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Managing Cashflows

Releasing internal funds to manage deficits rather than external sources of finance

82% of small businesses fail due to a lack of cash. While profitability is a key goal most managers tend to harp on, cash flow is the lifeblood of any business. A business can be profitable, yet have to cease operations if it runs out of cash.


In this article, we explore how businesses that are reeling for cash could look to maximize internal sources of financing to avoid cash crunches. We also explain how the strategic fit of external loans need to be assessed if a company is unable to release enough cash from internal sources.


First of all, managing cashflows requires a sound understanding of the type of business activities that generate cashflows. A firm’s cash flow statement includes cash inflows and outflows that stem from:
  1. Operating Activities - Operating cash flow (OCF) is a measure of the amount of cash generated by a company's day-to-day business operations such as selling and purchasing inventory, creating products, providing services, and paying salaries.

  2. Investing Activities - Investing transactions relate to capital expenditure and inflows from purchases and sale of physical assets and investments in securities.

  3. Financing Activities - Cash flow from financing activities refer to cash that is used to fund the company and include transactions involving debt, equity, and dividends.

A company’s potential to grow organically would depend on if it can generate sufficient positive cash flows from operations, otherwise, it may require external financing (from investing and financing activities) for capital expansion.

Crucial cash shortages are often the result of operating activities. This is because when a company earns healthy operating cash surpluses, which is defined as the excess of revenue over expenses, it can choose to channel the funds to set off cash shortages arising from investing and financing activities without compromising on profits. For example, paying off investment capital outlays or loan repayments without impacting profitability.


However, when cash shortfalls arise from operating activities and are to be bridged through investing and financing inflows, a firm ends up taking on more outflows as commitments in the form of more debt or equity on which interest or dividends payments need to be made.

Hence, operating cash deficits are the most critical deficits that a firm needs to watch out for as it should ideally self-fund itself for effective growth. Let’s take a look at what are the most common causes of such financing gaps.


Hence, operating cash deficits are the most critical deficits that a firm needs to watch out for as it should ideally self-fund itself for effective growth. Let’s take a look at what are the most common causes of such financing gaps.

1. Unplanned, rapid growth

  • More costs being incurred than revenue earned - Businesses face short term cash deficits if they end up growing too rapidly, and the growth is largely unplanned. This leads to businesses adding more costs to payroll, increasing sizes of manufacturing facilities, and increased production costs without factoring if costs are over stripping revenues. The risk of rapid and unplanned growth is that a business may end up over-trading, without having cash to pay for day-to-day expenses and meet expanding orders.

  • Timing of inflows versus outflows could be mismatched - For example in a service firm that is growing rapidly, and hiring people to meet increased demand, there is a lag between job posting, to hiring, then the new employees working for billable time, followed by generating an invoice, followed by payment. However, it may take almost an entire quarter for service delivery to be completed and record an inflow. This indicates the time lag between incurring expenses and recording revenue. The timing and extent of expansion costs have to be factored in detail before embarking on growth or accepting higher sale orders. Hiring too many too soon can drain cash reserves, and bring the business to an emergency cash status.

2. Unplanned efforts to increase sales:

  • Low product pricing to encourage more sales - Offering products at discounted rates to encourage sales is another risk as the price point may not be high enough to cover the cost of sale. Other than employees on the payroll, a majority of other expenses such as utility and internet bills may not directly relate to production and can easily get out of hand if not factored into product pricing.

  • Overstocking inventory – Cash tied up in inventory can be a bottleneck for other working capital financing needs. Inventory that is stocked up to generate high sales can lead to increased holding cost in terms of warehousing, electricity for refrigerators (if products are perishables) and the opportunity cost of using the space for other forms of revenue generation. It could also lead to stock wastage if demand halts.

  • Incurring high overhead expenses – Setting up shop in prime locations for higher visibility and footfall to generate more sales can lead to commitments to rentals higher than what the firm can afford.

