Poor cash flow management
leads to failure of many startups and small businesses. Common cash flow
problems are the following:
1) overestimating future sales, especially when a
business has no historical forecasts. One must be realistic and when there is
no precedent then the business owner must look at similar business in the
industry.
Forecasting revenue is difficult
for early businesses especially when there is no past figures from which one
can rely on.
2) Managing expenses is
another problem since spending on unnecessary costs can take away from profit
margins. Gross profit margins show how efficient a business’s management or
owners use material and labor in the production process. Gross profit margin is
found by using the formula sales – cost of goods sold / sales. So for example,
if the gross profit margin is 40%, this can be explained that labor and
material costs have increased, and they are likely to lower gross profit
margins. One way this can be alleviated is to pass the costs to customers
through higher prices.
Operating profit margin
shows how successful the business has been in generating income from its
business operations. The formula to use is EBIT/sales. The numerator represents
earnings after deducting cost of goods sold and operating expenses from sales.
So if a business has an operating profit margin of 20%, it indicates a measure
of the operating leverage a business can achieve in the conduct of the
operational part of the business. It shows how much EBIT (earnings before interest
and taxes) is generated per euro or dollar of sales. High operating profits
mean effective control of costs.
3) Past due receivables,
the volume of accounts receivables is basically determined by the credit policy
of the business. If credit standard are relaxed it has both advantages and
disadvantages. The advantages are that sales increase, more customers are
attracted to the business, and higher accounts receivables (on credit) are
generated. The disadvantages are reflected in the profitability of more bad debts
and the additional financing costs of accounts receivables.
Before making decisions
to lower credit standards, the cost of additional accounts receivables and the
benefit of more sales should be compared. If the result of this cost/benefit
analysis is a net profit, the business should relax credit standards. The
benefit of lowering credit standards is the profit from additional sales, the
costs are additional bad debts and greater financing costs for additional
accounts receivables.
The benefits of raising
credit standards are reduction of bad debts and lowering financing costs. The
cost is reduction of profits from sales.
4) Keeping cash on hand
in order to have reserves in place to protect the business from unexpected slow
sales.
5) Use cash flow amount which
tracks inflow of revenue and outflow of expenses. The cash flow statement provides
a comprehensive analysis of the process by which a business generates cash from
operations, investments, and financing activities. It also traces the ways this
cash is put to use by the business. The cash flow statement helps pinpoint area
of weakness in a business’s cash positions and its ability to meet debt
obligations.
