08/ 19/ 2004
by Charles R. McConnell
A business purchases materials and supplies, pays wages and upgrades equipment and facilities out of profits, right? Wrong, although that's what some people believe. Profits are an important source of capital for expansion and for reduction of debt obligations, as well as for the eventual ability to pay bills and meet payroll. But wages, materials and supplies -- indeed all of the above -- come from cash. A business can remain open indefinitely if it doesn't run out of cash. There's no general ledger account titled "profits," so all checks written are charged to cash. Without cash, a business can remain open only weeks or months regardless of how profitable it might be on paper.
Most of the time profits eventually lead to cash. But this isn't always so; any number of businesses large and small have been profitable -- on paper -- when they were forced to close because of a shortage of cash. It is decidedly possible to go bankrupt while experiencing extraordinary "profits" if adequate cash isn't available.
For the most part 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. In most instances wages and salaries must be paid one to two weeks after they are earned. Payments on mortgages and other repeating obligations must ordinarily be made monthly. All of these add up to a steady outflow of cash that must be backed with sufficient income or reserves to meet these obligations in timely fashion. And if cash is insufficient to meet all these obligations, the business can fail. A company can be "rich" in accounts receivable and inventory, for example, but these assets may not be convertible into cash quickly enough to meet current obligations.
Cash is an asset. You can increase this asset by decreasing other assets, increasing liabilities or increasing retained earnings. Most cash comes from business income, in many instances from accounts receivable. Collecting on accounts receivable increases cash. Also, increasing liabilities can increase cash; this is what occurs when the business borrows. The proceeds of a loan flow into cash, which is then used to meet various needs. And over the long haul, an increase in retained earnings, the balance sheet entry representing net income accumulated over time, increases cash.
Net operating cash flow is the difference between cash receipts from the sale of goods or services and cash outlays associated with the production of those goods or services. Profit differs from net operating cash flow in a number of ways; for example, certain expenses that affect profits, such as depreciation, don't involve cash outlays. Cash receipts from operations approximately equal sales minus the increase (or plus the decrease) in accounts receivable. When sales are made on credit, actual cash receipts lag behind the sales themselves. A modest increase in accounts receivable can have a dramatic negative effect on cash. Also, some customers will deliberately delay payment as long as possible to keep their money working for them up to the last minute.
In any business, cash must be managed. Here's how:
Offer a modest discount for payment in full within a limited time. The customer gets a small break, and the business receives payment sooner.
Have strict control over inventories. Money tied up in inventories represents sunk cost. Inventories are not quickly adjusted, and they deplete cash.
Do comparison shopping. Equipment and other major purchases can take large bites out of cash. Take time to shop. Don't be pushed; there's no such thing as that "last great deal." Consider installment purchases as necessary to lessen the immediate cash drain.
Take credit-card payments. Credit card sales ensure fast payment from the card companies, and in many instances the cards bring in enough new business to offset the card companies' charges.
Some businesses deliberately increase their accounts payable lag to cover temporary cash shortages. This uses accounts payable much like an interest-free short-term line of credit. However, this stretching out of accounts payable time must be stopped short of tagging the business with a slow-payment record.
Continually forecast the cash needs of the business. Based on ongoing volume of business activity and customer payment history, estimate the incoming cash expected over the coming weeks and months and spend accordingly.
To be kept under control, cash must be monitored daily and actively managed on an ongoing basis. In the final analysis cash will prove itself to be the only asset the organization absolutely must have to remain in business.
