Avoiding Cashflow Problems

How to successfully manage your cash flow | Ashored

Introduction One of the major causes of small business failure is running out of cash. There are many reasons why your business may face a cash crisis, and it is important to understand the factors that can cause cash flow problems. No matter how healthy your balance sheet may appear in terms of the physical assets your business owns or the money that is currently owed to it, your ability to convert sales into actual cash at critical times may make the difference between survival and failure.

This factsheet looks at the situations that can lead to cash flow problems and how you can avoid running into trouble. It outlines the practical steps you can take to build and maintain your cash flow.

Why cash is important A business can only continue to trade if it has the cash available to pay its bills when they fall due. To ensure this, it is necessary to understand how cash flows into and out of a business.

Cash flows into a business from money that is invested in it by its owners and any shareholders, and from the money that is paid by customers when a sale is made.

Cash flows out of a business when it pays suppliers, staff wages, overhead costs and taxes.

Problems can arise when outflows of cash are greater than inflows and ultimately at the critical point where all the cash available to the business has been spent. It is essential to address any cash flow problems in good time, well before this stage.

The main causes of cash flow problems

Late payment by customers A sale is completed only when an invoice has been paid in full. Many business owners concentrate on generating new sales, and fail to set up adequate procedures to ensure that customers pay on time. As a result they experience cash flow problems.

A key customer becomes insolvent If your business is dependent on a few major customers, you are exposed to the risk of one of them having financial problems that could result in non-payment of an invoice. This can be disastrous if the income from that client makes up a large proportion of overall revenue, and is needed for your business to pay its own creditors or employees.

Insufficient working capital Working capital is the money that finances the day-to-day operations of your business. When you first set up your business you are likely to face significant costs. You then have to pay suppliers and staff regularly before you actually receive any money from your customers. If enough money is not invested in your business when you set it up, you can quickly encounter cash flow problems once you start to trade as the cash flows out much faster than it is received.

You can also run into problems with working capital if your business grows very quickly. This is because as sales grow working capital requirement also grows. Money becomes tied up in stock and an increasing amount of money is owed by customers, who may pay more slowly than is needed for the business to pay its suppliers. This situation is commonly called over-trading.

Focusing on turnover instead of profit Everyone wants to see their sales grow as quickly as possible but long-term sustainable cash flow into a business is generated only through making profits. Products that the business sells, and services that it delivers, should therefore be costed carefully to ensure that they generate a profit for the business at their expected selling prices. Focusing on high-volume but low-profit-margin sales can quickly lead to a position of over-trading if the working capital needs of your business have been underestimated.

Poor financial planning Problems can occur if you do not make plans to ensure that you have cash to cover major expenses such as Value Added Tax (VAT), Pay As You Earn (PAYE) and National Insurance (NI) contributions, business rates and rent. You must take account of these payments in your cash flow forecast and ensure that sufficient funds will be available at these key times. It is also important to purchase any costly equipment when cash flow is stronger, or consider leasing equipment over a longer period to reduce the impact on cash reserves.

Over-committing with stock purchases Wholesalers and other suppliers often offer discount incentives for bulk purchases, to encourage you to buy larger volumes of their goods. This may appear attractive at first, but careful thought is necessary before committing to large orders of stock, particularly for a new start up. A bulk order for items that quickly go out of fashion or have a short shelf life might mean being left with unsaleable stock that still has to be paid for.

Practical steps for maintaining cash flow

A cash flow forecast is an important tool for avoiding cash flow problems. The forecast makes it possible for you to anticipate most cash flow issues that could occur during the normal course of running your business. It also allows you to work out what effect lower sales or slower payments would have on cash movements.

The key ways to reduce cash flow problems are as follows.

Adopt tight credit control procedures Only provide credit to approved customers. To decide whether or not to approve a customer for credit, set up procedures that allow you to obtain all the information you need to make a credit decision. For example, ask customers to complete a credit application form.

