Cash Flow Archives : Planergy Software

How To Establish & Build Business Credit

Keith Murphy — Tue, 17 Oct 2023 10:52:09 +0000

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How To Establish & Build Business Credit

Category

Finance

Written by Keith Murphy
19 min read

Tags

Last edited

July 2, 2024

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KEY TAKEAWAYS

Businesses don’t automatically receive a credit rating upon creation.
An established business in good standing with the business credit reporting agencies will get better terms.
Sole proprietors cannot establish a business credit file.

Building and maintaining a strong business credit profile can be a game-changer for your company.

From securing better loan terms to winning more clients, the benefits of good business credit are hard to ignore.

This comprehensive guide will dive into business credit, its importance, and how to establish and build your credit effectively.

Understanding Business Credit

Business credit, also known as commercial credit, measures a company’s ability to meet its financial obligations.

Similar to personal credit, business credit is tracked by credit bureaus and is reflected in a credit score.

This score indicates the creditworthiness of a business and helps lenders, vendors, and other stakeholders make informed decisions when working with the company.

Deciphering Business Credit Scores

A business credit score is a numerical representation of a company’s creditworthiness.

It’s typically calculated based on factors such as credit history, outstanding debts, payment history, and public records like bankruptcies, liens, or judgments.

The most well-known business credit scoring system is the Dun & Bradstreet PAYDEX score, which ranges from 1 to 100, with higher scores indicating better creditworthiness.

Other major business credit bureaus include Experian and Equifax, each with its own scoring system. The FICO Small Business Scoring Service (FICO SBSS) ranges from 0 to 300, for instance.

Personal vs. Business Credit Scores

While both business and personal credit reporting share the common goal of providing a measure of creditworthiness, there are a number of key differences between the two.

Credit Reporting Agencies

Personal credit reports are generated by three major credit bureaus: Experian, Equifax, and TransUnion. These agencies track and record your personal credit history, which includes credit cards, mortgages, student loans, and other personal debts.

On the other hand, business credit reports are typically generated by different agencies, the most prominent being Dun & Bradstreet, Experian Business, and Equifax Business.

These bureaus track credit information related to businesses, such as business credit cards, trade credit from suppliers, and business loans.
Information Included in the Reports

A personal credit report includes personal information like your name, Social Security number, addresses, and employment history. It also contains detailed information about your credit accounts, payment history, and any public records such as bankruptcies or tax liens.

Business credit reports, however, focus on the business’s details. They include the business name, address, industry, and information about the company’s credit obligations and payment history. They may also contain information about the business’s public records, such as judgments, liens, or bankruptcies.
Scoring Models

Personal credit scores typically range from 300 to 850, based on models like FICO or VantageScore. These scores take into account factors such as your payment history, amounts owed, length of credit history, types of credit used, and new credit.

Business credit scores, however, can vary more widely depending on the scoring model used by the credit bureau. These scores consider factors such as the business’s payment performance, credit utilization, length of credit history, and the company’s size and industry risk.
Privacy

Personal credit reports are protected by the Fair Credit Reporting Act (FCRA), which limits who can access your personal credit information and for what purposes. You’re also entitled to one free personal credit report from each of the three major bureaus every year.

Business credit reports, however, do not have these same protections. Credit bureaus can sell business credit information to anyone willing to pay for it, and there’s no legal right to a free annual business credit report. This makes it even more crucial for businesses to monitor their business credit reports and ensure the information is accurate and up-to-date.

Starting With an LLC

When you first form a limited liability company (LLC), it doesn’t automatically have a business credit score.

You’ll need to take steps to establish credit for your LLC, starting with setting up a separate business entity, opening a business bank account, and getting an Employer Identification Number (EIN) from the IRS.

Once these initial steps are taken, you can build your business credit profile by obtaining credit from vendors, securing loans, and making timely payments.

Note: A sole proprietorship cannot establish business credit, as it is not considered a separate legal entity from the person who operates it.

While entrepreneurs who are just getting started can benefit from a sole proprietorship because of how easy it is to start, it makes sense to form an LLC or corporation as a business grows.

Startups seeking venture capital or other forms of funding to expand their business must be an LLC or a corporation.

The Importance of Building Business Credit

Establishing and maintaining strong business credit offers several advantages.

A good business credit score can help you secure better loan terms and lower interest rates, reducing borrowing costs.

This gives you additional flexibility and options for cash flow management, liquidity management, and for managing your working capital.

Lenders are more likely to approve larger loans and lines of credit if your business has strong credit. Suppliers often offer more favorable payment terms and discounts to businesses with good credit.

A solid credit profile can also make your business more attractive to potential investors and clients, who may view it as a sign of financial stability and competence.

Steps to Establish and Build Business Credit

Register Your Business and Obtain an EIN

For a business to establish its own credit, it must first be recognized as a separate entity from the owner. This involves registering your business with your state’s Secretary of State office. The type of registration (e.g., LLC, Corporation) will depend on your business structure.

Next, you’ll need to get an EIN from the IRS. An EIN is like a Social Security number for your business and is used by the IRS to track your business’s tax obligations. It’s also required by most banks to open a business bank account, or run payroll.

For example, if Joe wants to start his coffee shop as an LLC, he would first register his business with his state’s Secretary of State office.

After receiving confirmation of his LLC status, he would apply for an EIN through the IRS website. Many companies that put together business filing packages for you charge for obtaining an EIN, but you can do it for free. Once you have it, don’t lose it! You’ll have to call the IRS to obtain it again.
Open a Business Bank Account

After your business is registered and has an EIN, the next step is to open a business bank account. This helps reinforce the separation between your personal finances and your business operations. It makes managing business expenses, tracking cash flow, and preparing for taxes easier.

Let’s say, Joe, from our previous example, opens a business checking account under his coffee shop’s name and EIN. He uses this account to pay for all business-related expenses, such as buying coffee beans and paying employees. By doing this, he’s establishing a financial history for his business.
Establish a Business Address and Phone Number

Establishing a separate business address and phone number further reinforces your business as a distinct entity. It also provides credit bureaus with consistent information about your business. You can use a physical address or a registered agent service and set up a landline or virtual phone number for your business.

For instance, Joe might rent a small office space for his coffee shop and list that address for all business registrations and applications. He might also set up a separate business phone line or use a VoIP service for business calls.
Register with Business Credit Bureaus

Registering with the major business credit bureaus—Dun & Bradstreet, Experian Business, and Equifax Business—helps ensure your business’s credit activity is accurately tracked. For example, Dun & Bradstreet issues a D-U-N-S number, a unique nine-digit identifier for businesses.

Joe, wanting to build good business credit for his coffee shop, would request a D-U-N-S number for his business. Later, when he starts working with suppliers and lenders who report to these credit bureaus, his business’s credit activity will be associated with this number.
Obtain Business Credit

To start building your business credit history, obtain credit from suppliers, vendors, or lenders that report to the business credit bureaus. This could be a business credit card, a trade account with a supplier, or a small business loan.

For instance, Joe might apply for a business credit card and use it for regular business expenses. Or he might set up a trade credit account with his coffee bean supplier, where he receives the beans now but pays for them 30 days later (net-30 terms). Both activities will help establish his business credit if reported to the credit bureaus.
Pay Your Bills on Time

There are many reasons to pay your bills on time, including to maintain strong vendor relationships. Maintaining a strong credit rating is another reason for this.

Just like with personal credit, your payment history plays a significant role in your business credit score. Consistently paying your bills on time shows lenders and creditors that your business is reliable and financially stable.

If Joe consistently pays his business credit card bill and trade credit account on time, this positive payment history will be reflected in his business credit score, making it easier for him to secure additional credit or loans in the future.
Monitor Your Business Credit Report

Regularly reviewing your business credit report allows you to catch any errors or discrepancies that could negatively impact your business credit score. It also helps you understand what actions improve your score and which might hurt it.

For example, Joe might notice that one of his suppliers isn’t reporting his on-time payments to the credit bureaus. After noticing this, he might choose to switch to a supplier who does report payments, thus further building his business credit.

As with personal credit, building credit for your business takes time. The better you score, the better your financing options become.

Fast Track to Business Credit for an LLC

To quickly establish business credit for your LLC, consider the following strategies:

Use a Business Credit Card

Business credit cards are a powerful tool for building business credit quickly. They allow businesses to make purchases and pay them off over time, demonstrating reliability and creditworthiness to credit bureaus.

For example, a business owner could use a business credit card to pay for routine expenses such as office supplies or utility bills. By paying off the balance each month, the business establishes a history of reliable payments, which can help improve its business credit score.

Choosing a business credit card that reports to the major business credit bureaus is important. Also, manage the card responsibly – keep the balance low and make payments on time.
Secure a Small Business Loan or Line of Credit

Securing a small business loan is another effective way to establish business credit. When a business takes out a loan and makes regular payments, it demonstrates to lenders that it can handle debt responsibly.

For instance, a business owner might take out a small business loan to purchase new equipment. If they make their loan payments on time, this positive payment history will be reported to the credit bureaus, helping to build the business’s credit profile.

Small business loans can be obtained from various sources, including banks, credit unions, and online lenders. Some businesses might also qualify for government-backed loans from the Small Business Administration (SBA), which often have lower interest rates and flexible terms.
Leverage Your Personal Credit

In some cases, business owners with strong personal credit can leverage it to get business credit. This can be particularly useful for new businesses that haven’t had the chance to establish their own credit yet.

For example, some lenders offer personal guarantee business loans, where the business owner’s personal credit score is used to guarantee the loan. If the business fails to repay the loan, the lender can seek repayment from the business owner personally.

While this method can help businesses establish credit more quickly, it also carries risks. If the business fails to repay the loan, the business owner’s personal credit could be damaged. Therefore, this strategy should be used carefully and as a last resort.

Building Small Business Credit Takes Time and Effort

Building business credit takes time and effort, but the benefits are well worth the investment.

By following these steps and remaining diligent about managing your business finances, you’ll be well on your way to establishing and improving your company’s credit profile.

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Accounts Payable Cash Flow: How AP Impacts Cash Flow and Your Cash Flow Statement

Mary Girsch-Bock — Mon, 21 Aug 2023 15:23:42 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

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Accounts Payable Cash Flow: How AP Impacts Cash Flow and Your Cash Flow Statement

Category

Accounts Payable

Written by Mary Girsch-Bock
19 min read

Tags

Accounting Cash Flow Financial Planning & Analysis (FP&A)

Last edited

July 2, 2024

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What Are Accounts Payable?
How Does an Increase in Accounts Payable Affect Cash Flow?
How Does a Decrease in Accounts Payable Affect Cash Flow?
How Can You Manage Accounts Payable to Improve Cash Flow?
How Accounts Payable Affects Cash Flow
Are Accounts Payable Included in Cash Flow?
Best Ways To Improve Cash Flow Management
What Is The Flow of Accounts Payable?
What Is the Difference Between Cash Flow and Accounts Payable?
Where Does Accounts Payable Fit on a Cash Flow Statement?
Other Ways To Improve Cash Flow
Improving Accounts Payable Management Improves Cash Flow

Even though accounts payable is an expense your company incurs when purchasing goods or services on credit, properly managing accounts payable can result in a long list of benefits for your business, including increasing your cash flow, if you plan carefully.

