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Essentials of Entrepreneurship and Small

Business Management

Eighth Edition

Section 3: Launching the Business

Chapter 12

Managing Cash

Flow

Learning Objectives (1 of 2)

12.1 Explain the importance of

cash management to a

small company’s success.

12.2 Differentiate between cash

and profits.

12.3 Understand the five steps

in creating a cash budget.

Learning Objectives (2 of 2)

12.4 Describe fundamental principles involved in

managing the “big three” of cash management:

accounts receivable, accounts payable, and

inventory.

12.5 Explain the techniques for avoiding a cash crunch

in a small company.

The Importance of Cash

• “Everything is about cash – raising it, conserving it,

collecting it.” ~ Guy Kawasaki

• Common cause of business failure: Cash crisis!

• It is possible for a business to earn a profit and still go

out of business by running out of cash.

– Valley of death

Figure 12.1 The Valley of Death

Source: Yoshitaka Osawa and Kumiko Miyazaki, “An Empirical Analysis of the Valley

of Death: Large Scale R&D Project Performance in a Japanese Diversified Company,”

Asian Journal of Technology Innovation, vol. 14, no. 2, 2006, pp. 93–116.

Cash Management (1 of 2)

• American Express Open Small Business Monitor

study:

– 52% of small business owners experience

problems with cash flow.

– Their biggest cash flow concern is the ability to pay

bills on time.

Figure 12.2 Small Business Owner's

Rating of Their Companies' Cash Flow

Source: Based on data from Wells Fargo Small Business Index, 2nd

Quarter 2014, p.11.

Cash Management (2 of 2)

• Cash management:

– The process of forecasting, collecting, disbursing,

investing, and planning for the cash a company

needs to operate smoothly.

• Young and growing companies are “cash sponges.”

• Know your company’s cash flow cycle.

Cash and Profits

• Cash ≠ profits.

• Profit is the difference between a company’s total

revenue and total expenses.

• Cash is the money that is free and readily available to

use.

• Cash flow measures a company’s liquidity and its

ability to pay it bills.

Figure 12.4 Cash Flow

The Cash Budget

• Cash budget:

– A “cash map” that shows the amount and the

timing of a firm's cash receipts and cash

disbursements over time.

• Predicts the amount of cash a company will need to

operate smoothly.

• Helps to visualize a company’s cash receipts and

cash disbursements and the resulting cash balance.

Preparing a Cash Budget

• Five steps:

1. Determining an adequate minimum balance.

2. Forecasting sales.

3. Forecasting cash receipts.

4. Forecasting cash disbursements.

5. Estimating the end-of-the-month cash balance.

Determine an Adequate Minimum

Cash Balance

• Step 1

– The most reliable method of deciding the right

minimum cash balance is based on past

experience.

Forecast Sales (1 of 2)

• Step 2

– The heart of the cash budget.

– Sales are ultimately transformed into cash receipts

and cash disbursements.

– Cash forecast is only as accurate as the sales

forecast from which it is derived.

Forecast Sales (2 of 2)

• “Lumpy” or seasonal sales patterns are common.

– 15% to 18% of wine and spirits shops’ annual

sales occur between December 15 and 31.

– 40% of toy sales take place in last 6 weeks of the

year.

• Prepare three sales forecasts:

– Pessimistic

– Optimistic

– Most Likely

Sales Forecast for a Start-Up

Example:

Number of cars in trading zone 84,000 autos

× Percent of imports × 24 %

= Number of imported cars in trading zone 20,160 imports

Number of imports in trading zone 20,160 imports

× Average expenditure on repairs and maintenance × $485

= Total import repair sales potential $9,777,600

Total import repair sales potential $9,777,600

× Estimated share of the market × 9.9%

= Sales estimate $967,982

Forecast Cash Receipts

• Step 3

– Record all cash receipts when the cash is actually

received (i.e. the cash method of accounting).

– Determine the collection pattern for credit sales;

then add cash sales.

– Monitor closely: Slow and non-payers.

Figure 12.5 Probability of Collecting

Accounts Receivable

Source: Based on data from the Commercial Agency

Section, Commercial Law League of America, 2011.

Forecast Cash Disbursements

• Step 4

– Record disbursements when you expect to make them.

– Start with those disbursements that are fixed amounts

due on certain dates.

– Review the business checkbook to ensure accurate

estimates.

– Add a cushion to the estimate to account for “Murphy’s

Law.”

– Don’t know where to begin? Try making a daily list of

the items that generate cash and those that consume

it.

