Improving cash flow using credit management : the outline case

Improving cash flow
using credit management
The outline case
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Improving cash flow using credit management

Foreword
This guide explores credit and cash management in small and medium sized enterprises and includes advice on
maximising cash inflows, managing cash outflows, extending credit and cash flow forecasting. It is not intended to be
complex or exhaustive, but rather to act as a basic guide for financial managers in smaller businesses.
Cash flow management is vital to the health of your business. The oft-used saying, `revenue is vanity, profit is sanity;
but cash is king` remains sage advice for anyone managing company finances. To put it another way, most businesses
can survive several periods of making a loss, but they can only run out of cash once.
The importance of cash flow is particularly pertinent at times when access to cash is difficult and expensive. A credit
crunch creates extreme forms of both of these problems. When the `real economy’ slips into recession, businesses face
the additional risk of customers running into financial difficulty and becoming unable to pay invoices – which, allied to
a scarcity of cash from non-operational sources such as bank loans, can push a company over the edge.
Even during buoyant economic conditions, cash flow management is an important discipline. Failure to monitor credit,
assess working capital – the cash tied up in inventory and monies owed – or ensure cash is available for investment can
hamper a company’s competitiveness or cause it to overtrade.
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in 165 countries. CIMA’s focus on management functions makes them unique in the accountancy profession. The CIMA
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Improving cash flow using credit management
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Contents
Improving cash flow using credit management ? the outline case

5
Working capital
6
1. The cash flow cycle






7
Inflows






7
Outflows







7
Cash flow management




7
Advantages of managing cash flow



8
Cash conversion period




9
2. Acclerating cash inflows






10
Customer purchase decision and ordering


10
Credit decisions





10
Fulfilment, shipping and handling



10
Invoicing the customer





10
Special payment terms





11
The collection period






11
Late payment: a perennial problem



11
The Late Payment of Commercial Debts (Interest) Act 1998
1
Bad debts







1
Improving your debt collection




1
Payment and deposit of funds





1
3. Credit management






14
Credit policy







14
Credit in practice





14
Credit checking: where and how




14
Credit insurance





15
4. Cash flow forecast







16
Forecasting cash inflows




16
Average collection period




16
Accounts receivable to sales ratio



17
Accounts receivable ageing schedule




17
Forecasting cash outflows




18
Accounts payable ageing schedule



18
Projected outgoings






19
Putting the projections together



0
5. Cash flow surpluses and shortages





1
Surpluses







1
Shortages







1
Factoring and invoice discounting



1
Asset sales








6. Using company accounts







Current ratio








Liquidity ratio or acid test or quick ratio




ROCE (Return on Capital Employed)




Debt/equity (gearing)







Profit/sales







4
Debtors’ days sales outstanding




4
Creditor’s days sales






4
7. Cash management, credit and overtrading: a case study

5
8. Conclusion








6
9. Further reading







7

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Improving cash flow using credit management
5
Improving cash flow using credit management –
the outline case
Cash flow is the life blood of all businesses and is the primary indicator of business health. It is generally acknowledged
as the single most pressing concern of most small and medium-sized enterprises (SMEs), although even finance
directors of the largest organisations emphasise the importance of cash, and cash flow modelling is a fundamental part
of any private equity buy-out. In a credit crunch environment, where access to liquidity is restricted, cash management
becomes critical to survival.
In its simplest form, cash flow is the movement of money in and out of your business. It is not profit and loss, although
trading clearly has an effect on cash flow. The effect of cash flow is real, immediate and, if mismanaged, totally
unforgiving. Cash needs to be monitored, protected, controlled and put to work. There are four principles regarding
cash management:
1. Cash is not given. It is not the passive, inevitable outcome of your business endeavours. It does not arrive in your
bank account willingly. Rather it has to be tracked, chased and captured. You need to control the process and there
is always scope for improvement.
. Cash management is as much an integral part of your business cycle as, for example, making and shipping widgets
or preparing and providing detailed consultancy services.
. Good cash flow management requires information. For example, you need immediate access to data on:
• your customers’ creditworthiness
• your customers’ current track record on payments
• outstanding receipts
• your suppliers’ payment terms
• short-term cash demands
• short-term surpluses
• investment options
• current debt capacity and maturity of facilities
• longer-term projections.
4. You must be masterful. Managing cash flow is a skill and only a firm grip on the cash conversion process will yield
results.
Professional cash management in business is not, unfortunately, always the norm. For example, a survey conducted by
the Better Practice Payment Group in 006 highlighted that one in three companies do not confirm their credit terms
in writing with customers. And many finance functions do not maintain an accurate cash flow forecast (which is crucial,
as we’ll see later).
Good cash management has a double benefit: it can help you to avoid the debilitating downside of cash crises; and it
can grant you a commercial edge in all your transactions. For example, companies able to aggressively manage their
inventory may require less working capital and be able to extend more competitive credit terms than their rivals.

