Cash Flow Management Guide

Cash Flow Management Guide

by Nick Donato
July 02, 2024

If your business or nonprofit lacks the cash to meet its monthly obligations for operations and liabilities, you are not solvent. A downturn in the economy or any loss of revenue could be devastating. Poor cash management can jeopardize the future of a small organization and impede the growth or sustainability of a larger one.

A good cash management system helps you reduce or eliminate any surprises when meeting cash requirements. It also helps you improve the efficiency of your operations and lower the overall cost of doing business. But how does cash management work? This guide addresses the most frequent questions, to help you gain a practical understanding of how to manage your organization’s cash flow.

What Is Cash Flow?

Cash flow is the net amount of cash or cash equivalents moving into or out of a business during a given period. Measuring it answers pivotal questions such as how much money you will have on hand after you pay your bills. At a deeper level, knowing your cash flow gives you the tools to determine whether your organization has sufficient cash to sustain its business operations.

There are three types of cash flow:

Operating cash flow shows the movement of cash from the primary revenue activities of the company during the accounting period.

Investing cash flow is from the purchase/sale of assets that are not part of the company’s primary activity, such as income from investments and expenditures on the purchase of investments and fixed assets.

Financing cash flow includes cash inflows or expenditures related to equity, debt and dividends. It measures how money moves between a company and its owners, investors and creditors.

What Is a Cash Flow Statement?

Cash flow typically is reported on a cash flow statement. This financial document helps you track inflows and outflows in a given period (typically a week, month or quarter). It measures cash and cash equivalents, including:

  • Cash on hand
  • Cash in bank accounts
  • Investments that are short term and very liquid with a low risk of changes in value
  • Bank overdrafts that are an integral part of treasury management

A cash flow statement helps you manage cash on a daily basis as well as long term. It’s a go-to tool for monitoring changes in equity, assets and liabilities. It allows you to analyze historic cash flows and make cash flow projections to understand how your liquidity will change over time.

Sources and uses of cash

Cash flow statements present “sources” and “uses” of cash, helping you understand where cash comes from and where it goes. But what do those words mean in a practical sense?

Sources of cash

Sales, in most business-to-business industries, are only the starting point. Cash comes from getting paid for what you sold.

If you get paid cash at the point of sale, then that’s your main ”operating” cash resource. If you invoice your customers, you may wait months to get paid, and sometimes you don’t get paid at all. Even if you count a sale as “revenue” because title has transferred from you to the buyer or your service has been performed, the cash represented by that sale becomes “accounts receivable” on your balance sheet while you wait for payment.

There are other non-sales/collection sources of cash. You may be in a business that collects periodic rents or monthly/annual service payments (e.g., SaaS businesses), or you may get cash from investors, banks or other sources of equity and debt.

Uses of Cash

There are typically far more uses of cash than there are sources. For product-producing companies, a major use of cash is parts and assemblies for their products, commonly known as cost of goods sold (COGS), or cost of sales (COS) if you’re not selling physical items. If you intend to build things or sell software or services, then you need to account for your COGS/COS.

Aside from the cost of your products and services themselves are the “operating and overhead” expenses directly related to running your company and selling your product/service. Frequently referred to as OpEx (operating expenses), these include things like employee salaries, payments to contractors/consultants, marketing and selling expenses, and a wide variety of “overheads” such as rent, internet and phones.

Cash triage

Cash “triage” means figuring out and prioritizing your sources and uses of cash in such a way that the business can survive an uncertain present. In this scenario, your priority is any cash you can collect today, from any source. Proper prioritization of both collection and spending can mean the difference between survival and bankruptcy.

What Is a Cash Flow Forecast?

A cash flow forecast is a tool for predicting your cash position in the coming weeks and months. You pick a set period, like the coming month or quarter, then subtract your expected expenses from expected receipts to see if you're building cash, spending it or staying at the same level.

Why do you need a cash flow forecast?

You can't manage what you don't measure. Forecasting enables finance teams to make data-driven decisions about how to use cash. Organizations that are low on cash need a forecast because they don't have the resources to manage a sudden negative stretch. If you have a strong cash position, forecasting is still a useful tool for managing your finances.

