Balancing the books

Picture the scene. You have just had the annual meeting with your accountant. You have had a good year and produced a reasonable profit. You were hoping to take out extra cash on the strength of the year’s result but the overdraft is at its limit. Sound familiar? If you make a profit, why can you not take the money out? Where does the cash go? Inevitably, profit – and therefore cash – is used for various business purposes during the year. For example, the firm may have bought new equipment or furniture, or replaced partners’ and directors’ cars.

In addition, funds are probably locked up in work in progress, for which the business has paid salaries and other expenses before it has been able to invoice customers. Stock (if held) is also financed from cash and the business may be awaiting payment of invoices. And finally, cash is used to pay business creditors.

Unfortunately, the proprietor can only take money out if any remains after all other expenses have been met. This is clearly a demotivating and inefficient way of operating a business.

Let us consider the separate components that comprise a firm’s working capital to see how each aspect can be used to improve cash flow.

Debtors

Debtors are those people or organisations that owe money to the firm, so it is essential to keep tight control of this area. Every business should operate a system of credit control to ensure that they only deal with credit-worthy customers; this minimises the possibility of bad debts, and makes it more likely that cash will be collected within the prescribed terms of business.

Work in progress

This relates to work that has been undertaken for a customer but that has not yet been invoiced. It is crucial to raise invoices on a regular basis so that unbilled work in progress is kept to a minimum. Remember, cash can only be collected once work has been invoiced and there are several benefits to prompt billing.

It is easier to invoice work that has just been undertaken, as most customers prefer to deal with a series of smaller regular invoices rather than occasional large ones, and each small invoice can be treated separately for cash collection purposes.

Creditors

The way in which creditors (suppliers to whom the firm owes money) are dealt with can significantly affect cash flow. Therefore, the firm should ensure that:

• Only properly authorised invoices are paid
• All settlement discounts are taken
• Invoices are paid when they are due
• Credit is obtained for incomplete deliveries, wrong prices and so on.

If the business receives money before completing a contract or piece of work, this should be noted under “creditors” until that project has been completed and invoiced. Ideally, those funds should only be used for salaries and expenses relating to that job.

How to improve cash flow

Let us consider the impact of implementing the above ideas on a hypothetical company, the figures of which are detailed in the box below. The company generates good profit but the directors have been unable to take their bonuses because of poor cash flow.

The company should take the following steps to improve its management of cash flow:

• Invoice work in progress at the end of each month, thus reducing the amount under the work in progress heading by £67 000 to £33 000 for one month. Debtors would increase by £67 000, rising from £175 000 to £242 000, and there would be no immediate effect on cash.
• Chase outstanding invoices for tighter credit control. Aim to shorten debtors repayment terms from 60 days to 45. This would reduce the amount outstanding by £60 000, taking debtors down from £242 000 to £182 000, which would have a direct and prompt impact on cash flow.
• Take all settlement and other available discounts from suppliers. As the company only pays creditors when it collects from debtors, the time taken to pay creditors would also reduce by 15 days. Although creditors would be paid earlier, with an additional cash outflow of £30 000, the business would benefit from early settlement discounts.
• Refinance the new car on hire purchase, thus providing £15 000 cash.
• Dispose of excess stock, generating, say, £5000 cash.

The combined effect of these improvements can be seen in the revised balance sheet in the box. The bank account is now £25 000 in credit, which is sufficient to pay the directors’ bonuses. Although there may be other issues, such as expansion, that make urgent demands on the firm’s cash resources, this example illustrates the benefits of good cash flow management.

Proprietors also need to ensure that sufficient funds are available for regular payments, such as VAT and rent, while partners and the self-employed need to allow for tax payments in January and July each year.

Cash flow management is only one of a number of tools to improve efficiency and practice management and it should be co-ordinated with the firm’s budgeting process and business plan, both of which will be covered in future articles.