3. Unexpected expenses falling due:

  • A few of the most common unexpected expenses that end up falling due are loss of staff and retraining needs, repairs for equipment breakdown, and an increase in market competition that compels the need for new technology or equipment.

4. Externalities such as COVID-19:

  • Sudden changes to planned revenues - Many businesses have seen a dip in their revenues as customers cancel orders, or ask for excessive discounts for early settlement, or due to production issues such as plant closures or plants operating at reduced capacities or being unable to import raw materials/end products for sale. Others have had issues with their distribution network or access to customers.

  • Expenses fall due even in the absence of income - On the other hand, fixed overheads such as rental for premises and salaries continue to be incurred. Even for the sales that continue, companies have experienced an escalation of operating costs through increases in raw material costs due to increase in cost of logistics and expenditure related to special hygienic and safety processes and systems to protect employees and other stakeholders.

Tactics to manage such operating cash deficits internally mainly include working capital management, cost reduction measures and cost restructuring.

1. WORKING CAPITAL MANAGEMENT


a. Receivables Management Generate faster cash flows from receivables – a pre-earned cash source - by collecting outstanding debts.

  • Offer dynamic discounts to speed up payment periods with varying percentages based on customer lifetime value. With this technique, the company is essentially paying customers for short-term financing. But the cost may be substantial - a conventional 2% net 10/30 early payment discount translates into a 36% Annualized Percentage Rate. However, if government loans or bank credits are not available, this might be one of the few available options as it reduces the risk of nonpayment or late payment.

  • For loyal customers with high lifetime value - offer more time for settlement, late-fee waivers, work together to identify revised credit periods, but discontinue further production or service to them until payment is received.

  • For the rest of the customers that show no signs of payment - organizations could charge late payment fees, and in worst cases, deploy more aggressive techniques such as factoring receivables and collection agencies to improve cash flow quickly, although it is a relatively expensive approach that can hurt relationships. Factoring or invoice discounting services are where a third-party company fronts the money, collects debts and manages books on behalf of the company.

  • Encourage cash sales by digitizing payments and requesting full payments before dispatching a product.

  • Request for advance payments before considering an order confirmed.

  • Avoid offering any extended credit periods on new sales.

  • Leverage technology to improve dues collection - Digitize payments to ensure customers can settle dues from wherever they are. Improve visibility to cashflow decision makers. Ensure that all decentralized information is made available on a single dashboard with key performance indicators (KPIs) to monitor current ratio, acid test ratio, inventory turnover, cash conversion cycle, receivable turnover.

b. Inventory Management – Reducing all inventory-related costs:

  • Promotional discounts to increase sales and inventory clearance.

  • Return excesses, avoid further inventory creation and wastage – In the case of products that are facing a drop in demand, explore the possibility of returning shipments/loads of raw material that haven’t reached ports/warehouses, returning unused raw material sitting in warehouses, hold off automatic material requisitions for the future and avoid dispatching into manufacturing lines for further production to avoid adding more inventory burden (both raw material and finished goods).

  • Consider new consignment arrangements - Approach key customers to identify if they are able to hold inventory on our behalf, or if vendors are willing to put supplies in our plants on consignment. This could be a win-win, so each party has a protective buffer in the event of a disruption while keeping inventory holding cost a minimal.

c. Payables Management – Collaborate with suppliers to establish optimal revised credit terms and reschedule payments accordingly.

  • Tailor payment strategies to suppliers based on their cruciality to operations. Supplier cruciality would depend on level of diversification of supplier base, our level of reliance on them and their replaceability. Then create a payment strategy tailored to each of them by:

o Negotiating better payment terms with suppliers in exchange for early settlement

o Negotiating for extended credit periods to delay payments until cashflow is smooth


2. COST REDUCTION MEASURES


a. Reducing costs to ensure firms are not incurring expenses related to operations in the absence of business.