A cash flow forecast helps you plan operations. For example, if you're going through a great stretch of sales, it's easy to overspend thinking the good times will continue. A forecast could warn you to be conservative because things are about to tighten up. It also helps you predict problems earlier, so you can be more proactive. If you anticipate that you're going to run low on funds, for instance, you can apply for a line of credit before the crunch hits.

If your forecast shows you're building too much cash, you can start thinking of more productive uses for the money, such as hiring or moving it into your investment account.

What's the optimum amount of cash to hold?

A general rule of thumb is that businesses and nonprofits should have at least a three- to six-month liquid reserve at all times. But there's no one answer, as it depends on your organization's goals and operations. In general, mature organizations with more predictable business cycles can hold less cash, and newer organizations should hold more.

You should also consider the frequency and predictability of your cash receipts. For example, a tech company with a subscription business model typically can hold less cash because money comes in every week, while an ad agency that constantly needs to find new projects should have more cash in case they hit a slow stretch. Upcoming activities, such as big expenditures that you need to save for, are another consideration.

Tips for Developing Your Cash Flow Forecast

What should you consider when developing your forecast? Look at these four main factors:

  • Timeframe – Traditionally 13 weeks is the right amount of time to assess near-term cash flow. It captures the next quarter, which typically includes significant quarterly payments like debt expenditures. Going further than 13 weeks is tough to predict accurately. Go shorter than 13 weeks and you could miss a significant payment.
  • Frequency – You must also decide how often to update your forecast. Weekly? Monthly? The frequency depends on the ebb and flow of your cash position. If money is tight, you need current information, so update weekly within a four-week timeframe. You can manage with less frequent updates if you have plenty of cash.
  • Audience – Who's going to review your forecast? If the audience is internal, you probably want a weekly working file. If the forecast is for your board or management, it may be monthly or quarterly.
  • Level of detail – If the forecast is for your board, it should be high-level. If it's for your internal use as a working tool, you'll want more detail.

How to analyze your cash forecast

Once you have your cash flow forecast, compare it to your past results. If your prediction is similar to what happened in the past, that’s a good sign. Then, later on, see how close your forecast was to your actual results so you can adjust your following estimates as needed.

As you review your forecast, look for any cash flow trends. Are there certain weeks or months each quarter when expenses and receipts are higher than usual? For example, you may notice that most of your costs are at the start of the quarter, but your customers typically pay a month later, so you need to budget carefully until receipts start coming in.

Some cash flow forecasting best practices

Always use your book numbers for forecasting, not bank numbers. Your bank numbers can catch you off guard when you have outstanding checks. You should also consider payment terms for clients when forecasting cash receipts. If you give clients 90 days to pay, don't forecast that invoices will be paid in 30 days.

Talk with your sales and operations teams to understand what's coming up and what could be changing. Is there a new marketing campaign that could increase incoming receipts? Has the sales team landed a new client and if so, when is payment expected?

Finally, consider what's changed since your last budget. Given that budgets become obsolete on day one, what do you know now compared to when you first put together your budget, and how will this impact cash flow?

Why Cash Flow Management Matters

Net income from your financial reports can’t be used to pay bills; that’s why understanding cash flow is critical to an organization’s success. Even if revenue looks excellent on paper, you need sufficient cash to pay suppliers and meet your debt obligations. Insufficient cash flow leads to unstable business operations that imperil solvency, including critical obligations such as payroll.

No industry or organization is exempt from this principle. This is why it’s essential to shift cash flow management in a direction that empowers data analysis and supports timely action. As you focus on profitability, keeping accurate books and creating tangible forecasts that help improve cash management is crucial. This will also shed light on revenue streams and their expected return on investment (ROI).

Implementing cost analytics, assessing product categories, and reviewing customer data can help you identify your most profitable revenue streams. This process may also lead to divestment in areas that haven’t yielded the expected returns while allowing you to identify new investment opportunities.

