Chapter 13, Page 203
CHAPTER 13. MANAGING CASH FLOW
Part 1: Learning Objectives
1. Explain the importance of cash management to a small company’s success.
2. Differentiate between cash and profits.
3. Describe the five steps in creating a cash budget.
4. Describe the 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.
Part 2: Class Instruction
Introduction
Running out of cash has driven countless small companies into bankruptcy. A cash
forecast is essential for new businesses because they usually do not generate positive cash
Cash Management
LO 1
Cash is the most important, yet least productive, asset that a small business owns.
Businesses must have enough cash to meet their obligations or run the risk of declaring
bankruptcy. It is entirely possible for a business to earn a profit and still go out of business
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Cash management is the process of forecasting, collecting, disbursing, investing, and
planning for the cash a company needs to operate smoothly. Any excess cash should be
invested, even if for a short time. Managing cash flow is also an acute problem for rapidly
growing businesses, which are also likely to run out of cash to meet the needs of a
cycle which is the time lag between paying suppliers for merchandise or materials and
receiving payment from customers. The longer this cycle, the more likely the business will
encounter a cash crisis. Refer to Figure 13.3, the Cash Flow Cycle.
The next step is to analyze their cash flow cycle, looking for ways to reduce its length.
Business owners should calculate their cash conversion cycle whenever they prepare their
LO 2
As important as earning a profit is, a company’s survival depends on its ability to
generate positive cash flow. Profitability is not necessarily highly correlated with cash
flow. Cash and profits are not the same. Profit is the net increase over a period of time
in capital cycled through the business, indicating how effectively the firm is being
expenses. It measures how efficiently the business is operating.
Cash flow is a method of tracking a company’s liquidity and its ability to pay its bills and
other financial obligations on time by tracking the flow of cash into and out of the business
over a period of time. Cash flow is the volume of actual cash that comes into and goes out
of the business during an accounting period.
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Chapter 13, Page 205
The Cash Budget LO 3
The need for a cash budget arises because the uneven flow of cash in a business cycle
creates surpluses and shortages throughout that period. This uneven flow of cash creates
periodic cash surpluses and shortages. Refer to Figure 13.5, Cash Flow.
A cash budget is a “cash map” showing the amount and the timing of cash receipts and
cash disbursements on a daily, weekly, or monthly basis. It is used to predict the amount
A cash budget is based on the cash method of accounting, meaning that cash receipts and
cash disbursements are recorded in the forecast only when the cash transaction is expected
to take place. Credit sales to customers are not recorded until the customer actually pays,
and purchases made on credit are not recorded until the owner pays them. Depreciation,
bad debt expense, and other noncash items that do not involve cash transfers are omitted
Some suggest that a firm’s cash balance should equal at least one–fourth of its current
liabilities, while others recommend a cash reserve large enough to cover three to six
months’ of operating expenses. Highly seasonal businesses often require an even
larger reserve fund.
The most reliable method is based on past experience. For example, past operating
Step 2: Forecasting Sales
Sales forecasts are the heart of the cash budget and are based partially on past patterns
of existing businesses. This is a much more difficult process for a startup business.
The startup could do research on similar firms and their sales patterns in the first year
of business. A local chamber of commerce, trade associations, publications such as the
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government statistics could possibly provide information. Talking with owners of
similar businesses (outside the local trading area) can provide realistic estimates of
sales. Refer to Table 13.4, Forecasting Sales for a Business Start-Up.
Financial analysts suggest a business create three estimates-ptimistic, pessimistic, and
most likely.
Collecting Accounts Receivable, and Table 13.5, The High Cost of Slow Payers.
Many banks now offer cash management tools designed to speed up collection of
invoices. Electronic (Automated Clearing House) collections, which is a bank
service that allows businesses to deduct automatically invoice amounts from
customers’ accounts and deposit them into the seller’s account within 24 hours.
Every entrepreneur should know his or her company’s “burn rate,” the amount of cash
it spends each month. Refer to Figure 12.6, Cash Flow Concerns among Small
Business Owners. The key factor when forecasting disbursements for a cash budget is
to record them in the month in which they will be paid, not when the obligation is
incurred.
the checkbook and expenses, adding a cushion to those estimates, and making a daily
list of items that generate and consume cash.
Step 5: Estimating the End–of-Month Cash Balance
The cash balance at the end of the month becomes the beginning balance for the
following month. Estimating the end–of-the-month balance will give you insight and
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By planning cash needs ahead of time, a small business can achieve the following
benefits of effective cash management:
Increase the amount of cash and the speed of cash flowing into the company
Reduce the amount of cash and speed of cash flowing out of the company
Develop a workable program of debt repayment
Impress lenders and investors
Reducing borrowing costs by only doing when needed
Provide funds for expansion
Plan for investing surplus cash
1. Accounts receivable – Extending credit to customers.
2. Accounts payable – Suppliers and others extend credit to you.
3. Inventory – The largest expense for retail and manufacturing businesses.
Product-based businesses need to monitor, manage, and control their inventory
on a continual basis.