What Are Accounts Payable?

Accounts payable are the goods and services purchased by a company on credit with a short-term due date.

An accounts payable balance on your general ledger represents the amount of money you currently owe for those goods and services and is always classified as a liability.

Historically, the AP department has been viewed as the department that paid the bills, but recently, businesses have begun to view AP in a different light, understanding the important role the AP department plays in their business.

As a result of this increased awareness and better AP management, businesses large and small are better able to reap the benefits that improved AP management brings, including increased cash flow.

How Does an Increase in Accounts Payable Affect Cash Flow?

An increase in accounts payable can positively affect your cash position since accounts payable is money owed to a vendor or creditor that has not yet been paid.

Even though accounts payable is a liability on your income statement, since the payment has yet to be made, an increase in accounts payable means an increase in available cash flow for that accounting period.

How Does a Decrease in Accounts Payable Affect Cash Flow?

A decrease in accounts payable decreases liability on your income statement but it will also decrease cash flow.

Though a decrease in accounts payable has a positive impact on your financial statements, it reduces the total amount of cash available, with the decrease representing the total amount of cash transactions that have been paid over a specific period of time.

How Can You Manage Accounts Payable to Improve Cash Flow?

Better AP management always starts with better credit terms. For instance, if your typical credit terms are currently Net 30, that means that you only have 30 days to hold onto cash before you’re required to pay vendors and suppliers.

However, if you could negotiate Net 45 or Net 60 terms, you’d be able to hold onto cash for an additional 15 days or even longer.

Of course, improving your cash flow is not a good reason to delay payment on accounts payable past their due date, since a delayed payment often results in late payment fees, increased interest, and a possible change in your current credit terms.

How Accounts Payable Affects Cash Flow

Your accounts payable balance should always be considered a source of cash since it represents money not paid to vendors or suppliers. Here’s how.

If your typical turnaround time to pay vendors is 30 days, and your average AP balance is around $50,000, if your payment terms were to change to 60 days, you would increase your short-term cash flow by $50,000.

This increase in cash flow can help you pay bills that are due earlier, invest in equipment, purchase additional supplies for resale, or make other investments in the company.

On the other hand, if you were to default on your regular payments and your vendors were to reduce your payment terms from Net 30 to Net 15, this would have a negative impact on your cash flow, reducing available cash by half.

Whatever your current payment terms are with your vendors and suppliers, it’s essential that you pay your bills by the due date and maintain a good relationship with your suppliers across the board.

Are Accounts Payable Included in Cash Flow?

Cash flow is always calculated on a cash basis, dealing directly with cash inflows and cash outflows.

For example, on your income statement, which displays revenue and expense balances that are based on accrual accounting, the accounts payable balance is listed as a negative against revenue, since it’s money that is owed to vendors and suppliers.

However, on your statement of cash flows, which is calculated on a cash basis, accounts payable is not considered a negative, since the accounts payable balance represents money that is owed, but not yet paid.

As an example, let’s say you have $250,000 in income and $40,000 in accounts payable.

On your income statement for April, you’ll subtract the $40,000 from the $250,000, leaving you with $210,000 in net income for the month.

For your cash flow statement, you start with $210,000 in available cash and need to add back the $40,000 accounts payable balance since it hasn’t been paid yet, leaving a cash flow balance of $250,000.

Remember that you would have to adjust any accounts receivable balances as well.

For example, if you had an accounts receivable balance of $50,000, you would need to subtract it from your cash flow statement, since the money has not yet been received, leaving you with an available cash balance of $200,000.

It can be confusing to switch back and forth between accrual accounting and cash accounting, but it’s necessary to calculate your net cash flow.

Best Ways To Improve Cash Flow Management

Improved cash flow management starts with better accounts payable management.
One of the easiest ways to improve AP management is to make the switch to using AP Automation.

An automated AP application like Planergy, which eliminates time-consuming manual AP processes while providing you with real-time reporting and up-to-date, accurate accruals.

Other ways to improve cash flow include:

Improve Invoice Processing Time
Improving invoice processing time can save you a significant amount of time and money, while also eliminating late fees and other penalties.
Improving invoice processing time also reduces labor hours, which in turn reduces payroll costs, while also allowing you to take advantage of any early payment discounts that may be offered.
The best way to achieve this is by introducing AP Automation into your accounts payable process.
Improve Visibility of Committed Spend
Committed spend is part of the spend management process, which is used to manage company funds using measures such as procurement, outsourcing, and supply chain management to better meet established company spending goals.
Committed spend refers to goods and services that have been ordered but not yet paid for.
Having real-time spend visibility of spend allows you to better manage cash flow by understanding when you will be required to make payments related to purchases.
Centralized spend data helps to achieve this. Committed spend report is a standard report in Planergy.
Properly Account for GRNI
Another form of committed spend is goods received not invoiced or GRNI. GRNI accounts are useful for businesses that utilize an automated perpetual inventory system.
Any goods received will be automatically recorded into your accounting software application before an invoice has been received. Once an invoice has been received, you can reverse the original GRNI entry.
Have Access to Real-time Reports
Having access to real-time reports gives you a more concise look at both AP and cash flow.
Instead of having to add and subtract items from your financial statements, having real-time reports gives you an accurate picture of both your AP balance and your cash flow balance on demand.
Use Automation to Better Forecast Your Cash Flow
Using automated spend management software and an automated accounting software application lets you better monitor both incoming revenue and outgoing expenses.
Part of managing cash flow is knowing how much money you expect to have at any given moment while offering more accurate budgeting capability.

What Is The Flow of Accounts Payable?

Since accounts payable is considered a current liability, it is recorded on a company’s balance sheet as soon as an invoice is entered.

As invoices are added to accounts payable, the balance of the liability account increases; increasing available cash flow as well. The longer a business is able to hold onto company funds and not pay an invoice, the more consistent its cash flow levels will be

What Is the Difference Between Cash Flow and Accounts Payable?

Your company’s cash flow is the money that flows into and out of your business and is always calculated based on real-time activity, not accruals.
This incorporates both accounts receivable, for incoming cash, and accounts payable, for outgoing cash.

For example, when you purchase goods and services on credit, you’re actually increasing your cash flow level, while also increasing your accounts payable balance. When it’s time to pay for those same goods and services, your cash flow balance will decrease.

If you purchase pens and paper from your local office supply store and pay for them immediately, you immediately reduce your cash flow balance.

However, if you purchase pens and paper on credit, with Net 30 terms, your cash flow increases until the pens and paper are paid for.

Where Does Accounts Payable Fit on a Cash Flow Statement?

Accounts payable activity falls under operating activities, which is the first section of the cash flow statement.

In total, there are three activities sections on a cash flow statement.

Operating Activities
Cash flow from operating activities covers the company’s operating cash in from the sales of goods and services, tax payments, interest payments, and other cash payments made to vendors and suppliers.
Cash flow from operations also includes employee wages and payments made for general business activities.
Investing Activities
Cash flow from Investing activities covers the purchase or sale of company assets, loans made, or payments received, as well as changes in equipment or other assets.
For example, if you purchase new equipment for your factory, the cost would be considered investing activity. If you decide to sell the old equipment, the proceeds from the sale would also be considered an investing activity.
Financing Activities
Cash flow from financing activities includes cash from investors and dividends paid to investors.

There are two methods commonly used when preparing a cash flow statement.

The direct method uses only cash and real-time totals and is useful for small businesses that use cash basis accounting, while larger businesses will want to use the indirect method, which uses information from a balance sheet and income statement.

Other Ways To Improve Cash Flow

Aside from properly managing accounts payable, there are other ways to improve cash flow for your business.

Make Sure Vendor and Supplier Payments are on Time
Having a strategy in place that takes advantage of vendor payment terms to improve cash flow is a great strategy, but not if you pay your vendors late.
This can result in invoice late fees, lost early payment discounts, and negatively impact supplier relationships.
While it may be tempting to withhold payment to hold onto cash, the long-term ramifications of that decision such as a change in payment terms, revocation of credit, and additional interest rates can quickly negate any advantages you may incur.
Invoice Customers Promptly
Your shipping department may be on the ball, but if you don’t promptly invoice your customers for orders, your cash flow will suffer.
Invoice when an order is shipped and be sure to provide your customers with plenty of different payment options, such as accepting credit cards, ACH transfers, or direct deposit.
Also, be sure to request an upfront deposit for any large orders or orders that require extensive customization.
Follow Up Early On Unpaid Sales Invoices
Don’t wait until an invoice is past it’s due date to follow up with your customers.
Sending reminders before the payment is due can be extremely helpful. And it’s important to continue to send those reminders until payment has been received.
Charge a Late Payment Fee
If your customers are routinely late paying their invoices, consider implementing a late payment fee.
Explain the particulars of the fee to all of your customers and be sure to follow through on assessing the penalty for any customer that sends in payment late.
Review Company Expenses Regularly
While managing AP properly can go a long way towards improving your cash flow, spending time reviewing company expenses across the board may also improve cash flow for your business.

Improving Accounts Payable Management Improves Cash Flow

Positive cash flow is the goal of CPAs and bookkeepers alike.

Better management of accounts payable can help you avoid negative cash flow, manage a comfortable level of liquidity for your business, and keep business operations running smoothly.

In many instances, having enough cash on hand can mean the difference between remaining in business and closing your doors.

If you’re still processing AP manually, switching to a dedicated procure-to-pay software that incorporates an automated AP application, like Planergy, can streamline the entire AP process, provide real-time financial reporting options, and help increase your cash flow.

Download PDF

What’s your goal today?

1. Use Planergy to manage purchasing and accounts payable

Read our case studies, client success stories, and testimonials.
Visit our Accounts Payable Automation Software page to see how Planergy can automate your AP process reducing you the hours of manual processing, stoping erroneous payments, and driving value across your organization.
Learn about us, and our long history of helping companies just like yours.

2. Download our guide “Preparing Your AP Department For The Future”

Download a free copy of our guide to future proofing your accounts payable department. You’ll also be subscribed to our and notified about new articles or if have something interesting to share.

3. Learn best practices for purchasing, finance, and more

Browse hundreds of articles, containing an amazing number of useful tools, techniques, and best practices. Many readers tell us they would have paid consultants for the advice in these articles.

The post Accounts Payable Cash Flow: How AP Impacts Cash Flow and Your Cash Flow Statement appeared first on Planergy Software.

Working Capital: What Is It, How To Calculate, and Why It’s Important

Lyle Del Vecchio — Tue, 18 Jul 2023 12:39:36 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

Download Free Copy

Working Capital: What Is It, How To Calculate, and Why It’s Important

Category

Finance

Written by Lyle Del Vecchio
17 min read

Tags

Cash Flow Financial Planning & Analysis (FP&A)Profitability

Last edited

July 2, 2024

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KEY TAKEAWAYS

All businesses have revenue fluctuations. A company’s working capital can keep things running smoothly during periods of slower revenue generation.
Small businesses need proper working capital management to finance day-to-day operations.
If your working capital isn’t where it should be, there are steps you can take to improve it.

Working capital is a fundamental component of any thriving business.

One of the most important aspects of procurement is understanding and utilizing working capital in the best way possible to ensure you are making the most of your resources.

Let’s dig into what working capital is, how it can be calculated, and why it’s important.

