Question

List some of the risks on company’s future cash flows, and provide options on how to avoid and reduce such risks.

Answer 1

Some of the risks on company’s future cash flows

Manager Decisions - Operations

Primary factors influencing cash flow are the strategic and ongoing decisions your company's management team makes. These include operating decisions and controls, or lack thereof. For example, a manager-driven policy requiring customers to pay within 30 days can deplete cash flow, while a policy requiring deposits or advance payments can increase it.

Manager Decisions - Investing/Financing

Since cash flows are also investment and finance driven, decisions involving these areas impact your firm's position. Investment decisions involve your firm’s assets. Decisions to purchase and hold real estate or large, expensive machinery may significantly decrease your company's short or mid-term cash flow. Investing decisions also indirectly impact cash through the financing decisions your company makes to fund its acquisition of assets.

Riskiness of Financing/Investing Decisions

Use of equity is less risky for the company's cash but may be difficult to obtain. Using debt can make cash flows riskier because that debt has to repaid. Significant short-term debt is riskier than long-term debt because short-term debt requires your company to immediately obtain cash from somewhere. Long-term debt allows your company time to consider various options.

External Environment - Markets

Your company's operating environment also plays a key role. Even with small companies, activity in the capital markets impacts investing and financing cash flows. If lending is restricted for public companies, it is typically more limited for smaller companies that have fewer debt options. When large private equity firms cannot take their companies public, small firms may be more cautious about taking investment stakes they may be unable to sell within a specified time period.

External Environment - Industry/Economy

Industry and economic events also impact all cash flows. For example, if your company is in the aerospace industry and that industry experiences a pronounced downturn, your sales may decrease or your sales-related expenses may increase as it takes more effort to drive sales. Both translate into reduced operational cash flows. If customers are failing, then the risk increases. If your municipality goes bankrupt, an economic event, all your company's cash flows could be impacted.

Options to avoid and reduce such risk.

1) Float Payables

One short-term strategy for improving cash flow is to float payables. For example, if you’re paying vendors a total of $100,000 in 30 days, you can pick up $50,000 in cash flow by paying in 45 days. You would only float payables one time because the next step would be to go to 60 days, which would only create $30,000 in cash flow, and vendors will start calling to find out when they’re getting paid.

The decision to float payables is typically based on the vendor’s value to and relationship with your organization. You might choose to pay key vendors in 30 days and push off smaller ones for a little longer. But again, this is a short-term strategy.

2) Extend Payment Terms

You can try to extend payment terms if you have a good relationship with the supplier. For example, if you’re struggling to meet 30-day terms, you could approach the vendor and say that you’ll never miss a payment if terms are extended to 40 days. Many companies, particularly smaller businesses will live with the extra 10 days if it means they know they’ll get paid on time.

3) Offer Credit Card Payments

Allowing customers to pay by credit card is a great way to quickly boost cash flow. Process the payment today, have the money in the bank tomorrow. For recurring business, it removes the risk of non-collection. However, this comes at a cost. Credit card fees mean it will cost you 2.5-3 percent of each payment to get that money up front.

4) Take Discounts

If you’re in a solid financial position and have the ability to pay quickly, see if your suppliers will take discounts. For example, if you have 30-day terms, request a 2 percent discount if you pay within 10 days. Even if you have to borrow money to pay faster, it can turn into excellent ROI. We’ve seen businesses turn this into a profit center. They borrow on their credit line at 4 percent, take discounts of 2 percent, and turn it into 18 percent ROI.

5) Offer Discounts

This is a last resort that we rarely recommend. It might not seem like much to offer a 2 percent discount, but if your margin is 25 percent, you sacrifice almost 10 percent of your profits. Also, if you offer a discount once, customers tend to expect that discount every time. That said, it could help you immediately increase cash flow.

6) Open a Line of Credit

This is standard for most businesses. Keep in mind that the best time to borrow money is when you don’t need it. Set up a line of credit today so it’s there when you need it tomorrow, and not just for a rainy day. If your business takes off, you’ll need money to grow.

Suppose you get a huge order. If you can’t get extended terms from the supplier, how will you meet payroll? How will you pay other expenses? Unfortunately, you can’t always sell your way out of cash flow issues. Even a huge sale won’t immediately improve your cash flow unless you get paid upfront. Many businesses have imploded because they tried to grow too quickly. They didn’t have the systems in place or the cash flow to support a high rate of growth.

7) Have a Reserve

For individuals, the rule of thumb is to have enough money set aside to cover expenses for three to six months. Businesses need to be prepared when something goes wrong. Notice we said “when” not “if.” Whether it’s a natural disaster, a market crash or a terrorist attack, every business should have a plan B.

Again, the key to building and maintaining a healthy cash flow is careful planning. If you’re not sure how to estimate cash flow, speak with your accountant or business consultant.