  • Employee related variable costs – When labour is a significant cost line, consider avenues that might help reduce spend to avoid getting to a situation where layoffs are required.

o Look for opportunities to reduce contract labour and re-distribute work to the existing permanent workforce.

o Implement typical variable cost reduction levers such as travel and hiring freezes and placing restrictions on discretionary spend like entertainment and training.

  • Other overheads - Closing down facilities or stores that are incurring rental expenses for prime locations while key sales channels are transferred online and substituting business travel and face-to-face meetings with conference calls, taking no unnecessary money out of the business while its cash flow is limited.

3. COST RESTRUCTURING

  • Reduce overall fixed cost or convert them to variable costs

o If rental periods are coming to a close, look for cheaper and smaller locations or encourage employees to work from home. This would help reduce rental, electricity and other corporate level expenses.

o Selling assets and leasing them back is another way to raise emergency cash. Expanding use of practices such as outsourced manufacturing, transportation fleet leasing, and third-party warehousing.


If any of the above adjustments/tactics to resolve operating cashflows is not releasing cash tied up in working capital, the firm will need to shift focus to reduce outflows from investing and financing activities to ease cash balances for the company.

Investing activities -. A negative balance on investing activities, often implies the outflow on fixed asset investments and might not be a bad sign if management is investing in the long-term health of the company and creating avenues for future revenue generation. This can in turn improve operating cashflows. Operating, Investing and Financing cashflows are inter-twined. However, for emergency cash management, such investing cash outlays can be managed by:

  • Revisiting capital reinvestment plans - opt to lease or hire-purchase new premises or machinery rather than buy outright. Identify capital investments that can be postponed until the situation improves. Assess which investments need to be entirely reconsidered versus those that are essential to position for rebound or for creating competitive advantage.

  • Cutting down on non-critical expenses like research and development while investing on technology and digitization platforms.

Financing activities Negative financing balances, on the other hand could mean the repayment of a loan, or the payment of dividends to shareholders, both which help create a better outlook for the company. Any negative balances on financing activities can be managed by:

  • Delaying payments to shareholders such as dividends or profit shares

  • Delaying payments to lenders (principal or interest) by requesting for grace periods.

If none of the internal tactics to manage cashflows is releasing cash, firms would now need to resort to external financing to bring in new money. However, seeking the wrong sources of funds can spiral into a bigger issue.


If finance cannot be raised from internal sources, many firms lean on external financing sources to bridge cash deficits and get over a dearth. Some firms tend to bring these external funds in the form of equity – raising capital from new investors or existing shareholders, while some firms resort to debt-capital such as organizing overdraft facilities from banks on a current account or overdrawing on credit card facilities, taking out a new bank loan or similar financial relief. During such cash crunches, while the need of the hour is to secure funding urgently, failure to evaluate the suitability of the loan can lead to longer term issues such as increased risk profile, profit erosion and longer periods of unnecessary committed outflows in the form of loan repayments.


Hence, whichever external financing option is resorted to, it is important to assess if the source of funds is the best fit to the company:

a. Would it increase current business risk?


The level of business risk would depend on the operating gearing, which refers to the proportion of a company’s operating costs that are fixed as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls also by a larger percentage.


Generally, it is a high-risk policy to combine high financial gearing (the ratio of debt finance to equity finance) with high operating gearing. Hence, companies with highly volatile operating profits should avoid high levels of borrowing as they may find themselves in a position where operating profit falls and they cannot meet the interest bill. High-risk ventures are normally financed by equity finance, as there is no legal obligation to pay equity dividend. High operating gearing is common in many service industries where many operating costs are fixed.


b. Would it be matched with the type of cashflow shortage and the risk profile of the company?


A firm has 3 key types of operating finance needs – Permanent working capital, Fluctuating working capital and Fixed Assets. Permanent working capital is the minimum amount of all current assets that is required at all times to ensure a minimum level of uninterrupted business operations. Fluctuating working capital is the amount of current assets that varies with seasonal requirements. Fixed assets are those that are used to generate cashflows such as equipment machinery etc.


