Cash flow is the lifeblood of any business. Without it, bills and people cannot be paid, and the company – even if it is profitable and growing – may face closure. In fact, it is growing businesses that are most at risk, as they will need to invest in new people, equipment and raw materials to serve new customers before those customers pay them.
As a result, preparing an accurate cash flow statement that delivers real insight is a vital task for any entrepreneur.
So what goes into a cash flow statement?
In basic terms, a cash flow formula looks like the following:
The cash you start with + The cash you expect to receive – The cash you expect to spend
= The cash you end up with
Here’s a fictional cash flow to indicate how this can work in practice:
|Less income yet to be received||-£75,000|
|Plus current debts yet to be settled||£25,000|
|Total cash flow from operations||£75,000|
|Investment in equipment||-£45,000|
|Payments to owner||-£30,000|
Our calculation is thus: Opening balance (let’s say £10,000) plus income actually received less debts payable imminently (£75,000) less cash actually removed from the business (£80,000), giving us a closing balance of just £5,000. Easy, isn’t it?
However, this cash flow formula tells us more than merely the fact we will start next month with £5,000 in cash. It also tells us something about customers’ behaviour: whilst the business billed £125,000 during the year, it received only £50,000, suggesting that many customers are paying late – and that the company in question has pretty lax credit control. (Had every customer paid in full, the business would have started the next year with a healthy cash cushion of £80,000.)
How a cash flow statement can transform your business
In simple terms, a good cash flow forecast will enable you to predict how much cash you will have on hand and when. In other words, it enables you to forecast whether you will be able to meet your financial commitments – suppliers’ invoices, wages, loan repayments, VAT and tax — and quickly take remedial action if a negative balance is predicted.
Let’s look at a more detailed cash flow statement and how it can shape decision-making:
|Month 1||Month 2||Month 3|
|Net cash flow||£1,800||£(2,980)||£2,800|
As we can see, the business has a positive cash flow in month one and month three, but a negative cash flow in month two, when a significant drop in sales is not matched by a corresponding drop in expenses. Thus, if the opening cash balance is £10,000, it will rise to £11,800 after month one, drop to £8,820 after month two, and climb to £11,620 after month three.
All well and good — unless our imaginary business has an agreement with its bank to keep £10,000 in its account at all times, in which case it will face difficulties at the end of month two. Similarly, if the business were very highly geared and started the quarter with no cash at all, it would face a debt of £1,180 after month two, which would need to be covered by an overdraft.
Alternatively, the business could look at ways of reducing its expenditure to minimise the downturn in month two. Salaries are fixed unless someone is laid off and it’s probably not worth restructuring loans to deal with a single bad month (though if things get really bad, this should definitely be investigated, as should the prospect of a repayment holiday).
Rent is clearly a fixed amount, unless the company moves premises – but if it can find suitable alternative accommodation that costs, say, £400 a month then this would be an excellent move. Addressing the administrative costs that make up part of “general expenditure” would also be a good decision: things like fixed line telephony, mobile phone contracts and office consumables can soon add up.
Finally, if the owner doesn’t require a fixed income to survive, more can be taken out in months one and three and nothing in month two, which would help to balance out the cash flow.
Best practice in cash flow forecasting
So that’s the basics of preparing a cash flow statement. But what should you do – and equally importantly, not do – when putting your figures together?
1 Be accurate and realistic
There are occasions when optimism is good in business – if nobody predicted positive outcomes, then nobody would ever become an entrepreneur. However, an optimistic outlook is extremely dangerous when drafting a cash flow projection.
Overestimate your likely income or underestimate your expenditure and you end up with a document that tells you nothing and is simply a waste of the time it took to prepare.
If you tend to experience a downturn in sales at a particular time of year, factor that in – and assume the worst. If you’re planning a major marketing campaign, assume that it will bring in some extra business but don’t go crazy and conclude that turnover will increase threefold in a matter of months.
This way, if the downturn is less than normal or your income suddenly skyrockets, you will receive a pleasant surprise – rather than a shock if things turn out worse than anticipated.
It’s also important that your figures are accurate: double-check every calculation, as a figure left out – or, worse, a decimal point in the wrong place – could produce a cash flow that provokes you into taking all the wrong decisions.
