Dec 162011

Profit is vanity, cash is sanity

It’s an unfortunate fact that a lot of profitable businesses go under because they run out of money.  But how can that be so, you ask.  Well, it’s because they don’t understand cash flow and cash flow forecasting and that profit and cash flow are two different things.

A cash flow forecast is just a simple tool for looking ahead to see when you think cash is going to come in to your business and when you will need to pay it out.  Ideally, you should do this monthly for most businesses, out about 2 years ahead . If your business is very fast moving in relation to stock and sales you might want to do a forecast every week if you find a month is too long.

One of the key things with a cash flow forecast is to be realistic (read pessimistic).  If you’re just starting a new business don’t expect to be selling huge amounts from day 1; equally, don’t expect all the people who owe you money to pay you on time (or sometimes even at all…).

The key thing that causes confusion is the time lag between money out and money in, which is why you need to look at quite a long period.  Imagine that you make wooden chairs; you might buy the wood in January, spend 2-3 weeks making the product and then not sell them until April.  Worst case (if you were buying for cash) you would have spent money in January but not received any money until April.  In the meantime you have also had to pay for more materials in February and March, plus paid wages, rent, fuel etc etc.

Another thing to look out for is the credit terms you allow others to have when buying from you.  When you first start out you might allow someone extended terms simply in the hope of gaining their business.  You then find that cash runs out before the first payments start coming back in.

A couple of tips for running your business successfully with regards to cash flow:

  • Always have an up to date cash flow forecast and study it regularly so that you can see the bumps in the road ahead.
  • Always try to ensure that you know what the standard credit terms are for your business and stick to them.
  • When you start out make sure that you have sufficient cash to cover the first 6 months of trading.
  • Be pessimistic when forecasting money in and out of the business; plan for less coming in and more going out as that will build in a safety factor.

Cash flow forecasting isn’t a black art, in fact it’s one of the easiest accountancy tools that you will use.  You do need t do a bit of “what if” thinking but provided you’re logical and realistic it shouldn’t be an issue.  After a couple of months you’ll wonder how you got along without it.