Lunch and Learn: How to manage cash flow in your business

In this Lunch and Learn, chartered management accountant Martin Mellor strips away the jargon that trips up so many people and focuses on how to use financial information to improve your decision-making and your business's overall performance.

Running out of cash is the biggest reason for why businesses fail, yet many business owners don't understand why that might be and what factors affect it. Here, Martin lays out ways you can manage cash going in and coming out of your small business.

Summary of Martin's key points from the webinar

• Small businesses are nimble and much more able to adopt new technology – for example, Xero, QuickBooks and systems like that. But there's a whole ecosystem out there, and a whole range of tools and techniques that you can use to support your small business.

• Lots of people lack confidence and don't feel comfortable talking about the financial side of their business. It isn't why they set out to do what they do, but with just a little bit more knowledge and understanding they can really overcome their concerns or worries.

• The financial management side of things is often a big barrier that can potentially put people off starting a business in the first place.

What cash flow means

• Fundamentally, cash flow is the availability of cash. When people describe businesses, they'll articulate its size in terms of how much revenue it generates or how much income or turnover it generates – "it's a million pound business" etc. What they're talking about is revenue or income generated. But the revenue that your business generates is only one step towards creating a return.

• By far the biggest thing that's likely to trip you up along the way – the biggest cause of businesses failing – is running out of cash and not being able to pay the bills, pay wages, pay taxes, pay suppliers and so on. You can be profitable as a business and yet still run out of cash.

• So cash flow specifically describes the flow of money in and out of your business. Even though the thing that most business owners focus on is revenue and profit.

The difference between cash flow and profit: Non-cash items

• Just because you've made a profit doesn't mean that it's money in your bank. From an accounting perspective, there are some things you do when you work out profit that are called "non-cash items".

  And it relates to where you spend money on the infrastructure of your business. Where you spend money on things that will help you to generate value over a longer timeframe, over more than a year – the short to medium term. That might be a car, a machine, a building, something like that. We call those things "capital items" or "fixed assets".

• The accounting treatment of them is that you spread their cost over the whole period that you own them. So when you're working out profit, you're working out effectively what proportion of those costs you should include in any given period. But that doesn't correlate to the point in time at which you buy that asset and spend the money. So the point at which you go and buy the car, computer, machine or whatever is typically the point at which the cash leaves your business.

• But it isn't the point in time at which your business recognises the cost of having bought those things. You might be familiar with the term "depreciation" and, to a lesser extent, "amortisation". They're just the accounting words we use for spreading cost over time.

  So that creates one difference between profit and cash. You might have included less cost in your profit and loss account than you've spent as cash at the point that you acquire these fixed assets. And then in subsequent periods, you might be including costs, but have no cash outflow. So that creates a timing difference.

The difference between cash flow and profit: Recognising income

• A fundamental principle of accounting is when we recognise income. And when we recognise income is the point at which we invoice our customer, not the point at which we get paid by that customer. So that's something called the "matching principle" or "accruals principle", and it's fundamental to understanding finance.

• What that does is create a time lag from when we recognise income and profit in our accounts and in our business versus when we actually get paid. And there are very few businesses out there that don't have some kind of issue with customers paying late.

• On average, there's about £14 billion of overdue debt owed to UK SMEs on any given day. It's massive! It translates into somewhere in the region of £65,000 to £100,000 of debt owed to every single business across the UK.

• So you've got that time lag. And yet typically most businesses will need to spend money before their customers pay them. From day zero, you go and buy supplies. So if you're physically manufacturing something, you're going to buy materials that you can then manufacture to sell to a customer and then eventually get paid.

  Even if you're a service business, chances are you're going to incur some kind of costs before you create that return flow back into the business. That's something we call the "cash conversion cycle", and it varies from business to business, but fundamentally there is usually a lag.

The difference between cash flow and profit: Treatment of tax

• The third main reason for the difference in terms of cash and profit is the treatment of tax. There are different types of tax. Typically, we're paying our corporation tax in arrears. So, after the end of the period. We might recognise that cost but we haven't yet paid it.

• And then you get into the world of VAT. Any business of reasonable size and scale will be VAT-registered. And, again, the cash that's coming into your business includes VAT and money that you pay to your suppliers may also include that.

  And then there's this offset, this quarterly catch-up, where most businesses pay HMRC. So you're effectively a debt collector for HMRC in terms of VAT. And, again, that just creates a difference in terms of the money that's coming into your business as cash, and the money that's going out of your business as cash as well.

Dealing with late payments

• A lot of businesses are consistently waiting on payments. Fundamentally, for a customer to pay you, you're reliant on that customer paying you. You can give them every opportunity and provide all sorts of tools, but you're still dealing with other people.

• More than half of all SME owners end up digging into their own pocket to subsidise their business while they're waiting for a late payment. It's a real cause of stress and a real drain on timing and resources.

