Assess your cash flow risk with this simple method here. Your business might not have the factors that make cash flow so different from profits. Maybe managing sales and expenses is enough for your business. It depends on the specific factors here.
Give yourself 1 point if you deal with product inventory you have to buy and pay for before you can sell it. Add another point for each month of average inventory
Sales on Credit
1 point if you have to wait for customers to pay invoices (instead of collecting all in cash, check, or credit card when you make the sale of deliver the service.) Add an additional point for every month beyond one that you wait, on average, for customers to pay.
Deposits in advance
If you added a point for #2 above, subtract 1/2 point for having customers pay significant (35% or more) deposits up front.
Add another point if you have to pay significant principle payments on debts, or purchase significant assets (equipment, vehicles, etc.)
Subtract 1/2 point if you pay expenses by collecting invoices from vendors and waiting a month or more before paying.
What the cash flow risk assessment means
If you scored less than one with this cash flow risk assessment, heave a sigh of relief and watch your sales, cost of sales, and expenses very carefully. You don’t have to calculate cash flow as a separate exercise. Develop and manage projections of sales, cost of sales, operating expenses, and other spending including repayment of debt and purchase of assets. Put your sales, costs, expenses, and other spending into a worksheet showing your projections for the next 12 months. And maybe, just to be sure, you continue reading with the next section on cash traps, and the one after that, showing a cash example.
If you assess your cash flow risk as 1 or more on this cash flow risk assement, you might still read the next two sections just to be sure, but face it, you can’t afford not to manage cash flow carefully. Aside from just lean business planning, you need to fully understand and manage cash flow; or have somebody on your team who does. You need the three linked projections covered in Section 5: Profit and Loss, Balance Sheet, and, especially, Projected Cash Flow.
These words put some people off because they sound like accounting and financial analysis. But they’re good terms to know, especially if you’re running a business. This is important cash flow vocabulary.
Cash in business planning and financial projections is not coins and bills. It’s liquidity, money in checking and other instantly available accounts; money you have and you can spend.
Cash sales include sales by real cash, bills and coins; plus sales paid by check or credit cards. In financial projections, sales are either cash or on credit (below).
Sales on credit isn’t about credit cards, but rather the common practice of businesses selling to other businesses, and sometimes businesses selling to consumers. It’s also called sales on account. It refers to when a business delivers the goods and services to a business customer along with an invoice that will be paid later, not immediately. The amount involved is considered Accounts Receivable for the seller, and Accounts Payable for the buyer.
Collection days is how many days, on average, a business waits for customers to pay their invoices. The unit is days, so 30 is about a month and 90 about three months. Accountants and analysts calculate average collection days for a business by multiplying 365 times times the average receivables balance and dividing that by annual sales on credit. And this is often called Collection Period.
Receivables is short for Accounts Receivable, which is money owed to a business. It may include some outstanding loans to employees, for example, and some other items; but the bulk of Accounts Receivable, and analysis of Accounts Receivable, is amount owed to a business by customers who haven’t paid yet.
Accounts Payable is money a business owes. When your business customers haven’t paid you, what is accounts receivable to you is accounts payable to them.
Payment days is how many days, on average, a business waits before paying its invoices. The unit is days, so 30 is about a month and 90 is about three months. In many ways it’s just the other side of the coin of collection days. If I’m your customer, then my payment days figure into your collection days. However, the formulas for payment days are harder to deal with than for collection days, because standard accounting keeps much closer track of sales on credit than new entries to accounts payable, and new accounts payable is not an obvious concept. So I’m defining it with this illustration:Total New Payables for a year would be the sum of all the monthly entries in the bottom row of the illustration above. So once you get that number for total new payables, you can then calculate payment days with a formula similar to the one for collection days: multiply the average payables balance by 365, and divide that product by the total new payables for the year.
Inventory is goods and materials that you’ve purchased and you keep until you sell it to customers. That could be materials you’re going to assemble into something, or products you’re going to sell. Inventory is an asset. It doesn’t become a cost until you sell it. Therefore it doesn’t show up on the profit and loss statement until you sell it. But you may have already paid for it by the time you sell it.
Inventory Turnover is a measurement of how much inventory you have on hand. Inventory on hand tends to be a drain on working capital because you pay for it before you sell it. The higher the turnover, the less inventory is sitting in your business waiting to get sold, and the better for cash flow. Analysts talk about “turns,” so that if your average inventory is equivalent to a year’s worth of sales, that’s one turn. Businesses aim for 10, 20, or more turns. Calculate inventory turnover by dividing your cost of goods sold by your average inventory balance.
Word of warning:
Unfortunately, even with financial analysts and accountants as literal as they are, with their insistence on things being exactly correct, there are different ways to calculate some of these numbers. And, to make matters worse, many of them calculate a number one way and don’t realize that there is more than one way. For example:
Many of them use the number 360 in these calculations instead of 365
Many of them use ending balance for these calculations instead of average balance.
Many of them calculate payment days using cost of goods sold instead of new payables.
And other discrepancies will turn up. Don’t take them too seriously when they say that one of these calculations are wrong. It’s just different.