What is Working Capital?

Working capital, sometimes referred to as net working capital, is a company’s current assets minus its current liabilities.

Assets are items a company owns that can be sold or converted into cash quickly; these include inventory, accounts receivable, and short-term investments.

Liabilities are obligations that must be paid off within one year; they include accounts payable, taxes payable, and short-term debt.

Working Capital Example

For example, if a company has $2 million in cash on hand (current asset) and $1 million in accounts payable (current liability), then its amount of working capital would be $1 million ($2 million – $1 million).

Working capital measures how efficiently a business uses its resources to generate sales and profits.

In other words, it indicates how well the company manages its short-term financial obligations.

Positive working capital indicates that a company has enough liquid assets (cash flow) to cover its current debts.

In contrast, negative working capital suggests it may not have enough liquid assets to cover its current liabilities. It’s an important metric to monitor your company’s financial health.

How to Calculate Working Capital

The net working capital formula is:

Current assets – Current liabilities = working capital

To calculate working capital, you’ll need the balance sheet.

Add up the values of your company’s current assets (cash on hand and cash equivalents, accounts receivable, inventory, etc.).
Subtract your total current liabilities (accounts payable, short-term debt payments due within one year).

The resulting number will be your working capital. Remember that this number should always be positive; if it isn’t, you may need to adjust your budget or restructure some of your debt payments to ensure adequate business liquidity.

Current Assets

This includes cash and liquid assets that can be converted to cash within 12 months of the balance sheet, such as:

Cash – money in bank accounts and any deposited customer checks
Marketable securities – money market funds, U.S. treasury bills, etc.
Prepaid expenses – rent, insurance premiums, utilities, etc.
Short-term investments the company plans to sell within 12 months.
Inventory – raw materials, finished goods, and works in progress
Accounts receivable, minus allowances for any payments expected to be written off as bad debts.
Notes receivable – short term loans to suppliers or customers that will mature within 12 months
Any other receivables – cash advances to employees, tax refunds, insurance claims, etc.

Current Liabilities

This refers to any liability due within 12 months of the balance sheet, including:

Loan principle that must be paid within a year
Deferred revenue – advanced payment from customers for goods or services not yet rendered
Wages payable
Taxes payable
Accounts payable
Notes payable due within 12 months
Interest payable on any loans
Any other accrued expenses payable

Why Working Capital is Important to Your Organization

Regardless of industry, chances are you have some seasonal fluctuations in revenue.

The hospitality industry, for instance, tends to earn more in the summer when everyone’s on vacation. Retailers tend to earn more toward the end of the year when everyone is focused on holiday shopping.

However, those businesses have to cover expenses, such as rent/mortgage, payroll, and utilities year-round.

With adequate spend forecasting and working capital management, those businesses can make sure they have enough cash to build a supply stock before the busy season and hire temporary employees while also ensuring they can support the permanent staff.

What is a Good Working Capital Ratio?

The working capital ratio, also known as working capital ratio, is your current assets divided by your current liabilities.

If your ratio is less than one – the business isn’t generating the revenue it needs to meet the company’s short-term obligations.
If the ratio falls between 1.2 and 2.0, your company is using its assets well.
A ratio of 2.0 or higher indicates maintenance of a lot of short-term assets, and the money could be put to better use by reinvesting the funds to generate more revenue.

In the example above, $2 million in assets and $1 million in liabilities creates a ratio of 2.0, so the volume of short-term assets hampers the company’s ability to generate revenue.

As an alternative to the current ratio, you can also use the quick ratio, which only includes the company’s most liquid assets – the ones that have a short cash conversion cycle.

Improving your working capital ratio means taking action to improve cash flow.

Tips for Improving Working Capital

If you find your company needs to improve working capital, there are several things you can do.

Avoid Financing Fixed Assets with Working Capital

Fixed assets cannot be easily converted to cash, so they’re not included in the current assets. This means you should avoid using your working capital to finance equipment, facilities, real estate, trademarks, and patents.

Selling fixed assets can boost your working capital and cash flow, but financing them with working capital isn’t smart because they tend to be expensive.

It depletes working capital reserves and increases your risk profile with lenders and other credits. You’re better off using long-term liabilities to address these needs.
Run Credit Checks on New Customers

Researching a new client’s or prospect’s creditworthiness is essential to determine if they are a sound candidate for extending credit. Credit reports can offer valuable insight, aiding you in understanding their payment history and public records.

However, as this data can become obsolete quickly, you must also consider the industry in which the company operates and any local market nuances that could be of significance before approving them for credit.

By considering all of this, you can make an educated decision about whether or not offering a line of credit is worthwhile and appropriate.
Reduce Risk of Bad Debt

Bad debt can quickly snowball and erode a company’s working capital, leaving it with limited resources to meet current financial commitments.

Businesses looking to reduce the impact of such debt need to be proactive in tackling the issue – by selling higher-margin products or increasing their margins across offerings, introducing tighter credit management processes, speeding up payment collections, and utilizing just-in-time logistics to recalibrate stock levels.

Although this may require an investment of time and resources upfront, protecting your business from expensive losses will pay off in the long run.
Improve Cash Flow Cycle Time

Increasing cash flow is a key component for driving working capital, and there are multiple ways to turn money tied up in the production or sales cycle into cash.

Options worth exploring include: asking for upfront payments on orders, reducing credit terms, billing customers immediately upon sale, or getting a better grip on sales forecasting/demand planning.

It’s important to accurately understand what demand is likely to be to ensure that you can properly manage cash flow while accommodating customer needs.

Flexibility in your operating cycle is necessary to remain competitive and make the most of your working capital. It is especially important to manage working capital well when you are experiencing an increase in business operations.
Seek Additional Long-Term Bank Financing

You can add to the company’s available cash by taking on more long-term debt without overly increasing your short-term liabilities.

You may also wish to consider refinancing some short-term debts into long-term ones. Since the debts are no longer due within 12 months, you’ll decrease your current liabilities.
Reduce Unnecessary Spend and Expenses

Regularly analyze your business expenses, especially the variable ones. With analysis, you can gain insight into how you may be able to restructure your costs and pricing to increase working capital or cut overall costs.

You can accomplish this by negotiating discounts with the most important suppliers in your supply chain, or finding suppliers who offer better pricing.

Regular analysis also helps you find other cost savings opportunities without sacrificing product or service quality.
Invest in Trade Credit Insurance

Trade credit insurance is a valuable tool for businesses seeking to protect their capital from late or non-existent payments. It acts as a financial safety net by insuring accounts receivable and helping to offset the costs of bad debt reserves.

Not only that, banks recognize this insurance and may offer businesses lower interest rates on loans because their accounts receivable are secured collateral.

Trade credit insurance provides the security of protection while freeing up capital in the long run and allowing companies to expand growth opportunities.
Optimize Inventory Management

You’ll spend less overall by reducing overstock and the chance that you’ll have to write off bad inventory. This frees up revenue to reinvest in other areas of the business. Good inventory management processes can help improve cash flow.

Working Capital Management

This is managing managing a company’s current assets and liabilities to ensure adequate liquidity to meet its short-term obligations and remain profitable over time.

Proper management allows your business to maintain sufficient liquidity to cover its short-term debt obligations without taking on additional debt or selling off assets.

This helps you remain competitive in the marketplace while also preserving your ability to take advantage of potential opportunities that may arise in the future.

By keeping an eye on current assets and liabilities, businesses can better anticipate potential cash flow problems before they become critical issues.

Forecast, Analyze Risk and Plan Properly

This includes forecasting cash flow needs, setting aside necessary funds for future investments, and creating a budget with realistic goals and objectives.

Having a plan will help you anticipate potential problems before they arise and identify areas where your business can make cost savings or increase revenues.

It will also give you an idea of how much money you need to keep on hand for contingencies or unexpected expenses.
Maintain Adequate Cash Reserves

It’s important to maintain adequate cash reserves to ensure that your business always has access to the funds it needs when it needs them.

This means setting aside enough monthly money so your business can weather any unexpected expenses or slow periods without having to borrow from outside sources or dip into other accounts.

You should also consider investing in short-term investments like CDs or Treasury bills to grow your cash reserves while taking advantage of higher interest rates than traditional savings accounts offer.
Manage Debt Wisely

Make sure you don’t take on too much debt at once and ensure that any loans are at reasonable interest rates with set repayment schedules that fit within your budget.

It also means avoiding high-risk investments or speculative ventures, as these can quickly strain your finances if things don’t pan out as expected. Pay off any existing debt as soon as possible so that more money is available for other endeavors.

Understanding and managing working capital is essential for any successful procurement professional who wishes to optimize their company’s resource utilization while maximizing profits.

Being mindful of liquidity enables you to make informed decisions about your purchases while negotiating better payment terms with suppliers when necessary.

By being aware of how much debt you can handle without compromising future operations or profits, you can help ensure the business remains afloat in any economic landscape—now more than ever!

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Tips for Managing Working Capital Effectively

Lyle Del Vecchio — Thu, 10 Nov 2022 15:54:56 +0000

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Tips for Managing Working Capital Effectively

Category

Finance

Written by Lyle Del Vecchio
18 min read

Tags

Cash Flow Profitability

Last edited

July 2, 2024

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KEY TAKEAWAYS

Working capital is the amount of money a business has to meet short-term obligations at any time.
Effective working capital management means understanding your situation at all times.
Proper procurement and inventory management are key.
Paying all vendors on time and managing debtors are also important.

Working capital is a concept used in accounting to define the funds available to a business to grow, expand, and pay for daily expenses and short-term debts.

In essence, working capital is the money that a business has on hand to meet its short-term obligations.

While working capital is important for businesses of all sizes, it can be especially critical for small businesses and startups.

That’s because small businesses often have less cash on hand than larger businesses and may not have access to the same lines of credit or other forms of financing.

As a result, managing working capital can be the difference between a small business succeeding or failing.

What is Working Capital?

Working capital is the difference between a company’s current assets and liabilities.

This metric is important because it shows how much of a company’s assets are liquid (cash or cash equivalents) and how much is tied up in long-term investments.

This metric is a good indicator of a company’s financial health because it shows whether it has the funds available to meet its short-term obligations.

For example, if a company has more current liabilities than assets, it could sign that it will have trouble paying its bills on time.

On the other hand, if a company has a large amount of working capital, that could be a sign that it is over-leveraged and may not be using its funds efficiently.

How to Calculate Working Capital

Working capital is calculated by subtracting a company’s current liabilities from its current assets.

This calculation provides a snapshot of a company’s financial health and liquidity at a given point in time.

The working capital formula is:

Current Assets – Current Liabilities = Working Capital

For example, let’s say Company XYZ has $100,000 in inventory, $50,000 in receivables, and $75,000 in payables.

Their net working capital would be $75,000 (($100,000 + $50,000) – $75,000)).

Working Capital Ratio

The working capital ratio is a financial ratio that measures a company’s ability to pay its current liabilities with its current assets.

The working capital ratio is calculated by dividing a company’s current assets by its current liabilities.

Current Assets / Current Liabilities = Working Capital Ratio

A company with a higher working capital ratio has more liquid assets and can better pay its short-term obligations.

A company with a lower working capital ratio may have difficulty meeting its short-term obligations.