Figure 12.6 Cash Flow Concerns

among Small Business Owners

Source: Holly Wade, Small Business Problems and Priorities,

National Federation of Independent Business, August 2012, pp. 13–14.

Estimate End-of-Month Balance

• Step 5

– Take Beginning Cash Balance ...

– Add Cash Receipts ...

– Subtract Cash Disbursements

– Result Is Cash Surplus or Cash Shortage (Repay

or Borrow?)

Benefits of Cash Management (1 of 2)

• Increase amount and speed of cash flowing into the

company

• Reduce the amount and speed of cash flowing out

• Make the most efficient use of available cash

• Take advantage of money-saving opportunities such

as cash discounts

Benefits of Cash Management (2 of 2)

• Finance seasonal business needs

• Develop a sound borrowing and repayment program

• Impress lenders and investors

• Provide funds for expansion

• Plan for investing surplus cash

The “Big Three” of Cash Management

• Big Three:

1. Accounts receivable

2. Accounts payable

3. Inventory

• The Big 3 interact to create a company’s cash

conversion cycle:

– The length of time required to convert inventory

and accounts payable into sales and accounts

receivable and finally back into cash.

Figure 12.7 Amazon’s Cash

Conversion Cycle

Source: Based on data from “The Cash Conversion Cycle,” Forbes, March 10, 2012,

http://www.forbes.com.

http://www.forbes.com/sites/ycharts/2012/03/10/the-cash-conversion-cycle/

Accounts Receivable

• About 90% of industrial and wholesale sales are on

credit, and 40% of retail sales are on account.

• Survey of small companies: 74% have accounts

receivable outstanding for 60 or more days.

• Remember: “A sale is not a sale until you collect the

money.”

• Accounts receivable goal: Collect your company’s

cash as fast as you can.

Establish a Credit and Collection

Policy

• Screen credit customers carefully.

• Establish a firm credit-granting policy.

• Send invoices promptly.

– Cycle billing

• When an account becomes overdue, take action

immediately.

Accelerating Accounts Receivable

• Ensure that invoices are accurate and timely.

• Include a description of the goods or services

purchased.

• Ensure that invoices match purchase orders or

contracts.

• Highlight the balance dues and due date.

• Include contact information in case customers have

questions.

• Use a security agreement.

Accounts Payable

• Stretch out payment times as long as possible

without damaging your credit rating.

• Verify all invoices before paying them.

• Negotiate the best possible terms with your suppliers.

• Be honest with creditors; avoid the “the check is in the

mail” syndrome.

• Schedule controllable cash disbursements to come

due at different times.

Inventory

• Monitor inventory closely; it can drain a company’s

cash.

• Avoid inventory “overbuying.”

– It ties up valuable cash at a zero rate of return.

• Arrange for inventory deliveries at the latest possible

date.

• Take advantage of discounts:

– Quantity discounts

– Cash discounts

Figure 12.8 A Cash Discount

Table 12.8 Cost of Forgoing Cash

Discounts

Cash Discount

Terms

Cost of Forgoing the Cash Discount

(Annually)

2 over 10, net 30 37.25%

2 over 10, net 40 24.83%

3 over 10, net 30 56.44%

3 over 10, net 40 37.63%

2 , net 30

2 , net 40

3 , net 30

3 , net 40

Avoiding the Cash Crunch (1 of 4)

• Barter

– Consider bartering, exchanging goods and

services for other goods and services, to conserve

cash.

▪ More than 500 barter exchanges operate across

the United States.

Avoiding the Cash Crunch (2 of 4)

• Trim overhead costs:

– Ask for discounts and “freebies”

– Conduct periodic expense audits

– Lease rather than buy

▪ Operating lease

▪ Capital lease

– Avoid nonessential cash outlays

– Buy used or reconditioned equipment

– Hire part-time employees and freelancers

Avoiding the Cash Crunch (3 of 4)

• Outsource

• Use e-mail rather than mail

• Use credit cards for small purchases

• Negotiate fixed loan payments to coincide with your

company’s cash flow

• Establish an internal security and control system

• Develop a system to battle check fraud

• Change shipping terms

Avoiding the Cash Crunch (4 of 4)

• Start selling gift cards

• Switch to zero-based budgeting

• Be on the lookout for employee theft

• Keep your business plan current

• Build a cash cushion

• Invest surplus cash

– Money market account

– Zero-balance account

Conclusion

• “Cash is King”

• Cash and profits are not the same.

• Entrepreneurial success means operating a company

“lean and mean.”

– Trim wasteful expenditures.

– Invest surplus funds.

– Plan and manage cash flow.