No company buys what it needs or pays its employees out of profits. Certainly profits are a source of capital for expansion and debt reduction, as well as for the eventual ability to pay bills and meet payroll, but wages and other expenses must be covered with cash. A business can survive indefinitely if it doesn't run out of cash, but without cash it can remain open only weeks or months regardless of how profitable it might be on paper. Many businesses have appeared profitable on paper right up until the time they were forced to close because of a shortage of cash.
In most businesses materials and supplies must be paid for upon receipt or within 30 days or so. Utility bills are usually due within two or three weeks of receipt, wages and salaries are paid a week or two after they're earned, and mortgage payments and other repeating obligations are usually payable monthly. These add up to a steady outflow of cash that must be backed with sufficient income or reserves, and if cash is insufficient to meet these obligations the business can fail. A company can be "rich" in accounts receivable and inventory, for example, but these assets are rarely convertible into cash quickly enough to meet current obligations.
Consider the principal characteristics of cash:
- It's an asset, influenced by changes in other assets, liabilities, and retained earnings.
- It comes mostly comes from business income, including accounts receivable; collecting on accounts receivable increases cash.
- It can be increased by increasing liabilities, such as by borrowing.
- It can be increased over time by an increase in retained earnings.
Definition: Net operating cash flow is the difference between cash receipts from sales and cash outlays for the production of goods or services sold. Operating cash flow is affected in a number of ways:
- Cash receipts approximately equal sales minus the increase (or plus the decrease) in accounts receivable.
- When sales are made on credit other than credit cards, actual cash receipts lag behind sales.
- A modest increase in accounts receivable can have a dramatic negative effect on cash.
- Some customers deliberately delay payment as long as possible to keep their money working for them up to the last minute.
In any business, cash can be managed in a number of ways:
- Offering a discount for payment in full within a limited time. The customer gets a break, and the business receives payment sooner.
- Strictly controlling inventories. Inventories are not quickly adjusted, and they tie up cash.
- Comparison shopping for major purchases. Consider installment purchases to lessen the immediate cash drain.
- Taking credit-card payments. Credit card sales ensure fast payment from the card companies, and the cards often bring in enough new business to offset the costs.
Some companies increase the lag in accounts payable to cover temporary cash shortages, like giving themselves an interest-free short-term loan. But this practice must stop short of getting the business labeled as a slow payer.
Continually forecast the cash needs of the business. Based on business volume and customer payment history, estimate the incoming cash expected over the coming weeks and months. Spend accordingly, and always leave a modest cushion for the unexpected.
To be kept under control, cash must be monitored and actively managed on a continuing basis. In the final analysis cash is the one asset the company must have to remain in business.