Focusing on liquidity comes more naturally to a CEO than to an accountant who is trained to practice accrual accounting. When your business is just starting up, you essentially run it out of a check book, which is an example of cash accounting. As long as there is cash in the account, your business is solvent. As your business becomes more complex, you will have to adopt financial accounting. However, you have to keep a focus on liquidity and cash management even though you track net income through financial accounting.
Most companies should prepare monthly cash budgets to keep track of their cash. In fact, cash budgets should be done six to twelve months in advance to project cash needs. The cash budget will capture the timing difference between the profit you see on the income statement and the cash that is actually coming into the firm and flowing out of the firm.
The purpose of the cash budget is not to set targets for cash but to anticipate needs. If you prepare cash budgets 6 - 12 months in advance and your needs change, then change your cash budgets. Keep them up to date because the cost of running low on cash in a business is high. You should know that from your own personal finances. Prepare your budgets conservatively.
Cash budgets can address "what-if" scenarios. You can use them to test different possible future scenarios. You can attach a percentage of probability to the future scenario and test your assumptions. For example, you can change the speed of your collections or the timing of your inventory purchases and see how it affects your cash position.
How to Maximize Your Cash Flow
Your goal, as the owner and manager of your company, is to squeeze all the cash out of your balance sheet that you can. Not only do you want to get as much cash out of your company as you can, you want to keep it out in case of a potential or actual crisis.
Two of your current asset accounts are usually big drains on your cash. They are inventory and accounts receivable. Inventory is the products you sell and accounts receivable are your credit accounts or those the accounts that represent the credit you extend to customers. The balances in both accounts need to be converted to cash as soon as possible.
You can use financial ratio analysis to check out your position regarding inventory and accounts receivables. Inventory turnover ratios can tell you if your inventory is obsolete or if you are selling so fast you are stocking out. Accounts receivable ratios, such as day's sales outstanding, can tell you how fast your credit customers are cleaning up their accounts among other things. Once you determine the position of your inventory and receivables, you can take the appropriate actions to adjust the situations and have more cash coming in to your firm.
Another way to get more cash into your business regarding your credit customers and accounts receivables is using a lockbox system to collect payments. If you have payments wired or mailed to a lockbox, those payments get into your account faster. Your bank can then sweep funds into an interest-bearing accounts.
Another short-term strategy to squeeze money out of your balance sheet is to look at the current liabilities on your balance sheet. Focus on your accounts payable. They are what you owe your suppliers. Pay your accounts payable on the day they are due, not early. There is no reason to give your suppliers the use of your cash days before the bill is due. Your business needs to have use of that cash. Stretch out the use of your funds.
Keys to Good Cash Management
The bottom line to good cash management is that, in a crisis, typical financial statements become irrelevant and all that is important is surviving from a cash point of view. In a cash crisis, such as a recession, a business owner's focus becomes, by necessity, very short-term. Often, a cash crisis will instill good cash management practices into business managers that carry over from that day forward.
Managers have to understand how to prepare a monthly cash budget. Next, they must understand sources and uses of cash like are stated on the Statement of Cash Flows, one of three required financial statements. The feedback you get from these financial statements is invaluable. Starting with inventory and accounts receivable, if managers can maximize their cash flow, they can almost always avoid running out of operating cash and exposing themselves to cash flow problems.