The working capital ratio is an important financial metric for procurement professionals to consider when assessing suppliers.

Working Capital Turnover Ratio

The working capital turnover ratio is a financial metric that measures a company’s efficiency in using its working capital.

Working capital is the difference between a company’s current assets and liabilities.

The working capital turnover ratio is calculated by dividing a company’s sales by its working capital.

A high working capital turnover indicates that a company efficiently uses its working capital to generate sales.

Conversely, a low working capital turnover ratio indicates that a company is not efficient in using its working capital to generate sales.

The working capital turnover ratio is an important financial metric for procurement professionals to monitor. It can be used to assess a company’s financial health and identify opportunities for improvement.

A supplier with a strong working capital position is likely to be more financially stable and meet its contractual obligations.

A supplier with a weak working capital position may risk defaulting on its debt obligations.

A positive working capital balance indicates that a company has enough cash to pay its short-term obligations, while a negative balance suggests that it does not.

However, it’s important to remember that a positive working capital balance doesn’t necessarily mean that a company is profitable—it only means that the company’s liquidity can meet its short-term obligations.

To determine whether a company is actually profitable, you’ll need to look at other financial metrics, such as net income and gross margin.

Why is Working Capital Important?

Working capital is important because it can impact a company’s ability to finance its day-to-day operating expenses, fund expansion plans, and take advantage of new opportunities as they arise.

For example, if a company has strong working capital management, it may have the flexibility to invest in new product development or enter new markets without putting strain on its cash flow.

In contrast, if working capital management is weak, the company may find itself unable to respond to opportunities in a timely manner or make necessary investments in its business.

This can ultimately limit growth and hamper the company’s long-term prospects.

Tips to Help You Effective Manage Working Capital

An effective working capital management strategy is essential to ensuring that a company has the money it needs to meet its financial obligations and avoid defaulting on its debt.

Make sure you have a clear understanding of your company’s working capital situation.

This means having a clear picture of your short-term assets and liabilities. To do this, you’ll need to review your financial statements regularly.

Manage Procurement and Inventory Effectively

Establish Clear Procedures and Protocols

Who is responsible for placing orders? Who is responsible for receiving goods? What quality control measures are in place? By establishing clear procedures and protocols, you can minimize errors and misunderstandings.
Use Technology

Technology can be a powerful tool in managing procurement and inventory. Several software solutions, like Planergy, on the market, can help you keep track of orders, monitor stock levels, and more. Utilizing technology can help you work more efficiently and effectively.
Stay Organized

Keep track of purchase orders, invoices, delivery schedules, and more. Staying organized will help you avoid errors and ensure that you have the information you need when you need it.
Keep Track of What You Have On Hand

This may seem like a no-brainer, but it is important to keep an accurate count of what you have in stock at all times. This way, you will know when you need to reorder and can avoid overordering, which can tie up capital unnecessarily.

Use software to track your inventory levels, so you always have an up-to-date picture of what you have on hand.
Don’t Wait Until You’re Out of Stock to Reorder

Waiting until you are completely out of an item, especially raw materials, before reordering is a recipe for disaster. If possible, keep at least a month’s worth of inventory on hand.

This will help ensure that you never run completely out of an item and have to go without it while waiting for a new shipment to arrive.

Use the inventory turnover ratio to help determine how often and how much you should order.
Use the Just-in-Time (JIT) inventory Method

JIT inventory management is a system in which items are ordered only as needed rather than stocked in advance. This can help reduce the amount of money tied up in inventory and free up storage space.

To make JIT work, it is important to have good relationships with suppliers and a robust system for tracking inventory levels so that you only order what you need when you need it.

Make On-Time Payments to Vendors

Bad debts reflect poorly on your company and make it hard to build solid relationships with your suppliers and investors.

If the company’s cash reserves make it impossible to pay bills on time – that’s a troublesome sign.

Your days payable outstanding (DPO) will give you an idea of how long it takes your company to pay suppliers. Aim to keep it low while paying for everything on time.

Paying things early is great if you can capture a good discount. But, if that discount comes at the expense of paying another supplier late, it’s not worth it.

With a better understanding of your working capital needs, you can optimize your processes for better cash management.

Improve Your Accounts Receivable Process

Establish Clear Payment Terms with Customers from the Beginning

When invoicing a customer, include information about when the invoice is due and any late payment fees that may apply.

This will help ensure that your customers know your payment terms and avoid misunderstandings.

Offering early payment discounts can speed up the collection and improve your cash conversion cycle (CCC.)
Stay on Top of Invoicing

The sooner you invoice a customer, the sooner you’ll get paid. Make it a point to send invoices as soon as the work is completed, or the product has been shipped.

If you wait too long to invoice, you’re more likely to run into problems getting paid on time.
Follow Up on Past-due Invoices Promptly

Don’t hesitate to follow up if a customer doesn’t pay an invoice on time. A courteous phone call or email can prompt customers to make a payment they might have forgotten about.

However, be sure not to be overly aggressive in your collections efforts – you don’t want to alienate your customers!
Consider Offering Discounts for Early Payment

Many businesses offer a discount (usually 2-3%) for customers who pay their invoices within ten days or less. This can be a great way to encourage prompt payment and improve your cash flow at the same time.

Just be sure to clearly state the terms of the discount in your invoices, so there are no surprises for your customers.
Use Accounting Software to Automate Receivables Management

Keeping track of receivables manually can be time-consuming and frustrating. By using accounting software such as QuickBooks or Xero with Planergy, you can automate many of the tasks associated with receivables management, freeing up your time to focus on other aspects of running your business.

Manage Accounts Payable Properly

Establish Internal Controls

Internal controls for accounts payable are procedures that help ensure accuracy and compliance with regulations. They can also help deter and detect fraud.

Examples of internal controls for accounts payable include requiring all invoices to be approved by a supervisor before they are processed and keeping detailed records of all invoices and payments.
Develop Policies and Procedures for Invoice Processing

These should cover how invoices should be received and routed for approval, how often payments should be made, and what documentation should be kept on file. Following set policies and procedures can help ensure that invoices are paid promptly and accurately.
Carefully Review Invoices Before Paying

Check the invoice date, vendor information, invoice amount, and account coding to ensure everything is correct. Reviewing invoices before they are paid can help prevent errors and save money in the long run.

Benefits of Strong Working Capital Management

Improved Cash Flow

Businesses have improved cash flow when working capital is managed well. This allows them to reinvest in the business, pay down debt, and take advantage of opportunities when they arise.
Increased Profitability

Excellent working capital management leads to increased profitability. Businesses have more money to reinvest in growth initiatives and operational efficiencies.
Better Decision Making

With improved cash flow comes better decision-making. Businesses can invest in research and development, hire key personnel, and make other decisions to help them compete and succeed in the marketplace.
Reduced Borrowing Costs

Good working capital management can lead to lower interest rates and better credit terms. Businesses have a better chance of obtaining financing on favorable terms when they have strong working capital positions.
Improved Investor Confidence

Good management of working capital instills confidence in investors. When investors see that a company is effectively managing its finances, they are more likely to put their money into the business, providing it with the capital it needs to grow and thrive.

Effective Working Capital Management is Critical for All Businesses

An effective working capital management strategy is crucial to the success of any business.

By following these tips, you can ensure that your company has the money it needs to meet its short-term obligations and avoid defaulting on its debt.

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1. Use Planergy to manage purchasing and accounts payable

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Visit our Business & Productivity Software page to see how Planergy can save your employees time by automating tedious repetitive tasks so they can focus on more value-add tasks.
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The post Tips for Managing Working Capital Effectively appeared first on Planergy Software.

How To Avoid A Decrease In Cash Flow From An Increase In Operations

Rob Biedron — Tue, 21 Jun 2022 14:57:59 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

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How To Avoid A Decrease In Cash Flow From An Increase In Operations

Category

Finance

Written by Rob Biedron
18 min read

Tags

Cash Flow Governance Risk Management & Compliance (GRC)

Last edited

December 19, 2023

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How To Avoid A Decrease In Cash Flow From An Increase In Operations

Operating cash flow refers to the cash flow your business generates from its regular activities. It begins with net income from your income statement, adds back in the cash, and then incorporates changes in working capital.

On a basic level, if you have the balance on asset increase, cash flow from operations decreases. If the balance on an asset decreases, you’ll have an increased cash flow.

If you have a net increase in balance on a liability, cash flow from operations increases. If the balance on the liability decreases, your cash flow decreases as well.

Ideally, your business should develop a strategy that avoids declines in cash from business operations. To do this, you must focus on maximizing your net income and optimizing efficiency ratios.

What Factors Decrease Cash Flow from Operating Activities?

Net Income Decrease

The cash flow statement (CFS) is a financial statement that provides a summary of how your business has moved its cash and cash equivalents (CCE) over an accounting period. You may also hear it referred to as a statement of cash flows. It is a statement accepted by the Generally Accepted Accounting Principles (GAAP) standards for financial reporting in accrual accounting.

The CFS indicates how well a business manages its cash position. in layman’s terms, this refers to how well the company generates revenue to pay its debts and fund its operations. It is one of three main financial statements and it complements the income statement and balance sheet.

The cash flow statement starts with net income which is equal to all revenue minus cost including income taxes. The operating cash flow on the other hand begins with net income and any changes in that income that would affect cash flow from operating activities. If your revenues decrease or your costs increase and cause your net income to decline, you will see a decrease in cash flow from operating activities.

Changes to Working Capital

The biggest part of the cash from operating activities is the changes in working capital which include your current assets and current liabilities. Changes in your current assets and liabilities are shown in the cash flow statement. Growth in assets or a reduction in liabilities from one period to another constitutes the use of cash and reduces your cash flow from operations.

Evaluate your working capital management with efficiency ratios like inventory turnover, days sales outstanding, and days payable outstanding, so you can see how your company’s operations influence the actual cash available.

Low Inventory Turnover Rates

Calculate your inventory turnover rate by finding the ratio of sales to the inventory available at the end of the same period. If you find a lower inventory turnover, this indicates less effective Inventory management. Improper inventory management increase is the level of inventory shown on the balance sheet at any given time, meaning that you’re not selling your inventory. This is a cash use that decreases cash flow from operations.

Inventory Changes

Whenever you have inventory changes, you’re affecting your cash flow. If you have an increase in inventory, you’re changing your current assets and, you’re damaging your cash flow. If you can decrease your inventory, you’ll have more cash flow. Inventory is typically the largest short-term asset of businesses that sell products rather than services.

Increase in Days Sales Outstanding

Days sales outstanding is a metric that measures how quickly your organization collects cash from its customers. Calculate this much work by multiplying the number of days in a period By the ratio of accounts receivable to credit sales across the same period. If you see the number increase, it indicates poor receivable collection practices so your company isn’t getting paid for items it has sold. Ultimately, you end up with higher current assets with a use of cash that decreases cash flow from operating activities.

Decrease in Days Payable Outstanding

Your accounts payable, or notes payable, are the amounts you owed to vendors that are payable within the next 30 to 90 days. Without payables and credit, you have to pay for all goods and services at the time of purchase. For optimal cash flow management, you need to take a closer look at your payable schedule.

Days payable outstanding measures how quickly your business pays your suppliers. To calculate it, multiply the days in the period by the ratio of accounts payable to the cost of revenues within the same period.

