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Bookkeeping
September 15, 2022

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Glenn Harris

Glenn Harris

Director

What is Cash Flow?

In a business context, cash flow refers to the movement of cash in and out of your business. As a rule, your business will be considered healthy if cash inflows exceed cash outflows.

Cash flow is very different to profit or accounting earnings. In his 2019 letter to shareholders, Warren Buffet provided a blunt criticism of accounting profits reported by companies. Stating that “accounting profits” provide crazy earnings numbers versus cash earnings which he referred to as “real world.”

Warren Buffett, often referred to as one of the world’s greatest investors, touches on an important point here regardless of the business size. Most investors prefer to assess a company’s performance or value based upon its cash flow statement rather than its profit & loss statement.

Why Are Cash Flow Statements Important?

Cash flow is the lifeblood of any business. No doubt you have heard the phrase “Cash is King”. Without sufficient cash flow, you cannot keep your business healthy and thriving and will most likely be going backwards.

I have heard many times from clients, “I have all this profit but no cash in the bank; WHY??”

Understanding the difference between accounting profit and cash flow in your business is critical to the success of the business.

Strong free cash flow provides excellent flexibility to any business and allows the business management to take the following actions on a timely basis when the opportunities arise:

  • Mergers and Acquisitions
  • Access inventory at favourable prices or terms
  • Restructure your business (i.e., payout finance, rationalise workforce etc.)
  • Invest in new staff or equipment for growth
  • Increase dividends to business owners

If your business is constantly operating without free cash flow or breakeven, you will not be able to access these opportunities when they arise. Worse still, should trading conditions decline due to internal or external factors, you may be required to act in the short term, which may significantly impact the medium to long-term health of your business.

man woman working cafe

What Affects Your Cash Flow Statement?

The cash flow of any business will be impacted by a wide variety of factors depending on the size and the nature of your business. In our experience, the following are some key factors impacting the cash flow of a small to medium-sized business. Take a look at how you can best approach your cash flow management.

Factor Possible impact Possible Corrective Action
Unfavourable payment terms
  • A mismatch between the credit terms you offer your customers and those offered by suppliers may lead to pressure on your cash flow. This is particularly the case in a new business.
  • Actively negotiate favourable payment terms with suppliers, including discounts for payment on time.
  • Ask for deposits from your customers.
  • For a new business, ensure you have sufficient working capital at the commencement of trading.
High debt levels
  • Should you have a lousy trading month, a high debt level can put a big dent in free cash flow.
  • Interest rates increase, as seen in the current economic conditions, will quickly eat into free cash.
  • Your bank may require amortisation of your loan where the loan was interest only.
  • Budget for increases in interest rates and possible loan amortisation in your cash flow forecast. Have your bookkeeper assess the impact of increased rates on your forecast.
  • Fix interest rates with the bank
  • Raise equity for your business to reduce debt.
Underutilised equipment 
  • Excessive or incorrect equipment mix for your business, and the equipment is sitting idle.
  • Finance payments continue to be made on this equipment.
  • Assess the return on investment (“ROI”) for each piece of equipment by having your bookkeeper produce cash flow reports which allow this analysis.
  • Dispose of underutilised equipment to reduce debt OR use proceeds to invest in equipment that provides a more favourable ROI OR other business areas such as marketing.
Poor performing division or product line
  • Poor performing product lines may reduce free cash flow, and this may not be readily identifiable via your business’s current standard financial reporting model.
  • Increase the sophistication of your financial reporting by product line or divisions. This enables you to clearly see each product’s contribution to “net cash flow.”
  • Stop producing poor-performing products. Note: there may be a reason to continue to make these products even if they’re not producing positive cash flow, such as a loss leader or composite product.
Unproductive staff 
  • Excessive wage costs or unproductive staff can quickly drain the cash reserves of a business.
  • Assess the contribution each employee is making to the business. This can be done by setting appropriate KPIs and reporting.
  • Restructure your business where there are high wage costs or unproductive staff. Note: always consider the impact of seasonality or future growth of the business
Competition
  • Revenue from your customers can be diverted to new competitors. This may be subtle initially and can often be identified once it’s too late.
  • Keep yourself familiar with what existing or new competitors are doing, and how and when you need to respond.
  • Revisit your marketing strategies to attract new business or retain existing customers.
Innovation 
  • Advances or disruptions in your industry can come quickly and significantly impact your cash flow.
  • Keep up to date with the latest advances in technology and methods in your industry.
  • Move quickly as required
  • Develop your own innovations or “Intellectual Property”. You may be able to register this IP and license it as a separate source of income.
Loss contracts 
  • A fixed term or fixed price contract can result in a “cash” loss where there is movement in the industry, product supply or the economy in general (the building industry in Australia is a current example)
  • Review all contracts very carefully before entering and seek professional advice.
  • Consider all the changes that may occur over the contract term, which could reduce the positive cash inflow from delivering the contract.
  • Longer-term contracts will generally carry more risk due to the complexity of estimating costs in the future
  • Consider multiple contracts to allow projects to be delivered in stages. Allow flexibility in the terms of the contract.
  • Use a cost-plus contract rather than a fixed-price contract. Be very careful in entering a contract that has “thin margins.”

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Information is Key

In our experience, the key takeaway is that you must keep yourself informed regarding all aspects of your business, especially when it comes to cash flow management. It’s often too easy to “work in the business” rather than “on your business”.

To mitigate any of the cash flow issues detailed above, it is essential to have experienced advisors you can call to support you in making critical business decisions. At a minimum, these advisors would include:

  • Bookkeeper – To provide accurate and timely financial reports and data for your business. Also, ensure compliance with your taxation and related compliance obligations, including GST, PAYGW, Payroll Tax, Superannuation etc. Using an external bookkeeper frees you up from this compliance burden and allows you to work on your business.
  • Accountant – Provides support with creating cash flow forecasts and interpreting the data on the forecast vs actual regularly. This is critical to decision-making in your business. Your accountant will also ensure tax compliance and provide specialist advice regarding business restructuring and mitigating tax payments
  • Mortgage Broker – As it becomes increasingly challenging to secure finance for small to medium businesses, you should rely on a finance broker to support you to obtain more favourable terms on your existing debt.
  • Solicitor – Before signing any material contract, you should always have your legal advisor review your contract and interpret all the provisions for you so you are fully informed about the document you are signing.

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