Cash conversion cycle is a measure of the length of time required to convert inventory
and accounts payable into sales and accounts receivable and finally back into cash. This is
Accounts Receivable.
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Many customers expect to buy on credit, and business owners extend it to avoid losing
customers even though it is expensive, requires more paperwork and staff, and more cash
policy begins by screening customers carefully by developing a detailed credit application
and then checking the potential customer’s credit references by using a credit reporting
service. Know when to walk away from an order-why make the sale if you won’t get
paid?
Next, a small business should establish a written credit policy and let every customer know
The business must take immediate actions when an account becomes overdue. The longer
an account is past due, the lower the probability of collecting it. Steps to accelerate the
collection of accounts receivable through encouraging the prompt payment of invoices
include: start with a friendly reminder to avoid damaging the relationship with a good
customer. When contacting a delinquent customer get a commitment to pay the full
As a last resort, hire a collection agency.
Business owners must abide by the provisions of the federal Fair Debt Collection Practices
Act, which prohibits any kind of harassment when collecting debts, and also prevents
collectors from making false statements and from contacting debtors at inconvenient
times. Refer to Table 13.6, Ten Collection Blunders and How to Avoid Them.
in advance.
Insure all invoices are clear, accurate and timely.
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Include a telephone number and contact person in case the customer has
Offer incentives to encourage customers to pay early and impose penalties for
paying late.
Restrict a customer’s credit until past–due bills are paid.
Deposit cash, checks, and credit card receipts daily.
Identify the top 20 percent of customers, create a separate file system for them,
Small companies that sell high-priced items can couple a security agreement with a
financing statement. A security agreement is a contract in which a business selling an
asset on credit gets a security interest in that asset (the collateral), protecting its legal
rights in case the buyer fails to pay.
Accounts Payable.
of cash discounts for early payment.
Verify all invoices before payment.
Negotiate the best possible terms with suppliers. Table 13.7 shows the same
most likely cash budget from Table 13.2 with one exception; instead of
purchasing on C.O.D. terms as shown in Table 13.2, the owner has negotiated
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Inventory.
Few small business owners use any formal method for managing inventory. Entrepreneurs
may find that they have either too much inventory, or the wrong type of inventory that has
selection, and customer satisfaction. Inventory should grow no faster than a company’s
sales. Refer to Figure 13.9, Changes in Small Business Inventories.
Inventory management also plays an important cash management role:
Schedule inventory deliveries at the latest possible date to prevent premature
payment of invoices.
supplies. They exist in two forms: cumulative and noncumulative.
Take advantage of cash discounts, which are discounts offered to customers
as an incentive to pay for merchandise promptly. Refer to Figure 13.10, A
Cash Discount.
Consider using You Be the Consultant: “In Search of a Cash Flow Forecast” at
Barter.
Bartering is the exchange of goods and services for other goods and services rather than
for cash. Bartering became more common during the Great Recession. It is also a good
way to transform slow-moving inventory into needed product and services. More than
500 bartering exchanges exist today, in which businesses accumulate trade credits (think
barter dollars) when they offer goods or services through the exchange. Then they use
their trade credits to purchase needed goods or services. The typical exchange charges
membership and maintenance fees.
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Trim Overhead Costs.
High overhead expenses can strain a small firm’s cash supply. Ways to trim overhead costs
include:
Ask for discounts and “freebees”
Conduct periodic expense audits
When practical, lease instead of buy. An operating lease is a lease at the end
of which a company turns the equipment back to the leasing company and has
no further obligation. A capital lease is a lease at the end of which a company
may exercise an option to purchase the equipment, usually for a nominal sum.
Use e-mail rather than mail
Use credit cards to make small purchases
Negotiate fixed loan payments to coincide with your company’s cash flow
cycle
Establish an internal security and control system
Build a cash cushion
Invest surplus cash. Entrepreneurs must put surplus cash to work immediately
rather than allowing it to sit idle; the goal is to invest every dollar not being
used to pay current bills. The primary concerns for investing surplus cash
should be safety and liquidity. This will ensure the cash is not going to be put
zero-balance account (ZBA) is a checking account that never has any funds in
it. A company keeps its money in an interest-bearing master account tied to
the ZBA; when a check is drawn on the ZBA, the bank withdraws enough
money from the master account to cover it. A sweep account is a checking