Introduction To Cash - BC Bookkeeping Tutorials|

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Introduction To Cash


Calling The Bank
I've been around quite a few businesses where my little cartoon buddy is the way they determined how much cash their business had available to spend. Calling the bank to determine your cash balance can get you into trouble as it is only an estimate of what your true cash balance is.
Your balance in the bank could be much less than you were told by the bank due to the fact that not all the checks that you have written have been presented to your bank for payment by your employees and creditors. On the other hand, you might be pleasantly surprised due to the fact that not all the money you have collected has been deposited or posted to your account by the bank. These differences are called timing differences.
Where should you be looking to determine the cash balance that your business has available for paying its obligations ? Your own business records such as your check book or your cash reports. The bank should only be used to provide you with an independent method of determining that the balance you have is correct. This is done by doing a monthly bank reconciliation. Hopefully calling the bank is not the method you use to determine what your cash balance is.
Another practice I used to run across was where businesses issued checks to suppliers or employees knowing that they didn't have the cash available to pay them in order to get the supplier "off their back" or get the employee to come to work. They would then hope and pray that some customer(s) would mail them a check(s) so that they could deposit the money they needed to cover the checks that they had already written and issued.

Some businesses even had fancy "schemes" where they had more than one business checking account and would write a check from one of their bank accounts with no actual funds available to another of their bank accounts and then write a check back from another of their bank accounts. I'll have to say that they were managing their cash, but not in a proper, responsible, and legal manner. In the old days, they might could get away with these practices but today with the modern computerized banking systems these practices are sure to bite you in your tail.

Most small businesses at times have been confronted with what is normally referred to as a cash flow problem. This simply means that they didn't have the funds on hand that they needed to pay their bills or employees when due. The cash coming in is out of sync with the cash going out. What are some possible causes ? Customers not paying on time, a big customer check returned by your bank as not paid (bad check), an increase in sales (which is great but needs to be planned for), seasonal fluctuations in sales, poor customer credit policies, and the business operating at a loss all are factors that can contribute to a cash shortage or also called a "cash crunch".
Will good cash management eliminate all cash flow problems ?
Probably not, but at least it alerts you to potential problems ahead of time and allows you to consider alternative solutions (such as short term borrowing) that may correct the problem.

What exactly is Cash ?
I know you're saying what a dumb question, but I was told in life there's no such thing as a dumb question. Cash is the balance of your bank accounts, savings accounts, money market accounts, certificates of deposit, currency on hand, undeposited receipts, and even your business' petty cash fund. Note that some forms of cash may have restrictions on how fast the funds are available for you to actually spend. Even your regular bank accounts may have what are called uncollected funds which means you may have to wait a few days before you can actually spend this money.

Can a business making money (profit) also have cash flow problems ?
You bet your bottom dollar they can. Profit and Cash are two different concepts. Technically, if you're maintaining your books on the cash basis instead of the accrual basis your profits and cash flow will match more closely, but they still may have some differences resulting from accounting for such items as inventories and equipment depreciation. Even a very profitable business can have cash flow problems which without corrective actions taken may have to close their doors. Of course a business continuously operating at a loss will more than likely reach a point where they are unable to pay their obligations and have to shut their doors.
What's the difference between cash flow and profit ?
Profit is calculated by subtracting costs and expenses from sales and revenues. The recording of sales and their associated costs and expenses often do not coincide with when the resulting cash collected from sales and the cash spent for costs and expenses occurs. In a nutshell, we have a timing difference resulting in part from credit granted to our customers and credit from our suppliers granted to us. These timing differences often result in cash collections being delayed even though profits have been recorded on our books resulting in a short term cash shortage. In other words, we haven't yet converted all our profits into cash. So while profits are definitely important to the success of a business so is the management of cash. The lack of either of these can result in a business failure.