If you find a decrease in the days payable outstanding, your business is paying suppliers faster and money is going out the door sooner. It reduces accounts payable on your balance sheet. Reducing your current liabilities is the use of cash that decreases cash flow from operations.

Changes in Prepaid Expenses

If you encounter an increase in prepaid expenditures, your cash flow suffers. But if you encounter a decrease in prepaid expenses, you’ll improve your overall cash flow.

Net Changes in Accounts Receivable

Increasing accounts receivable hurts cash flow but decreasing helps it. Your accounts receivable asset indicates how much money customers who bought products on credit still owe your business. This asset is a promise of cash that your organization will receive but the cash will not increase until you collect money from customers.

Changes in Operating Liabilities

If you have an increase in short-term operating liability, you will see an improvement in cash flow. If you have a decrease in operating liabilities, your cash flow will decline.

Depreciation

When you record appreciation expenses, you’ll decrease the book value of your long-term operating assets. There is no cash outlay when recording the depreciation expense, such as when a piece of equipment has reached the end of its useful life. Every year, your business will convert part of the total cost invested and its fixed assets into cash. You’ll recover this amount through cash collections from sales so depreciation is a positive cash flow factor.

Credit Terms

Your credit terms are the time limits you set for your customer’s promise to pay for what they purchased from you. Your credit terms affect the timing of how often you receive revenue. Offering trade discounts is one way to improve cash flow. Giving your customers discounts for cash payments or cash transactions is a great way to boost your cash flow and keep things running smoothly.

Credit Policy

A credit policy is the guideline used when you decide whether or not to extend credit to a customer. A correct credit policy is crucial to ensuring that your cash flow doesn’t suffer because it is too strict or too generous.

By understanding the factors that influence changes in cash flow, you can build a strategy that keeps you in the black.

A Closer Look at Accounts Receivable and Cash Flow

Accounts receivable record sales that you have not yet collected revenue from. You sell goods or services in exchange for a customer’s promise to pay you within a certain time frame in the future. If your organization typically extends credit to customers, then the payment for accounts receivable is most likely the main source of cash.

Worst case, unpaid accounts receivable leave your business without the cash flow you need to pay your own bills. More commonly, slow-paying or late-paying customers create cash shortages which leave your business without the necessary cash flow to cover your outflow obligations.

Accounts receivable also represent Investments. Money in accounts receivable isn’t available to pay back loans, pay bills, or expand your business. The payoff from the investment in accounts receivable won’t occur until your customer pays, which influences the amount of cash you have on hand and the liquidity of your business. It’s important to understand the concept of accounts receivable as an investment if you want to consider its impact on your cash flow and free cash balance.

Use the following financial ratios to determine how your accounts receivable are impacting your cash inflows:

Average collection period
Accounts receivable to sales ratio
Accounts receivable aging schedule

Average Collection Period

Your average collection period is the amount of time it takes to convert your average sales into cash. Using this measurement, you can define the relationship between accounts receivable and cash flow for any period of time. If you have a longer average collection period, you’ll have a higher investment in your accounts receivable. It also means there’s less cash available to cover your expenses when other cash outflows.

Calculate your average collection period by dividing your annual sales by 360. you can use the annual sales amount and accounts receivable balance from the prior year as it is typically accurate enough to analyze and manage your cash flow. But if more recent information is available use that instead. Calculate the average daily sales correctly by using the number of days reflected in the sales figure. If you used data from the last quarter, divide the total by 90 rather than 360.

For instance, Sandra owns and operates a crafting business. Sandra’s total annual sales from the previous year were $50,000. The total balance of his accounts receivable at the end of the same year was $3,000. Sandra’s average collection period is calculated like this.

$50,000/360 = $138.89 average daily sales volume
$3,000/138.89 = 21.6 (rounded up to the nearest whole number for total days) = 22 days average collection period.

For Sandra’s previous year, each dollar of sales was invested in accounts receivable for 22 days. Assuming that her business hasn’t changed drastically from the last year, cash flows from sales on account won’t be available for use for 22 days.

Accounts Receivable to Sales Ratio

The accounts receivable to sales ratio is a metric that measures the rate at which your business is selling its invoices to customers. This ratio gives you an idea of how quickly your company converts invoice sales into cash in hand, and it can also give you insight into what might be slowing down that process. The higher the ratio, the faster your business converts its invoices into cash in hand, which can mean that you can rely on sales from invoices even if you’re not getting paid immediately by customers.

The ratio looks that your accounts receivable investment and how it relates to your monthly fails amount. It helps you to spot recent increases in your accounts receivable. With monthly sales information, this ratio serves as a quick and easy way to look at changes in accounts receivable. The more recent information you use, the easier it will be to find cash flow problems.

Calculate your accounts receivable to sales ratio by dividing your accounts receivable balance at the end of the month by your total sales for the month.

For example, Sandra’s accounts receivable balance at the end of the month was $2,000 and the total sales from the same month were $4,000. Sandra’s accounts receivable to sales ratio is 2.

Accounts Receivable Aging Schedule

The aging schedule is a table where each row shows daily credit sales, debits, and days of credit terms. The aging schedule provides an at-a-glance snapshot of which invoices are overdue, as well as how much money you’re owed. Aging schedules are an important accounting tool that shows how quickly your accounts receivable turn over.

When comparing two different businesses, a business with shorter accounts receivable aging schedule would have faster cash flow than a business with a longer accounts receivable aging schedule. Keep in mind that it’s not just about days past due; accounts receivable turnover measures both your outstanding debt balance and how fast you collect on your invoices.

Final Thoughts

Cash flow from operations is a crucial metric that tells you how much cash your organization is generating from business activities. Much of its function comes from the income statement and the balance sheet statement including net income and working capital. Any change in the factors that make up the line items such as inventory, accounts receivable, accounts payable, sales and costs, can all influence cash flow from operations.

Your net cash flow is a key indicator of your company’s financial health. While it’s okay for financing activities and investing activities to periodically and temporarily put you in a negative cash flow, you must operate with a positive cash flow overall.

When your business is spending more than it’s bringing in, you run a negative cash flow. In other words, your sales are not enough to cover your expenses. If it continues indefinitely, you risk going out of business because you won’t be able to pay your bills.

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1. Use Planergy to manage purchasing and accounts payable

Read our case studies, client success stories, and testimonials.
Visit our “Solutions” page to see the areas of your business we can help improve to see if we’re a good fit for each other.
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Download a free copy of our guide to future proofing your accounts payable department. You’ll also be subscribed to our and notified about new articles or if have something interesting to share.

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The post How To Avoid A Decrease In Cash Flow From An Increase In Operations appeared first on Planergy Software.

Liquidity Management: How To Maintain Good Cash Flow and Mitigate Risk

Mary Girsch-Bock — Thu, 06 Jan 2022 16:02:20 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

Download Free Copy

Liquidity Management: How To Maintain Good Cash Flow and Mitigate Risk

Category

Finance

Written by Mary Girsch-Bock
17 min read

Tags

Cash Flow Profitability

Last edited

June 24, 2024

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Why Is Liquidity Management Important?

Liquidity management is used to determine how financially stable your business is by calculating the amount of cash or other liquid assets you have available to cover upcoming business expenses.

If your business has enough cash or assets that can be converted to cash quickly, it’s said to be liquid.

However, if the amount of cash and other assets do not exceed the amount of money you owe vendors and others, you have liquidity issues.

To avoid being surprised, you must be aware of any possible liquidity issues before they can negatively impact your business.

The best way to do that is to calculate liquidity ratios regularly, with several to choose from, including the following.

Current Ratio:

The current ratio measures the ability to meet short-term obligations due within a year. The formula to calculate the current ratio is Current Assets / Current Liabilities = Current Ratio
Quick Ratio:

The quick ratio is similar to the current ratio, except it only includes a business’ most liquid assets which include cash, marketable securities, and accounts receivable. The formula to calculate the quick ratio is Cash + Securities + Accounts Receivable / Current Liabilities = Quick Ratio.
Cash Ratio:

The cash ratio provides the most conservative estimate of liquidity, using only cash. The formula to calculate the cash ratio is Cash / Current Liabilities = Cash Ratio.

Calculating these ratios at regular intervals can help keep you on track and provide you with both cash position and liquidity risk.

Liquidity is particularly important for businesses that are applying for a loan or additional outside funding, as both lenders and investors closely examine liquidity to determine whether a business is a good investment or risk.

In all cases, a higher liquidity ratio is better, indicating that your business can meet all current financial obligations.

Because cash is the most liquid asset available to businesses, calculating the cash ratio may be the most beneficial.

While the other two ratios can be useful, the assets included in the calculation will need to be converted to cash before use.

For example, you’ll have to collect on any outstanding accounts receivable balances from your customers or convert existing inventory into cash before that cash can be utilized.

Maintaining good cash flow is the only way to become and remain liquid.

Luckily, there are numerous liquidity management solutions you can implement in your business, starting with the following cash management processes that can directly assist with boosting cash flow.

Don’t pay supplier payables immediately

Instead, see if you can negotiate payment terms with your vendors that are better suited for your business. For example, if you have to pay $5,000 to your vendor upon delivery of products, but you currently offer your customers Net 30 terms, you will always have cash flow problems since more cash will be leaving the business than flowing in. If your vendor already provides you with 30 days to pay the invoice, take the entire 30 days to pay.
Consider offering discounts to your customers

If you have problems getting your customers to pay on time, you may want to consider offering an incentive for early payment. For example, many companies will offer their customers a small 1% or 2% discount if the invoice is paid in ten days or less. Giving your customers a reason to pay earlier will cost you a little upfront but may help with any cash flow issues you may be having. Not only that, but it eliminates the need to follow up on any late-paying customers later in the month.
Ask your supplier/vendor about payment incentives

Incentives can work both ways. It’s likely that your vendor is just as appreciative of early payments as you are. If vendors are actively competing for your business, they may be open to offering a discount for bulk orders or early payment. This is particularly true if you have a long-term relationship with your vendor.
Send an invoice immediately

If you offer your customers credit terms, don’t wait to send an invoice. Instead, send the invoice when the product is delivered or the service rendered. Waiting to send an invoice can add up to 30 additional days to your accounts receivable balances. While not all of your customers may pay you immediately, others may.
Ask for a deposit

Depending on the goods or services you provide, you may want to ask your customer for a deposit. This is particularly important when providing custom or one-of-a-kind merchandise to your customers, or undertaking a big job that requires a lot of up-front costs. Most customers will not even balk at being asked for a deposit upfront, and those that do may have financial issues you need to be aware of.

Maintaining good cash flow is the only way to become and remain liquid. Following good cash management processes can directly assist with boosting cash flow and improving liquidity.

Create and adhere to a credit policy

One of the best ways to grow your business is to extend credit terms to customers. But before you do, be sure you have an established process in place, starting with the completion of a credit application. Don’t feel obligated to offer credit terms to everyone. And when you do offer terms, make sure the terms are spelled out in a written disclosure agreement that you provide your customers.
Periodically reexamine current credit and billing processes

If your business has grown in recent years, be sure to take some time to reexamine your current billing processes. Chances are what worked for you as a startup does not work now. This is particularly true if you started your business with a few customers and now have hundreds or thousands. Another thing you can do is send an annual reminder to all of your credit customers of what their credit terms are and the repercussions of not abiding by those terms.

