What is a cash flow and why is it important

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What is a cash flow and why is it important

Cash is the lifeblood of any business. No business can survive for long if they continuously run short of cash to meet their obligations, no matter how profitable they are. So, what is cash flow and how can a profitable business go under due to cash flow shortages?

 

What is Cash Flow

Cash flow is the money that is moving in and out of a business. Cash flow moves both ways:

  • Into a business from your customers who buy your products or services.
  • Out of a business to pay suppliers, operating, and financing expenses

If more cash is flowing into the business than out of the business, the business is in a “cash flow positive” state. If more cash is flowing out of the business, the business is in a “cash flow negative” state, and the owners of the business will have to find additional funds to meet their obligations.

 

Cash v Receivables

Unless your business collects cash from your customers upon the completion of the transaction, a sale does not mean that the cash is in your account.
For example, if your business sells on 60 days credit terms, this means the cash is only received 60 days later. Unfortunately, your monthly expenses, such as salaries and bills are payable monthly. Therefore, your business is unable to depend on the sale to pay your suppliers or expenses until 60 days later.
If there is not enough cash in your bank account to meet your obligations for the month, your business will have to seek external funds to finance your cash flow. Most SMEs prefer to sell to large corporates due to their better credit rating, and larger purchasing power. However, these large corporates will usually have a policy of buying on credit terms.

 

Cash v Payables

Most businesses have 2 types of payables:
– operating expenses
– trade payables
Operating expenses are the monthly obligations that a business has. Examples of such expenses are salaries, CPF contributions, utility bills and finance expenses. These expenses are due monthly and need to be met in order to keep a business going.
Trade payables are payments to your suppliers for goods and services, that are consumed by a business in order to generate revenue. The longer a business takes to pay its suppliers, the more cash the business holds. However, due to their lack of bargaining power and track record, most SMEs are unable to negotiate for longer payment terms with their suppliers. In addition, if you continuously pay your suppliers late, it will affect your relationships with your suppliers.

 

Net Profit does not mean Cash Flow positive

From the above examples, we can see that as a result of a preference to sell to large corporates, and a lack of bargaining power to negotiate for payment terms, most SMEs face a cash flow gap created by its trade practices.

cash-flow-diagram

 

Example:
SME makes 60 days credit sale of $1,000 and has to pay suppliers $400 and monthly expenses of $200
From the net profit perspective, the company will have recorded a net profit of $200 from the above example
From the cash flow perspective, the SME has to meet its expenses of $800 for months 1 and 2 before receiving payment in month 3. If the SME waits until month 3 pays their expenses, the suppliers might have taken legal action to recover the debt, and their staff might have stopped working, leading to business failure.
It is no wonder that, according to an Enterprise Singapore survey, 64% of SMEs currently face some form of delay in receiving payments from customers. In fact, delayed payments were ranked as the top finance-related challenge they expect to face. Delayed payments can have a serious impact on an SME’s cash flow and working capital management if not managed carefully.

 

Strategies to improve Cash Flow

In light of the above, what can SMEs do to improve their cash flow, and their chances of survival?
Below are some strategies that Beacon Financial Services have implemented for our clients:

  1. Receivables Finance– SMEs can sell their invoices due to a funder in exchange for cash upfront to plug the cash-flow gap. Funders usually disburse up to 80% of the invoice value and are repaid when your customer pays you. It is important to know the actual time your customers take to pay you.
    (Tip: If your credit terms to your customers are 30 days but your customers regularly pay in 45 days, your business actual credit terms are 45 days).
    This type of financing is very suitable for SMEs selling to large corporates, as they are leveraging on the good credit rating of the large corporate.
  2. Supplier Finance – Conversely, the SMEs can also get financing to pay their suppliers. The funder will usually pay the suppliers first, and SMEs have up to 120 days (or to match their customers’ credit terms) to repay the funder. This type of financing also helps to plug the cash-flow gap. However, this type of financing is much harder to obtain as the funder will scrutinize the SME’s track record, financials, customers and suppliers and trade cycle closely before approving. The funder might also request for additional security before they will approve
  3. Do Research on Your Key Buyers – You can request to buy a Trade Credit Insurance on the default or non-payment on your customers. In the process, you will discover the credit ratings of your customers when the insurers inform you, on which customers they can insure against default since insurers will only insure companies with good credit rating and track record.
  4. Have a Diversified Payment Term – Another method to minimize your business risks and manage your cash flow is to offer different payment terms to different groups of customers. You can offer longer credit terms with good-paying customers while offering shorter credit terms with new customers. This means that you will have cash flowing into your business at different time periods, which can improve your cash flow.
  5. Bulk Purchase – This is usually used in tandem with Supplier Finance lines to reduce the cost of purchases.

 

Example:
If your business has an ongoing requirement for a certain type of goods or has fixed product lines, it can make sense to bulk purchase those goods/products due to several benefits. Suppliers are more likely to offer you a discount if you bulk purchase and the discount could be sufficient to cover your supplier financing costs, and even add to your overall net profit.

 

Conclusions

Cash flow keeps your business afloat, and is a major factor in the success of every business, by driving everyday operation and purchasing power. The availability of cash resources can be a dynamic and unpredictable part of life for a startup or small business, and often is a reason why a new business fails. Regular and reliable forecasting can address many problems the SMEs can face with capital. Don’t forget cash is a king! If you ask us, if cash flow is more important than the profit, we would say it might be!

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