Let's use a simple illustration to illustrate how a business making profits can still have a cash flow problem and also illustrate the difference between profit and cash flow. The following simplified income statement shows a profit of $100,000 earned during the month.
Income StatementMonth 1
Not too shabby a month if you ask me ! But as the newsman Paul Harvey would say - wait for Page 2. In other words, wait to you see our cash position presented below.

Collection and Payment Assumptions:
  • 10 % of Sales during a month are cash sales and are collected in the month of the sale.
    Month 1 Collections
    10 % X $250,000 = $25,000
  • The remaining sales of $225,000 (250,000 - 25,000) are credit sales with payment terms of 60 days which is customary for the industry.
    90 % of the sales on account are collected when due and the remaining uncollected sales are collected in the following month.
    Month 3 Collections
    90 % X $225,000 = $202,500
    Month 4 Collections
    $225,000 - 202,500 = $22,500
  • 40 % of the costs are payroll costs are paid in the current month.
    Month 1 Payments
    40 % X $150,000 = $60,000
  • 10 % of the costs are cash purchases and other costs.
    Month 1 Payments
    10 % X $150,000 = $15,000
  • The remaining costs of $75,000 (150,000 - 60,000 - 15,000) are costs that have payment terms of 30 days. In other words, our suppliers (creditors) have allowed us 30 days to make the payments. We normally pay all our bills when due.
    Month 2 Payments
Cash Flow Forecast
Cash Flows Resulting From Month 1 Month 1Month 2Month 3Month 4Total
Collections From Sales Month 125000
Payments To Suppliers, Employees, And Others Resulting From Month 17500075000

Net Cash Flow<50000><75000>20250022500100000
Cumulative Net Cash Flows<50000><125000>77500100000100000

Wait a minute - what happened ?

My little cartoon buddy has the answer. It's all timing ! Our example shows that although we made a profit of $100,000 during Month 1 we had to wait to Month 3 to be in a positive cash position. Because of the credit terms that we granted to our customers we were unable to immediately convert our sales into cash.
We had to wait 60 days for most of our customers to pay us . Take a good look at Month 1 and Month 2. We have to find a way to come up with an extra $50,000 for Month 1 and an extra $75,000 for Month 2 or a total of $125,000. If we had done a cash forecast, we would probably be alerted to this problem and have adequate time to secure a short term loan of $125,000 from our friendly banker.
Let's extend our analysis and include another month of the same sales, costs, and profits and see what this does to us. Wow ! Now were going to have a profit of 100,000 for Month 1 and Month 2 for a total profit of $200,000. Can we go out and have a lobster dinner to celebrate ? Let's see.
Income StatementMonth 1Month 2Total
Wow it looks like we're getting rich with this business ! As earlier, before we get too excited, we need to take a look at the timing of the cash flows resulting from these profits.

Using the same assumptions that we used earlier here are our results.
Cash Flow Forecast
Cash Flows Resulting From Month 1 and Month 2Month 1Month 2Month 3Month 4Month 5Total
Collections From Sales Month 125000
Collections From Sales Month 2
Payments To Suppliers, Employees, And Others Resulting From Month 17500075000

Payments To Suppliers, Employees, And Others Resulting From Month 2


Net Cash Flow<50000><12500>1275002250022500200000
Cumulative Net Cash Flows<50000><175000><47500>177500200000200000
More profit even made our situation temporarily worse. We're in the hole $175,000 after two months instead of $125,00 and it takes us four months instead of three in order to reach a positive cumulative cash flow. When we finally collect the cash for all our profits; however, it's time to celebrate.

What's your point ?
Making a profit does not guarantee that you'll have all the cash you need to pay your bills. Profits and Cash Flow are both critical elements needed for a business to survive and be successful ! Good Cash Management is also just as important as making a profit. Great cash management is even better.