Closely track accounts receivable

One of the best ways to get an idea of who’s paying and when is to keep a close eye on your accounts receivable activity. Reviewing your A/R balances regularly allows you to see who’s paying early, who regularly pays on time, and who the chronic late-payers are. To help mitigate late payments, start sending payment reminders as the due date approaches. You may also want to offer multiple ways to pay an invoice. For example, many customers prefer the convenience of paying a bill online rather than cutting a check. Allowing them to do so can increase your collection time considerably. For late accounts, have staff follow-up with late-paying customers immediately, and stop the further shipment of products until all past-due amounts have been collected. You may also want to revise terms to include a late-payment clause that will automatically charge your late-paying customers a penalty for any late payment.

Reduce your expenses

One of the quickest ways to improve cash flow (and liquidity) is to reduce your expenses. While fixed expenses are a little harder to reduce, other expenses such as business travel, employee overtime, unused subscriptions, even phone usage can usually be trimmed. Do you still have an expensive telephone system when all of your employees use cell phones to connect with customers? If so, get rid of it. The same goes for subscriptions to business journals, magazines, and newspapers that no one reads. If overtime is an issue, make sure that department managers know that all overtime expenses need to be approved ahead of time. And while it may be difficult to reduce rent or insurance costs, if you’re paying for more space than you need, consider looking for something smaller (and cheaper). The same goes for insurance. Insurance agents are always happy to talk to potential customers, and can even be of assistance in switching over all of your accounts, should you decide to change your insurance provider.

Manage your inventory properly

Managing inventory is much more than simply reordering more products or materials when they run low. Proper inventory management requires you to keep a close eye on inventory turnover and performance. What products are selling? What products are slow to move? Knowing the answer to both of those questions will do two things; first, it will allow you to purchase more of the product that is selling, and it will prevent you from purchasing too much of the product that isn’t selling. By eliminating or reducing the amount of slow-moving inventory, you’ll free up more cash. You may also want to consider using a drop-shipper, which eliminates the need to purchase large amounts of inventory for resale. Instead, your customer purchases an item, and it is shipped from your contracted drop-shipper. This method can improve cash flow immediately, and works particularly well for businesses that don’t have a lot of space available to store large amounts of inventory.

Open a line of credit.

It’s difficult to obtain needed cash from a bank or other lender if your business is suffering financially. Remember, even if you’re doing everything right, you may run into a situation that causes your available cash to drop. But arranging for an available line of credit from a bank, financial institution, or other financial services company before cash becomes tight can help you out should you need it in the future.
Consider raising prices

Raising prices is not the best solution for a one-time cash flow problem, but if you find your business is always short of cash, consider adjusting your pricing levels. Of course, if supplier costs rise, you’ll have to raise prices or absorb the cost, which is usually difficult for small businesses with tight profit margins. If you do decide to raise prices, make sure to give your customers plenty of notice and explain the hike in price as best you can.

Healthy cash flow is the path to sustained liquidity

Chances are you can pinpoint exactly where your cash flow gets bogged down. Perhaps your sales have dropped in the last year due to the pandemic, or supply chain expenses have increased. In either case, you’ll want to implement a cash management solution for your business.

It can be helpful to spend a few moments preparing a cash flow forecast. You’ll also want to run a cash flow statement that details cash inflows and outflows in real-time.

In many cases, small businesses with very limited cash flow may want to track their cash flow daily to ensure that the business can continue to operate uninterrupted.

By reviewing the statement regularly, you can pinpoint the source of your cash flow problems, and address those problems immediately. Did your suppliers raise their prices?

Do your customers pay their invoices late?

Whatever the reason, addressing the issue is the only way to get your cash flow back on track, since the longer your cash flow remains low, the harder it becomes to find a way back to liquidity.

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The post Liquidity Management: How To Maintain Good Cash Flow and Mitigate Risk appeared first on Planergy Software.

Liquidity Ratio Analysis

Mary Girsch-Bock — Fri, 29 Oct 2021 15:46:12 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

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Liquidity Ratio Analysis

Category

Finance

Written by Mary Girsch-Bock
20 min read

Tags

Cash Flow Financial Planning & Analysis (FP&A)Financial Ratios

Last edited

June 5, 2024

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As a business owner, you understand the importance of having access to accurate financial statements. But the typical financial statements which include income statements and balance sheets only tell a portion of the story.

To get a better handle on how your business is performing financially, consider using accounting ratios. With dozens of ratios available to choose from, you can obtain detailed metrics and KPIs on things like company profit margin, working capital, accounts receivable turnover, and inventory movement.

You can also get some much-needed insight into the liquidity of your business by using a series of specialized ratios which can show you how well you can meet your short-term financial obligations, such as payroll, rent, and taxes.

Liquidity ratios concentrate on current assets and liabilities, not concerned with long-term assets that cannot be converted into cash quickly, nor long-term liabilities that are not payable within the year’s time. Liquidity ratios are important for a variety of reasons, including the following:

Ability to pay bills – If all of your current obligations came due today, do you have enough current assets in place to pay them without resorting to credit? Liquidity ratios will tell you if you have enough cash to pay your bills.
Reassure creditors and financial institutions – Are you applying for credit from a vendor, or trying to obtain a business loan? If so, one of the first things that they’ll look at is your liquidity. The number one thing that a potential creditor wants to know is whether your business can repay a loan, while a vendor will want to know that your business can pay its bills on time and in full.
Attract investors – Like creditors, potential investors will want to see that your business can pay its bills on time. But investors also look at high liquidity ratios with caution as well, since a higher-than-normal result can point to the possibility that cash is not being used properly.

These are just a few of the reasons why calculating your company’s liquidity ratio and understanding the results of that calculation are so important for both small businesses and global enterprises.

While a large corporation may want a good liquidity ratio to attract quality investors, small business owners want to know that they have enough assets on hand to pay any bills that may come due in the short term.

Luckily, calculating liquidity ratios is a quick and easy process, giving you the information you’re looking for in minutes. There are numerous types of liquidity ratios, with three common liquidity ratios used most frequently. Though each of these ratios is similar, they offer differing levels of detail.

Current Ratio

The current ratio is the most inclusive of the liquidity ratios, providing you with detailed information on the liquidity of your business by measuring the ability of your business to pay current liabilities only using current assets.

Common current assets that should be included in the current ratio calculation include the following.

Cash and cash equivalents such as marketable securities
Accounts receivable
Prepaid expenses
Inventory

When calculating the current ratio, you’ll only use current liabilities or liabilities that are due and payable within a year. These liabilities can include the following.

Accounts payable
Employee payroll
Taxes
Accrued liabilities
Any short-term debt (due within 12 months)

How to calculate the current ratio

The current ratio formula is simple. Simply take your current asset total and divide the total by your current liability total.

The simplest ratio to complete; the current ratio calculation is:

Current Assets/Current Liabilities = Current Ratio

Because the current ratio includes ALL of your company’s current assets, there is no need to take individual totals of your current assets such as cash or inventory. You can simply use the current assets and current liabilities totals that can be found on your balance sheet to calculate the current ratio.

When reviewing results, a good current ratio is usually anywhere between 1.2 and 2, with 1.2 indicating that you have an equal amount of current assets and current liabilities, while a current ratio of 2 indicates that you have twice as much in current assets.

Quick Ratio

The quick ratio is also known as the acid-test ratio and looks at your ability to pay off short-term liabilities with quick assets; or assets that can be converted to cash within 90 days.

But unlike the current ratio, the quick ratio does not include certain assets such as real estate, inventory, and prepaid expenses, because they are unlikely to be converted into liquid assets quickly.

Many companies choose to use the quick ratio over the current ratio because it provides a more accurate depiction of a company’s true liquidity.

How to calculate the quick ratio

You can calculate the quick ratio by adding cash and cash equivalents, current accounts receivable, and short-term investments and dividing that total by your current liabilities.

Quick Ratio = (Cash + Cash Equivalents + Accounts Receivable + Short-Term Investments) / Current Liabilities

1 is considered a good quick ratio, though creditors prefer a quick ratio of at least two, which increases the likelihood that they will be paid on time.

Cash Ratio

The cash ratio is just as it sounds, using cash or cash equivalents such as marketable securities to measure liquidity.

All other current assets such as accounts receivable, inventory, and prepaid expenses should not be included in the cash ratio calculation.

Because the cash ratio focuses on cash and its equivalents, it can provide the most realistic results of any of the liquidity ratios.

How to calculate the cash ratio

The cash ratio uses only cash and equivalents, dividing your cash totals by your current liabilities. The calculation is:

Cash Ratio = (Cash + Marketable Securities) / Liabilities

A cash ratio will normally be lower than both the current or the quick ratio because the parameters are much narrower. Most businesses should strive for a cash ratio between .5 and 1, although creditors may want to see it higher.

A good liquidity ratio can vary from industry to industry, making it important to always compare the results of your company to those of similar companies.

Differences between the liquidity ratios

While all of the liquidity ratios are designed to measure how easily your business can pay off short-term liabilities with current assets, they all provide a different level of measurement.

Using the following balance sheet, we’ll calculate the Current Ratio, the Quick Ratio, and the Cash Ratio for JNB Manufacturing.

	JNB Manufacturing 2020 Balance Sheet
ASSETS
Current Assets
Cash Marketable Securities		$125,000.00 $30,000.00
Accounts Receivable		$31,000.00
Prepaid Expenses		$10,000.00
Inventory		$111,000.00
Total Current Assets		$307,000.00

LIABILITIES
Current Liabilities
Accounts Payable		$66,000.00
Salary/Wages Payable		$14,000.00
Total Current Liabilities		$80,000.00

Current ratio calculation

For example, in December of 2020, JNB’s balance sheet had total current assets of $307,000 and total current liabilities of $80,000.

Because the current ratio uses all current assets in the calculation, you can use the entire current assets total to calculate the current ratio.

$307,000 / $80,000 = 3.84

This shows that for every $1 that JNB has in current liabilities, they have $3.84 worth of current assets, giving them a current ratio of nearly 4.

Quick ratio calculation

The quick ratio calculation includes only liquid assets such as cash and accounts receivable, so you’ll need to include only JNB’s cash total, marketable securities total, and accounts receivable total found on the balance sheet.

($125,000 + $30,000 + $31,000) / $80,000 = 2.32

When removing prepaid expenses and inventory, you’ll notice that JNBs liquidity drops from nearly a 4 to 1 ratio to a 2 to 1 ratio. The result above indicates that for every dollar in liabilities, JNB has $2.32 in assets.

Cash ratio calculation

Used most frequently by creditors and financial institutions, the cash ratio is considered the most stringent of the three liquidity ratios, using only cash and marketable securities in its calculation.

($125,000 + $30,000) / $80,000 = 1.93

The result of 1.93 means that for every dollar in liabilities, JNB has $1.93 in assets.

Based on the above calculations, you can see that the results dropped from a high of 3.84 when calculating the current ratio to a low of 1.93 for the cash ratio, depending on what current assets were included in each of the calculations. A low cash ratio can also pinpoint an issue with company cash flow.

What is a good liquidity ratio?