2 Understand that an invoice is not income
When preparing a cash flow statement, it’s tempting to cut corners and assume that money invoiced is money earned. Not so. For sure, unless your customer goes to the wall or disputes the transaction, you will get paid – eventually.
But a cash flow projection needs to be realistic about when this will happen, so if you bill Amalgamated Amalgamations plc, who habitually take 60 days to pay no matter what you try, £1,000 in January that £1,000 should appear in March’s cash flow.
The same, of course, applies to purchases. If the time has come to update your laptop and you spend £1,000 on it in January, that doesn’t mean the expense should be recorded in January’s cash flow.
If you have an ongoing arrangement with the supplier, you will receive an invoice for £1,000 with 30 days to pay, meaning that you should show the £1,000 as a debit for February. More likely, you will pay on a credit card, and if you do so at the beginning of a charging period the money won’t leave your account until March – even if you pay off the bill in full and bang on time.
3 Don’t leave anything out
The whole point of a cash flow is that it includes everything you are likely to spend, right down to office consumables. If you leave anything out, you end up with a document that’s both meaningless and dangerously optimistic.
In this context, everything means absolutely everything – not just the big recurring expenses like costs of production, rent, salaries and owner’s remuneration, but also your electricity, heating, telephone line, mobile phones, broadband and so on. You should also remember to include VAT and tax bills when they will fall due, and make certain you forecast these accurately.
However, that’s not the total of your outgoings. You also have to remember all the little things that can add up to a surprisingly large sum. Postage doesn’t pay for itself and nor does stationery.
And if a vital piece of office equipment fails or needs repair outside guarantee, that will affect your cash flow too (though note the point above about such expenses not necessarily falling in the month in which they occur).
For the latter, you might wish to make some provision, as such irregular expenditure is bound to occur at some point and you will need to have the cash on hand to deal with it.
4 Understand the difference between fixed and variable costs
Your fixed costs are your predictable, recurring expenses, such as salaries, loan repayments, and broadband bills. These remain identical however much or little business you do, which is good news when you’re growing but bad news if the business suffers a contraction.
Your variable costs are those that change from month to month. Whilst your production costs may be a fixed ratio of your turnover (in the example above, the ratio is 0.3) that certainly doesn’t mean it’s a fixed cost. If our fictional business turns over £10,000 in a given month it will spend £3,000 on production and if its turnover increases to £15,000 then its production cost will be £4,500.
Some costs can be either fixed or variable, or a mixture of both. For example, if you have electric heating you are certain to use a great deal more electricity in the winter, but you can elect to make a fixed monthly direct debit that averages out these costs if this helps you to budget.
Meanwhile, your phone line may be a mixture of fixed costs (the line rental) and variable costs (the calls you make), though you may be able to opt for an all-inclusive package that covers both line rental and unlimited calls to most types of number.
When compiling your forecast, remember that fixed costs will not change whatever your turnover does, production costs will rise in line with turnover (and so will certain other costs, such as petrol to visit clients), and some expenses may rise or fall seasonally or sporadically.
4 Plan out more than one scenario
Even with the best will in the world – not to mention the most pessimistic forecasts, the most complete information and the most accurate calculations – there is an element of assumption in preparing any cash flow statement.
That’s because you can never exactly predict what your sales are going to be, precisely when a customer may misplace an invoice and pay it late, or when some vital piece of office equipment will choose to fail, requiring urgent repair.
One way to avoid a worst-case scenario is to plan out three alternatives: one closest to what you believe will happen, one more optimistic (let’s say with sales about 20% higher and no unfortunate emergencies) and one pessimistic (with sales about 20% lower and an emergency or two thrown in for good measure).
Provided the pessimistic prediction shows your cash flow as being sustainable, then you can know with virtual certainty that your business is not going to run into any problems in the short term.
Make the time to save yourself time and trouble later
When you’re running a small business – and particularly when it’s growing fast, requiring all hands to the pump – it’s tempting to take your mind off financial projections and concentrate on more immediate tasks. However, as the old saying goes, it you don’t plan to succeed then you plan to fail.
Without a realistic, accurate, carefully constructed cash flow projection you could find yourself running into problems just months down the line – and getting yourself out of the financial mire will take a lot more work than assembling a set of figures.
To learn how Cashsolv can help with your business finance requirements – and particularly if you encounter a cash flow problem – please visit our business finance page.