What is Cash Flow ?
A businesses' cash flow is simply the money (cash) flowing in and out of the business during a period of time. The major inflow of cash to a business results from the sales to customers and the immediate payment (cash sale) or the later payment (sales made on credit) resulting from these sales. Other cash inflows may result from investors contributing cash, bank or other loans made to the business, and the sale of equipment and other fixed assets.
Major cash outflows are purchases of inventory, manufacturing costs for products, and payroll. Some other outflows are repayment of loans and interest and purchases of equipment and other fixed assets.

What type of Cash Flow would you like your business to experience - Positive or Negative ?
I know I insulted your intelligence - of course all businesses strive for a positive cash flow. A positive cash flow results when the cash coming in exceeds (is greater) than the cash going out during a period. The opposite case which you want to avoid is a negative cash flow where the cash going out exceeds (is greater) than the cash coming in.

What is a Cash Flow Forecast / Budget ?
Another term often used to refer to a cash forecast is a Cash Flow Projection. Whether we use the term cash flow forecast, cash flow budget, or cash flow projection we're talking about the same business tool used for analyzing our cash. A cash flow forecast (projection or budget) is simply an estimate of the cash coming in and going out of a business during a period of time.

What does it do for me ?
A cash flow forecast helps identify possible future cash shortages and allows you the time needed to take corrective action(s). No it doesn't have to be prepared using a fancy cash management or spreadsheet computer program although in my humble opinion these tools if used properly make the job easier and less time consuming. Preparing the forecast whether manually or with the help of a computer program does require you to analyze your business' financial records and future plans in order to come up with any meaningful estimates and assumptions used for preparing the cash flow forecast. As with most things, your cash forecast tool is only as good as the data and assumptions used in preparing the forecast.

If I had only one business tool to recommend to my clients, aside from preparing monthly financial statements, the cash flow forecast would be my pick. The importance of managing your cash is one area of business that can not be over emphasized.

What's actually involved in good cash management ?
Actually it really only involves applying some good ole fashion common sense. A few of the basics are:

  • Maintain an accurate check book, register or cash summary record.

  • Make daily bank deposits and deposit your receipts intact (don't pay bills with cash out of your cash receipts).

  • Make all disbursements by check whenever possible.

  • Prepare Monthly Bank Reconciliations.

  • Establish procedures for handling cash and insuring that all cash is properly accounted for and timely deposited in your bank.

  • Establish relationships with banks and other lending resources so you already have in place a source you can go to for help if you experience a temporary cash shortage.

  • Strive to pay your suppliers and creditors on time. By building a good credit record and establishing a good relationship they are more inclined to work with you if you encounter a temporary cash shortage.

  • Establish Credit Terms and Policies applicable to your trade or business and investigate and continue to monitor customers that you sell to and grant credit terms. Notice I said continually monitor your customers credit status. Do you know why ? Few things in life stay the same. Just because a customer had great credit when you approved them does not necessarily mean that their business can't experience a down turn. If that happens their problems might also cause your business some problems in collecting what they owe you.

  • If you have quite a few cash related transactions each day, you may want to prepare a daily cash status report. If you don't have a lot of daily banking transactions, you may just want to prepare the report on a weekly basis.

  • Analyze your cash needs and prepare Cash Forecasts / Budgets to help identify possible future cash shortages and allows you the time needed to take corrective action(s).

Is there such a thing as having too much cash ?
Believe it or not there is, but this is a "problem" that every small business wishes they had. I wish I had more cash than I knew what to do with, don't you ? On the down side, excess or idle cash sitting in a bank does not make your business any money. You are in the business to make a profit aren't you. This is no different than a manufacturing plant sitting idle and not producing any products. What should you do with these funds? If you're a conservatives type you could invest in certificates of deposit (CD's) and at least earn something on these idle funds. You may, however; have better alternatives for the use of this cash. What are they ? I don't know. No I'm not copping out on you, I just am not familiar with what type of business you have. You and your financial advisors are the ones in a position to be able to answer this question.
What should you now be aware of ? A very important business concept - profits and cash flow are two different "animals".

What's next ?

Improving Cash Flow

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