Calculating liquidity ratios is a fairly simple task. But liquidity ratio analysis can be more complicated for a variety of reasons.

First, a good liquidity ratio can vary from industry to industry, making it important to always compare the results of your company to those of similar companies.

For example, the industry standard for the current ratio usually falls between 1.2 and 2, with a higher result considered better.

A good current ratio is 2, meaning that you have twice as much in assets that can pay off any liabilities due. A business with a current ratio of less than 1 indicates that your business may have difficulty paying any short-term financial obligations.

But higher isn’t always better. Too high of a liquidity ratio can also be problematic; signifying possible issues with cash management.

For example, potential investors will likely view a liquidity ratio between 1 and 3 favorably.

However, a ratio higher than 3 can raise a red flag with investors, who may view a company with a higher liquidity ratio as too cautious or unable to properly use its resources.

It’s important to remember that each industry will have its own standard. For example, a retail business that needs to stock large amounts of inventory will have a much different liquidity ratio than a service business.

As an example, let’s take a look at Amazon.com’s liquidity ratios and what they mean. As of December 2020, Amazon.com had a current ratio of 1.05, meaning that it has equal amounts of both short-term assets and liabilities. Their quick ratio was 0.83, while their cash ratio was 0.67.

However, Amazon’s business model like Walmart and Target is based on inventory, which means a much higher accounts payable liability total. Their business model does not typically offer credit to customers, eliminating an accounts receivable balance.

Their current ratio of 1.05 means that they have just about the same amount of current assets as they have current liabilities, while their quick ratio and cash ratios are a bit lower. But because of their inventory-heavy business model, these totals are actually within the range that they should be.

Liquidity vs. Profitability

With all this talk of liquidity, you might be wondering what the difference is between liquidity and profitability. To make things even more confusing, a company can be profitable but not liquid.

For example, considering Amazon’s liquidity ratios, when you look at their profit margin, you’ll see that their relatively low liquidity does not impact their profit margin. As of December 2020, their profitability ratio was 39.57%. So, what is the difference between liquidity and profitability?

Profitability is the ability of a company to make a profit after all business expenses have been deducted from revenue earned. On the other hand, liquidity refers to a company’s ability to pay short-term debt with its current assets.

Companies like Amazon.com remain profitable even when liquidity is at a minimum since the majority of their assets are tied up in inventory. While profitability is more important for the long-term success of any business, liquidity is a short-term measurement of a business’s ability to pay the short-term debt at any given time.

Should you calculate liquidity ratios?

Though primarily used by credit analysts and potential investors, liquidity ratios can also provide useful metrics for business owners and managers who want to check on their company’s solvency.

This is particularly important when applying for a loan or credit terms from a vendor since they will likely calculate the ratios themselves to determine the ability of your company to pay its short-term debt.

But financial ratios can also provide you with some much-needed insight, offering insight into whether you’re able to meet current financial obligations including employee salaries, utility bills, rent, and taxes.

Easy to calculate and easy to analyze, there is no good reason not to calculate liquidity ratios for your business.

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Visit our “Solutions” page to see the areas of your business we can help improve to see if we’re a good fit for each other.
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The post Liquidity Ratio Analysis appeared first on Planergy Software.

How To Improve Your Working Capital and Liquidity

Mary Girsch-Bock — Tue, 19 Oct 2021 15:31:17 +0000

Download a free copy of "Preparing Your AP Department For The Future", to learn:

How to transition from paper and excel to eInvoicing.
How AP can improve relationships with your key suppliers.
How to capture early payment discounts and avoid late payment penalties.
How better management in AP can give you better flexibility for cash flow management.

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How To Improve Your Working Capital and Liquidity

Category

Finance

Written by Mary Girsch-Bock
20 min read

Tags

Cash Flow Profitability

Last edited

June 5, 2024

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Working capital is the money that is available to a company to handle costs for its entire operating cycle after paying its current liabilities.

Having a sufficient amount of working capital available is important for any business. But it’s also an important part of any growth strategies you may have for your business, since to grow and expand, you’ll need available working capital.

Your available working capital can also be a good indicator of how healthy your business is since it involves the following:

Revenue: Working capital is directly impacted by the amount of revenue you collect. If you’re not collecting revenue effectively, or your business is plagued by late payments, it will be reflected in your working capital totals.

Accounts payable: Accounts payable can also impact your working capital totals. Since accounts payable represents most if not all of your current short-term expenses, accounts payable balances and your current payment processes can directly impact your working capital and liquidity.

Inventory management: Inventory management can play a large role in working capital. For example, having an excess of raw materials on hand that have not been converted to product can impact both short-term debt and your liquidity.

How to calculate working capital for your business

Calculating working capital is one of the simpler accounting calculations, with the required totals easily obtained from your balance sheet. All you’ll need is your current asset and current liability totals.

Current Assets – Current Liabilities = Working Capital

For example, if your current assets equal $490,000 and your current liabilities total $405,000, your working capital calculation would be:

$490,000 – $405,000 = $85,000 Net Working Capital

While knowing the amount of working capital available can be helpful, many businesses prefer to calculate working capital as a ratio, finding the ratio a more helpful metric than a dollar amount.

To calculate working capital as a ratio, you can use the following formula:

Current Assets ÷ Current Liabilities = Working Capital Ratio

Using the same numbers as above, your calculation would be as follows:

$490,000 ÷ $405,000 = 1.21 Working Capital Ratio

This result means that for every $1 in current liabilities your business has, there is $1.21 in current assets available to pay for them.

What’s a good working capital ratio?

Every company’s working capital is different. Generally speaking, a working capital ratio between 1.2 and 2 is considered a healthy ratio, with different types of businesses typically having different working capital ratios.

But there are some standards that your business should aim for that can be used for any business type.

For example, if your working capital ratio is between 1 and 2, that means that your business is fairly liquid and that your company is able to meet all of its current financial obligations. However, a working capital ratio of less than 1 indicates a lack of liquidity, meaning that your business will likely need to turn to outside resources in order to cover its current liabilities.

But a higher working capital ratio isn’t necessarily better. A ratio of more than 2 can indicate that your business is not using your capital resources properly.

What does my working capital ratio tell me about my business?

For such an easy calculation, working capital and the working capital ratio can tell you a lot about the financial well-being of your business.

You already know that a ratio of less than 1 can indicate liquidity issues, while a ratio higher than 2 can show that your company isn’t aggressive enough in using its assets. But your working capital ration can also indicate the following:

Whether changes are needed

Calculating your working capital ratio can alert you to potential issues before they happen, allowing you to make changes proactively. If your ratio is low due to a temporary issue, it will sort itself out. But if you continue to have low working capital, you’ll knee to address the root cause of the problem.

If your business is attractive to lenders and investors

Your working capital ratio can be particularly important to anyone looking to invest in your business, whether as a potential partner or a lender. If you’re in the market for a loan or actively looking for investors, the working capital ratio provides the information they’re looking for.

Why is working capital important?

Having access to working capital can sometimes be the difference between remaining in business and closing up shop and can help businesses remain operational even during a temporary downturn. Seasonal businesses in particular find having excess working capital a necessity to maintain their financial health.

For example, Kate runs an ice cream shop in a small resort town. While the population swells during the hot summer months, in the winter, the number of residents drops significantly.

As a result, Kate earns the majority of her revenue during June, July, and August. Once the population drops and the weather gets colder, the number of customers she serves drops as well.

Because Kate plans for this influx of revenue, she is able to survive the cold winter months, when sales are a fraction of what she has in the summer, and is able to remain open for business.

Even service businesses can benefit from having excess working capital. While CPAs handle financial planning and tax consulting services for their clients year-round, their busy season typically runs from January to April 15 each year, with CPA firms that specialize in preparing tax returns earning between 50% to 75% of their yearly revenue in the first four months of the year. But having excess working capital will allow them to continue operations as normal throughout the other eight months of the year.

Having a negative working capital ratio isn’t always a cause for alarm.

Many big business retailers such as Walmart and Amazon have a negative working capital ratio, but because of their massive operations and the fact that they frequently sell products to customers before they’ve even paid their supplier for them, it doesn’t impact their operations.

However, in most cases, smaller businesses don’t often have the luxury of turning items around so quickly, which is why working capital management and cash management should both be a part of regular business operations.

Having access to working capital can sometimes be the difference between remaining in business and closing up shop and can help businesses remain operational even during a temporary downturn

How can I improve my working capital?

You’ve just calculated your working capital, and you’re horrified to find out it’s less than 1. There’s no need to panic. First, it’s helpful to determine what is causing the low working capital.

Once the source has been identified, you can make changes that will improve cash inflow, which in turn will increase working capital. This can be done in a variety of ways including the following:

Keep a close eye on accounts receivable balances: Bad debts can ruin your business credit and impact operations. Small businesses and startups, in particular, can find themselves in a bind if they provide goods and/or services but fail to collect payment in a timely fashion. Take the time to create a good follow-up plan for late-paying customers to improve your accounts receivable turnaround time. However, if late payments continue to be an issue across the board, you may also want to examine pricing levels to see if they need adjusting.

Institute cost-saving measures: For businesses that are already on a tight budget, this may not be necessary. However, it’s advisable for all business owners and managers to periodically take a look at recurring expenses and see if they’re still valid. Monthly subscriptions and recurring bank fees are a great place to start.
Create and use a budget: Take the time to create a working budget and use it regularly. Many business owners spend a lot of time and energy creating a budget, and then never refer to it again. Managing and using a budget effectively with business budgeting software that provides real-time spend against budget reporting will help make better informed decisions related to your budget. And remember, don’t create your budget based on what you’d like to happen, create it realistically based on what you expect to happen.
Offer payment incentives: Offering good paying customers incentives for paying on time can encourage them to continue to do so. You may also want to consider offering an early payment discount to your customers. Though the amount can be small, such as 1% if paid in ten days, the incentive can be beneficial for your customers, who will receive a small discount for paying on time, and your business, which gets money in the door a lot quicker.
Reevaluate customer creditworthiness: Never forego a thorough credit check on any new customer, even if they’ve come with stellar recommendations. Every potential customer that applies for credit should be subjected to a thorough credit investigation which includes filling out an application. Always ask for vendor references and be sure to call those references to see if your applicant pays their bills on time. Never feel that you have to extend credit to everyone; only certain customers should have the privilege of having credit terms offered to them.
Change credit terms: If your credit customers pay on time, but you still have cash flow issues, consider changing your credit terms. For example, if you commonly offer 30 net or 45 net payment terms, consider shortening that to 10 or 15 days. In many cases, it won’t make a difference to your customers, and for the ones that it does impact, you can negotiate terms that will work for both of you. You may also want to negotiate how much credit you’re offering your customers. For example, allowing customers to have multiple accounts receivable invoices open can negatively impact your cash flow, lowering your working capital. Only offer as much credit as you can legitimately afford. While offering a line of credit to your customers can increase sales, it also increases the likelihood of customers paying late or even defaulting on the amount due. If you can’t offer credit, don’t.
Negotiate more favorable terms with creditors: Just as you negotiate more favorable terms with your own customers, consider negotiating better terms with your vendors and suppliers. If you offer 30 net terms to your customers, but your vendors and suppliers require you to pay in 15 days, you’ll be perpetually short on cash, resulting in a low working capital ratio. If you’re a good customer, and you pay on time, the odds are good that your vendors and suppliers will be willing to renegotiate credit terms with you.
Improve inventory management: To properly manage inventory, you’ll first need to accurately forecast sales. This should always be done based on historic sales totals. Ordering more inventory than you can sell results in overstock, tying up your assets while reducing cash flow. On the other hand, not ordering enough inventory can result in back orders and customers looking for their product elsewhere. Supply chain issues can also pop up from time to time, which is why having a proper inventory management system in place is essential.
Move away from cumbersome manual systems: If you’re still using manual systems to manage your business, it might be time to automate. Even very small businesses can benefit from automating the accounts payable and accounts receivable process. Upgrading your business finance systems can indirectly affect your working capital, and may even lower it temporarily. However the benefits of automation far outweigh the cost, providing you and your employees to devote their energies to increasing sales and developing additional products and services; things that directly impact cash flow and working capital.
Run reports regularly: The best way to stay on top of cash flow and the working capital is to run financial reports and spend analysis in real-time on a regular basis. Doing so will allow you to address potential issues before they become problematic. Procure-to-Pay software that incorporates Spend Analysis Software can help make this easier.