6 benefits of cash flow management

Strong cash flow management practices reduce or eliminate surprises that may impinge your ability to meet cash requirements, enabling you to:

  1. Specify adequate cash for purchases and other purposes
  2. Validate your ability to meet cash flow needs
  3. Plan for capital expenditures
  4. Empower negotiations for better financing terms
  5. Make special purchases and take advantage of business opportunities
  6. Facilitate investment decisions

Building Your Cash Flow Model

Cash flow management is essential to sustaining profitability. A cash flow model is the first step toward creating a cash flow management system, which enables effective cash flow forecasting. A basic cash management model provides insight into your current and future financial picture. It gives you the confidence to make critical and timely business decisions and establishes a foundation for understanding your valuation, efficiency and profitability.

The model can be designed to suit your primary objectives, which may include:

  • Short-term cash management
  • Interest and debt reduction
  • Medium- and long-term planning and budgeting

Effective cash forecasting can also help you make decisions that optimize your business operations. For example, the decision of whether to offer or take advantage of early pay discounts might be clearer based on the insights gained from your model. You may use these insights to decide to lengthen time to pay and update your payables strategy or opt to reduce inventory to shorten time between input costs and sales.

Building the model is the first step; using it to make business decisions should follow. As a company grows and matures, so can the cash model. There are many opportunities to expand and continue improving such as workflow automation, artificial intelligence (AI) and robotic process automation. Even without these tools, the operational insights gained using the model can prove valuable to your bottom line.

Benefits of an AI-enabled 13-week cash flow model

AI can read and analyze bank statement activity much faster and more accurately than a human — categorizing thousands of transactions in minutes and allowing for seamless integration into weekly financial processes. An AI-enabled 13-week cash flow model offers a dynamic tool to forecast and prioritize both sources and uses of cash, providing a granular understanding of a company’s financial landscape.

By meticulously tracking cash inflows from sales, investors, bank lines and other sources, companies can proactively manage their liquidity. Simultaneously, the model can help finance teams dissect the cash outflows associated with various expenses, allowing businesses to strategically triage their spending.

With a clear focus on prioritizing collections based on amount owed, time to collection, and probability of collection, business leaders can use AI-enabled cash flow forecasting to make informed decisions on cash management, optimize revenue streams and strategically address operational and overhead expenses.

Short-Term Cash Management Strategies

A cash model is based on business scenarios and forecasting. Your first step must be to update your forecast and build the ability to update the model quickly with new assumptions. The forecast model can then identify how to free up cash with specific actions for each core cash flow component: receivables, payables and inventory.

The goals of a short-term cash forecast are to verify your business can remain operational, whether a loan is needed, and to determine the right amount of cash to keep on hand. Once you set your goals and have insight into the biggest opportunities through your forecast model, consider the following three initiatives to drive capital improvement:

1. Tighten up receivables

  • Identify at-risk customers and proactively collect
  • Set up a plan for any customers who request extended terms
  • Focus on boosting on-time collection
  • Offer discounting options
  • Educate your sales team about the importance of cash flow

2. Update your payables strategy

  • Prioritize suppliers as critical and non-critical
  • Negotiate terms extensions or payment plans with suppliers
  • Audit payables and contracts to ensure you’re not over-paying or paying too soon
  • Identify supply chain risk and expand sources of supply
  • Shorten and automate the invoice-to-pay cycle to maximize cash forecast visibility
  • Verify that direct draws meet contract terms and are not paid early, or convert to another payment method

3. Reduce inventory

  • Refresh inventory plans based on sales forecasting that accounts for changes in customer behavior
  • Tighten minimum/maximum requirements and move to just in time
  • Incorporate cost or margin into inventory decisions
  • Liquidate excess and obsolete inventory
  • Change or cancel orders for raw materials

Ready to Transform Your Cash Flow Management?

Answering how much cash you have on hand sounds simple, but it can lead to frustration and poor decisions without proper guidance. Find out how our Financial Planning & Analysis experts can help you turn your cash flow management into a strategic advantage.

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Nick Donato - Consulting| Armanino
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