Funding such needs from external sources would mean that the type of financing matches the risk profile of the company. Conservative firms tend to fund a majority of the need with long term financing although they may lead to more outflows. Aggressive firms with a high-risk profile tend to fund a majority of the operating need with short term finances as they are less costly and more profitable, and medium risk firms, match the fixed and permanent needs with long trm financing and variable needs with short term financing.


The three diagrams below depict the different risk appetites and, in each case, how the working capital financing approaches vary. The diagrams assume growth, and the amount of fixed assets and permanent current asset go on increasing with the passage of time but the volume of fluctuating current assets change with the change in production level.




c. Is it affordable and payable by the business?


The cost of finance - Interest on debt finance has to be paid before dividend and in the event of liquidation, debt capital is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Interest expenses are also tax deductible (unlike equity dividends) making it even cheaper to a taxpaying company.


Although debt is attractive for being cheaper interest payments are a commitment and have to be paid even if the company is out of cash or profits. If too much is borrowed then the company may not be able to meet interest and principal payments and liquidation may follow. It also reduces the amount of profits available to shareholders.


While external sources can help get over cash shortfalls, the LONG-TERM financial stability of a company depends on adequate, internal cash generation. It is not sustainable to regularly finance longer term operating cash deficits through funds sought from external sources.

IMPROVED FINANCIAL PLANNING CAN REDUCE CASH TIED UP IN OPERATIONS


a. Early estimation of operating needs


Accurate demand forecasts - These enable early identification of optimal stock levels, re-order points and lead times. Having the required stock in time drives more revenue through improved fill rates and service levels, whilst keeping inventory holding costs down. It avoids the loss of business caused by an unavailability of products.


On the other hand, multiple firms that rely on outdated forecasts expecting usual inventory turnover in order to drive revenue and create space for new products, but end up having to close down locations owing to plummeting sales leading to inventory backlogs while additional inventory is en-route to them through vast supply chains


When the goal is cost minimization rather than only order fulfilment, firms should add the cost of the inventory, along with the ordering cost and holding cost at multiple inventory volume levels to assess what the optimal order quantity is.





b. Early identification of investment needs


Early forecasts highlight periods of time when the business would record cash surpluses. In order to maximize returns, a company should not leave cash sitting idle. It is important to identify suitable projects, carry out investment analysis ahead of time, so that when surpluses materialize, there are pre-planned projects ready for execution. Investment analysis includes assessing return analysis, cost of capital, payback period and strategic fit to business.


Fund investments with financing sources that have lower cost of capital to justify the return on investment - Using operating cashflows to fund such large projects may mean the lack of retained earnings to fund day to day activities, with cash being tied in a project that would take years to payback. In such instances, it is sensible to fund long term projects with long term loans, or equity capital rather than retained earnings which could be reinvested back into the business.


c. Early estimation of financing needs


Preparing cash budgets and forecast plans to identify the difference in cash inflows versus outflows helps bridge the gap via well planned financing that suits their risk-profile. Early identification of shortages helps secure cost-effective financing to be injected precisely at the time of the shortage. Failure to do so only leads to the realization of shortages in the last minute with very limited time to resolve the issue. As a result, firms end up having to rely on quick modes of cash availability such as overdraft facilities, or collateral based loans and expensive interest-rate loans.


For more information on the different types of external financing that is available to a company, check our article next month.


References:


“Cash Flow: The Reason 82% of Small Businesses Fail” – Preferred CFO, June 2020; “Operating Cash Flow (OCF)” – Investopedia, December 2021; “Working Capital Investment Policies” – Your Article Library; “Working Capital Types” -Notesmagic; “Selecting sources of finance for business” – ACCA Global


About the Author:


Seyeda Mowhiba is a Consultant at Stax and has been with us since 2016. As a holder of ACMA, CGMA, UK and four world awards in Financial Management and Strategy, she has led multiple projects assisting companies across diverse industries on business strategy formulation, process improvement, and financial modeling. Prior to her role at Stax, she worked at Moody’s Analytics and Dilmah.