bigger issues than cash management. Only small companies and startups should be looking at cash at such a transactional level.
In larger companies, you can’t create models to monitor transactional expenses. You have to make much broader assumptions, such as ‘on average, our debts are going to be collectable in 35 days’. If a single customer delaying their payment means that you can’t do the payroll then, unfortunately, the business is badly financed. Short-term cash flow models are too focused and detailed to fix this problem.
Cash flow management and forecasting
We use two main types of forecasting: medium-term forecasting and immediate cash flow forecasting. Let’s have a quick look at each:
Immediate cash flow forecasting
This is forecasting on a much more micro-scale. Immediate cash flow forecasting looks at money going in and out from week to week. This would include the company’s financial details such as when to pay wages, the timing of invoices, what is the best time to pay VAT, etc.
Medium-term cash flow forecasting
Medium-term forecasting is usually a budget covering one to three years. It looks at expectations for cash flow, profitability, and expenses over time. You can identify patterns from month-to-month and year-to-year with this wide overview. Medium-term forecasting allows for the development and support of business plans and strategies while allowing for new opportunities when a period of surplus comes around.
You can use this budget to keep an eye on relationships with debtors and creditors and understand how they impact cash flow. We recommend medium-term forecasting to our clients – it’s great for monitoring if your cash flow is increasing (i.e., checking what net cash you’re bringing in). You do this by looking at the month’s trade. Perhaps in the month of June you increased your cash position by €30,000, but your expectations were higher at €35,000. This means you are behind, so you need to keep an eye on it.
This is a much healthier style of cash management than monitoring at a transactional level. Cash flow forecasts are not only good for healthy business growth and your own peace of mind, but should you apply for a grant or a loan your cash flow projections will be one of the first documents requested from you. Learn more about setting up budgets in Xero.
A healthy company should have reserves, a business plan, and be cash generative. Therefore, if you need to be micromanaging your cash flow then something else is wrong and this won’t fix it. If you want to explore this further, take a look at my blog that explains how to increase your company’s cash reserves in more detail.