• Although there were some changes in the law, and the government has recognised the issue, it relates mostly to big businesses and their payments. By far the biggest market for smaller businesses is dealing with smaller businesses themselves.

  People don't want to annoy, don't want to lose customers, by being harsh and rigid in their treatment of debt. But, equally, that customer paying late is disrespecting you as a supplier and as a provider. So it's a difficult balance to strike in terms of the right level in terms of managing debt.

• It's so easy for the scope to creep. You might have 30-day terms or 60-day terms, and it's so easy to just accept payment on the 35th day or the 62nd day. When, in reality, you've already given credit to 30 days or to 60 days. What possible reason can there be for non-payment within that timeframe?

Other factors affecting small business cash flow

• The cash conversion cycle depends on the type of business that you are. If you're a manufacturer or a physical producer of something, for example, it's about the amount of time it takes for you to get stuff through your production cycle, or the length of time that you have stock.

• There's a term called "working capital" that describes the flow of cash around your business. It's the money that your business needs to keep working. The quicker you get money out of the door to get round your production cycle, to get paid by a customer to come back in, you need less money overall.

  Basically, holding stock is an inefficient thing to do. It's why Toyota, the Japanese car manufacturer, came up with the just in time method of production. And there are loads of different methodologies now, lean and agile and so on. They're all basically designed to reduce wastage to reduce inefficiency in your process.

• If you're a service-based business, it will be about the milestones, the triggers for billing, who it is you're working with and so on. If you don't get to the point of being able to issue a bill, no-one can ever pay you. And so whether you've got milestones or structure or retainers or those type of things, it can have a big impact on that flow of cash in and around your business.

• And it's how what you do correlates with who you're paying. So is it wages and staff that's your primary cost? Is it supplies and materials? Or is it something else? And the nature of the services that you use will have a bearing on that flow, but it's called "operating cash conversion" or the "cash conversion cycle".

  If you know what you're looking at, you can work out how many days you're holding stock for, how many days it takes your customer to pay you, how many days you take to pay your suppliers. And if you piece those three things together, you can basically work out how much money you're going to need. But loads of people don't do it. Loads of people don't understand it. They don't know what to do. They've never been advised that that's a thing that you can do.

• And work out if you have what's called a "funding gap". There's a point in time at which you've paid your supplier. There's then a lag to when you're getting money back in the door. How long is that and how much money do you need to cover that gap? And it's a really easy thing to work out, but loads of people don't even know that that's possible.

Tools and technology for financial management

• As an SME, you can be nimble. First things first, cloud accounting systems – for example, Xero, QuickBooks etc. They make information much more visible. On the dashboard, you can see how much money you've had come in, how much money has gone out, what's coming up, what's going out. As long as the information in your accounting system is accurate, that's a great start point.

• Then there are tools that you can use to forecast into a plan. You can roll the clock forward three months and see what that looks like. Any bumps in the road? Anything you already know about? Because all businesses at some stage are likely to borrow money. All businesses are likely to need funding from somewhere. That's not a bad thing. What is a bad thing is reaching that point and not knowing it and then all of a sudden it becomes really expensive.

  The same way if you get to the end of the month and you've run out of cash and you have to go borrow money from a payday lender, it'll cost you a lot more to borrow. So as a business, being strategic and planning really helps. There are a couple of great cash-flow forecasting tools out there – one's called Float and one's called Fluidly, and they're worth a look.

• You can also automate the chasing process – we call it "credit control". There are some really nifty apps out there, including one called Chaser. And what they do is engage with your client, talk in your tone of voice, and basically escalate that chasing process. And they've been proven to work, in that you'll get about 30% of your money in quicker if you use tools like that.

• To get even smarter, if you're able to offer payment services, there are some really clever payment providers out there that will enable you to take card payments, which gives your customers another payment option. Stripe is a great example of that. It gets added into the invoice as a link, and just removes some of the barriers that get in the way of being paid.

Cash-flow forecasting

• It can be where a lot of businesses come unstuck, in that they just look at the bank account and think everything's OK. They're not really thinking ahead. With forecasting, too many people do it as a one-off exercise. Forecasting has its power when it's refreshed regularly.

  If you work on a rolling forecast, you're looking at the next three to six months. If you refresh that a month later, what does the next three to six months look like then? It gives you that forward-looking view and the ability to be more agile, more nimble, and go and seek things that might help your business. You can work how you'll fund it, what finance you need in place, and so on.

• Forecasting is critical, but it becomes so unwieldy and so static, it just puts most people off. Little tip: Get it as accurately as you can as quickly as you can and start using it. Don't pontificate. Don't make it an academic exercise. Don't tie up loads of time and resource in doing it. You'll see the benefits much quicker. The more it becomes habitual, the more it becomes a routine, the less significant an exercise it becomes when you do it. And so it's quick, and it's easy, and it's painless, and you move on.

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