Check when their accounts are due for payment and ensure that they pay according to agreed terms. It is important to have efficient administrative procedures for preparing invoices promptly and sending statements to customers.

Check that customers are creditworthy Credit checks can be performed through a variety of third-party services including credit agencies, bank references and trade references.

Credit agencies provide status reports on customers, along with details of County Court judgments as well as credit ratings.
Bank references involve asking a customer's bank its opinion on the customer's ability to meet payment demands.
Trade references come from referees who have dealt with that customer before. Referees should be asked questions regarding the customer's payment habits, sales and payment terms.

The Better Payment Practice Campaign has useful guidance on the various ways to check customers' creditworthiness.

Offer incentives for early payment Consider offering customers a discount if they pay either on delivery or within a certain number of days (typically 7-14 days) of the invoice date. Common levels of discount are 2%-5%, but the exact level will depend on the effect on the business's profit margins and how important early payment is.

Make it easy for customers to pay Offer customers a range of different payment methods including, for example, secure online payment via a payment services provider such as PayPal (www.paypal.co.uk) and credit/debit card payments through Chip and PIN, smartphone payment apps or over the telephone. Factoring and invoice discounting If your business is growing rapidly, it may be helpful to use an invoice discounting or factoring service. These provide an advance (usually 80%-85%) on the value of invoices as soon as they are raised. Interest is charged on the advance and there is a service charge. Factoring firms may also take direct control of collecting payments from customers, which can save businesses the cost of managing this process. Part-payment If you have a large order to fulfil or a big project to complete for a client, it is advisable to consider negotiating part-payment in advance. For example, you could ask to be paid half the total amount of the bill at the outset, or for completing half the order or achieving a particular deliverable in a project. The outstanding amount would be payable on completion of the project/order. This guarantees some cash income for the business upfront and it means payment for the full amount won't have to be pursued once the project/order is fulfilled.

Negotiate better credit terms with suppliers As your business grows, it may be possible to negotiate better credit terms with suppliers. If the majority of your customers expect to have 30-day credit accounts, your business will benefit from 30-day payment terms with its own suppliers.

Set up a bank overdraft facility An overdraft makes it possible to borrow money as and when required from the bank, up to an agreed limit. It can be a helpful way to finance working capital for businesses with large variations in cash flow during the course of a month, or large seasonal variations, because interest is only paid on the amount actually borrowed.

On the other hand, continued reliance on an overdraft can become expensive. More importantly, it may also highlight that a business needs additional working capital, or a longer term form of finance. With an overdraft, a business is also exposed to 'repayment on demand', which means that the lender can ask for full repayment at any time. A 'term loan' with fixed monthly instalments can be a better option as the lender can only demand full repayment if the borrower defaults on instalments.

Asset financing If your business needs to invest in new equipment but does not have the cash, the purchase can be funded with a term loan, a hire purchase loan or a leasing deal. These arrangements allow fixed regular repayments over a set period, usually two to five years. In situations where the asset is being used as security for the finance, it is likely that a deposit of at least 10% will be required.

Hints and tips

Keep a close eye on the cash book and the sales ledger so that peaks and troughs in cash flow throughout the year can be forecast.
Regularly monitor debtors and pursue customers promptly for payment of overdue invoices. Analyse their payment patterns to help spot any potential problems early on in the process.
Pay all cheques and cash from customers into the bank as soon as they are received.
Plan ahead for expenses such as utility bills and tax payments. Cash flow problems are best caught early and the more time there is to respond the better. Where problems are anticipated with meeting payment demands for tax, PAYE or NI, contact HMRC's Business Payment Support Service.
Act quickly when a shortage of cash is expected. Contact the bank and suppliers as soon as a problem arises. Delay risks harming relationships with the bank, suppliers and customers. Banks are far more understanding about cash flow problems when they are tackled in advance.
Remember that businesses have a legal right to charge interest on late payments, under the Late Payment of Commercial Debts (Interest) Act 1998 (as amended).