With the working capital ratio such a simple calculation, there’s no good reason not to calculate this metric on a regular basis.

Knowing your working capital position and consistently monitoring and calculating both working capital and your working capital ratio will allow you to manage your business finances properly while providing you with the opportunity to make any working capital improvements when necessary.

Download PDF

What’s your goal today?

1. Use Planergy to manage purchasing and accounts payable

Read our case studies, client success stories, and testimonials.
Visit our “Solutions” page to see the areas of your business we can help improve to see if we’re a good fit for each other.
Learn about us, and our long history of helping companies just like yours.

2. Download our guide “Preparing Your AP Department For The Future”

Download a free copy of our guide to future proofing your accounts payable department. You’ll also be subscribed to our and notified about new articles or if have something interesting to share.

3. Learn best practices for purchasing, finance, and more

Browse hundreds of articles, containing an amazing number of useful tools, techniques, and best practices. Many readers tell us they would have paid consultants for the advice in these articles.

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Cash Flow Management Strategies and Best Practices

Lyle Del Vecchio — Tue, 31 Aug 2021 15:27:23 +0000

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Cash Flow Management Strategies and Best Practices

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Finance

Written by Lyle Del Vecchio
16 min read

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Best Practices & Tips Cash Flow Strategy & Planning

Last edited

June 5, 2024

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One of the most important elements in crafting a successful and financially healthy business is developing and implementing an effective cash flow management strategy.

From sole-proprietor startups to small business owners to financial professionals working at major corporations, anyone who has to manage cash flow knows cash is the lifeblood of their organization—and a positive cash flow, maintained at the proper cost and with the proper timing, is key to financial health.

By following some basic best practices and investing in the right software solutions, you can craft a cash flow management strategy that helps you optimize your working capital for performance, growth, profitability, and competitive advantage.

Why Having an Effective Cash Flow Management Strategy Matters

Cash flow management challenges are the number-one killer of small businesses. Maintaining or improving your cash flow is crucial to keeping things running while waiting for accounts receivable to obtain and process the payments from your customers.

Cash management is, at its core, about putting your company’s working capital to optimal use by:

Minimizing excess cash on hand;
Balancing cash inflows and cash outflows accurately and completely;
Ensuring all cash is spent with an eye toward maximum return on investment (ROI) and value creation (i.e., optimizing the working capital turnover ratio); and
Maintaining sufficient working capital to cover the company’s financial obligations with enough left over to manage unexpected expenses and take advantage of investment opportunities. This requires balancing business liquidity against opportunity cost.
- In determining an optimal cash balance, companies need to identify, track, and mitigate the risks associated with their target cash balance.
- They also need to chart the expected ROI and opportunity cost for various options, e.g. paying vendor invoices early to capture discounts versus having more cash on hand and making payments when they’re due.
- A simple formula businesses can use to calculate opportunity cost is:
  Transaction costs + Potential Risk Exposure Created By Maintaining a Minimal Cash Balance = Opportunity Cost for that balance.

In order to perform these business-critical tasks, you need both a clear understanding of your cash flow’s importance and a realistic, detailed, and data-driven approach.

Without a formalized strategy for managing working capital, a system for evaluating and improving performance using metrics, or complete buy-in from your organization at all levels, cash flow problems may prove frequent and frustrating.

Tying disciplined cash flow management to the company’s larger goals for growth, innovation, profit margins, and competitive strength will go a long way toward encouraging team members at all levels to get on the same page.

Best Practices for Effective Cash Flow Management

Invest in a Software Solution

From optimizing your cash conversion cycle to calculating and optimizing accounts payable days (i.e., accounts payable turnover), every part of improving your cash flow is easier and more effective with help from a best-in-class procure-to-pay solution like Planergy.

Artificial intelligence (AI), process automation, and advanced data management and analytics are all core components of modern procurement software. Armed with these tools, you can:

Capture, organize, and analyze all your spend data for maximum transparency, accuracy, and completeness. Spend visibility is essential for optimizing all your business processes, but it’s particularly important to cash flow management, since having the wrong data can leave you with an inaccurate cash flow forecast—and without enough cash to cover your operating costs, pay salaries, or pay vendors, let alone making strategic investments or covering emergencies.
Provide a single, cloud-based repository for data, with secure, role-appropriate access. Everyone can access the data they need, when they need it, so it’s easier to make smart business decisions for both short-term and long-term cash flow management.
Integrate your accounting software, procurement solution, and other applications into a cohesive software environment with better communication and collaboration.
Create and enforce policies that encourage responsible, cash-savvy spending and smart, strategic decisions for improving cash flow over time.
Create accurate and complete budgets, forecasts, and cash flow projections, as well as core financial documents such as income and cash flow statements.
Automate and optimize core accounts payable processes, integrate with vendor systems, and facilitate collaboration with accounts receivable to ensure you have full visibility into and control over your cash outflows and cash inflows. This is particularly important to shortening the cash conversion cycle.
Create and track metrics used to monitor and streamline processes related to managing cash inflows and outflows, including:
- Days Sales Outstanding (DSO)
- Days Inventory On-Hand (DIO)
- Days Payable Outstanding (DPO)

Create a Cash-Savvy Culture

To be truly successful in making optimal use of their working capital, companies need to ensure everyone from the CEO to the bookkeepers in accounts payable and receivable understand the importance of effective cash flow management.

The C-Suite can kickstart the process by providing not just instruction, but leadership and guidance in prioritizing a strategic approach to positive cash flow.

Tying disciplined cash flow management to the company’s larger goals for growth, innovation, profit margins, and competitive strength will go a long way toward encouraging team members at all levels to get on the same page.

In the accounting and procurement departments, developing and implementing policies that promote both financial discipline and value-centered, strategic spending can make it easier to achieve compliance, monitor performance, and identify problem areas in need of improvement.

Other departments and business units can be incentivized to support financial discipline (and manage cash outlays attentively) by connecting departmental bonuses, budgets, or even salaries to cash flow targets.

Introducing software tools that simplify the cash flow projections, budgeting, and forecasts required to pursue this strategy will make things simpler still.

Ensuring everyone is trained on the software tools, understands and agrees to comply with financial and cash flow management policies, and knows their roles and responsibilities in supporting the company’s pursuit of financial health will provide a final layer of reinforcement necessary to get everyone working together toward shared success and better cash management.

Take a Proactive Approach to Invoicing

Even a profitable business needs cash in hand to go with the healthy numbers on the balance sheet. Streamlining your invoicing workflows for accuracy and speed gets your invoices into your clients’ hands as soon as possible—and money into your bank account sooner.

Automate your invoicing workflows. Collaborate closely with clients to ensure each invoice has a corresponding purchase order to minimize exceptions, chargebacks, and delays.

Rather than tying invoice dispersal to a specific day, consider sending them out whenever you hit a preset target such as a certain number of projects completed.

Streamline Your Inventory Management

Inventory that’s languishing in your storerooms or warehouses isn’t generating revenue for your business. Prioritize stocking for strong sellers and have systems in place to liquidate dead stock and minimize or eliminate reorders as required.

Prioritize Agility, Continuous Improvement, and Business Resilience

While the global economy is definitely a fiercely competitive place, your toughest competitor when it comes to achieving optimal performance will always be your own business.

Companies who turn the microscope on themselves to evaluate and improve business practices (including business operations, financial activities, strategic sourcing, etc.) can trim the fat while finding new ways to wring value from their workflows.

Practicing agile procurement and prioritizing supply chain resilience will not only make it easier to track financial data and streamline your workflows, but will also eliminate waste, human error, and costly delays while ensuring your company has a flexible footing that promotes profitability while guarding against disruptors (further insulating your cash balance from unexpected turmoil).

The net result is a leaner, more focused organization that can more readily implement financial discipline into its business processes and leverage working capital much more effectively.

Don’t Shy Away from Financing

Both short-term and long-term financing can be extremely helpful in providing an infusion of cash when you need it most or want to take advantage of an exceptional investment opportunity.

Short-term financing, such as a line of credit, can help you close the gap when you need working capital fast.

Better still, you can set up a line of credit with your lender before you need it. This not only provides you with additional peace of mind but can potentially yield a more favorable interest rate since you’re negotiating when you’re flush rather than coming to your financial institution with your hat in hand (so to speak).

Small business owners and startups can definitely take advantage of other short-term financing options such as credit cards, provided they draw a clear, heavy line between the personal and the professional by establishing a separate bank account and credit cards for the business.

Keeping things separate also allows you to more easily integrate your business credit card purchases with your overall spend management system, providing valuable insights you can use to refine your cash flow management and reduce your reliance on plastic in future cash flow forecasts.

Long-term financing is a better option than working capital when you’re investing in major purchases such as manufacturing equipment, real estate, etc. You can space payments and depreciation over the life of the asset, and while you’ll need to keep an eye on interest rates, your cash position will be much stronger.

Balance the Carrot with the Stick

Creating a clear and comprehensive collection policy is crucial to keeping your cash flow under control.

Formalize your payment terms, make penalties for late payments clear, and make sure you distribute the latest version of your policy to all your clients as well as your staff at regular intervals.

You can integrate your collections process with your accounts receivable workflows to monitor due dates and amounts and automatically issue collection reminders, too.

This will encourage swift payment while keeping things friendly (or at least professional) with clients.

That’s the stick. The carrot comes in the form of discounts for early payment. Discounts can help you reap more cash, more quickly, even though you’re receiving a little less from each client taking advantage of the discount.

Sacrificing 5% or 10% of an invoice to get the cash in hand within 10 days is well worth it if it prevents you from having to take out a short-term loan and pay hefty interest fees.

Make Sure Your Working Capital is Doing Its Job

To survive in today’s competitive marketplace, you need to keep your company’s financial heart beating with a steady flow of well-managed cash.

Create a culture of cash-flow mindfulness, invest in a reliable and comprehensive software solution, and develop and implement effective cash flow forecasting and management strategies today, and you’ll have the resources you need when it’s time to pay the bills, make strategic investments, and cover the emergencies that pose a risk to your company’s financial health.

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Cash Flow Archives : Planergy Software

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