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Improving cash flow using credit management
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Working capital
Working Capital reflects the amount of cash tied up in the business’ trading assets. It is usually calculated as: stock
(including finished goods, work in progress and raw materials) + trade debtors - trade creditors. It is made up of three
components:
1. Days sales outstanding (DSO, or `debtor days’) is an expression of the amount of cash you have tied up in unpaid
invoices from customers. Most businesses offer credit in order to help customers manage their own cash flow
cycle (more on that shortly) and that uncollected cash is a cost to the business. DSO = 65 x accounts receivable
balance/annual sales.
. Days payable outstanding (DPO or creditor days) tells you how you’re doing with suppliers. The aim here is a
higher number, if your suppliers are effectively lending you money to buy their services, that’s cash you can use
elsewhere in the business. DPO = 65 x accounts payable balance/annual cost of goods sold.
. Finally, your days of inventory (DI). This is tells you how much cash you have tied up in stock and raw materials.
Like DSO, a lower number is better. DI = 365 x inventory balance/annual sales.
Almost all businesses have working capital tied up in receivables and inventory. But not all of them. Many of the UK’s
big supermarkets chains, for example, have negative working capital. Customers pay in cash at the tills, but stock is
provided by suppliers on credit, often on very generous terms. That means that at any given time, the supermarket has
excess cash which can be used to earn interest or be invested in new store roll-outs, for example. That’s one reason
their business model is so successful – and demonstrates the importance of cash flow management.
Working capital consultancy REL conducts an annual survey of Europe’s biggest businesses. In its 008 report, it said
that in response to the global recession, they were paying suppliers more slowly to artificially bolster their balance
sheets. `But in doing so they’re often damaging supplier relationships and creating gains that can’t be sustained over time,’
claimed the report. `A typical European company [in 2008 was] taking over 45 days to pay its suppliers - nearly a day and a
half longer than last year.’
So simply cutting down on your DSO or increasing your DPO are not necessarily good long-term solutions. Smart
management of cash flow cycle, including tighter business processes and better credit management, is essential.

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Improving cash flow using credit management
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1. The cash flow cycle
Cash flow can be described as a cycle. Your business uses cash to acquire resources. The resources are put to work and
goods and services produced. These are then sold to customers. You collect their payments and make those funds
available for investment in new resources, and so the cycle repeats.
It is crucially important that you actively manage and control these cash inflows and outflows. So what do these look
like?
Inflows
Cash inflow is money coming into your business:
• money from the sale of your goods or services to customers
• money on customer accounts outstanding
• bank loans
• interest received on investments
• investment by shareholders in the company.
Outflows
Cash outflow is, naturally, what you pay out:
• purchasing finished goods for re-sale
• purchasing raw materials to manufacture a final product
• paying wages
• paying operating expenses (such as rent, advertising and R&D)
• purchasing fixed assets
• paying the interest and principal on loans
• taxes.
Cash flow management
Cash flow management is all about balancing the cash coming into the business with the cash going out. The danger is
that demands for cash, from the landlord, employees or the tax man, arrive before cash you’re owed is collected. More
often than not, cash inflows seem to lag behind your cash outflows, leaving your business short. This money shortage is
your cash flow gap.
If a company is trading profitably, each time the cycle turns, a little more money is put back into the business than
flows out. But not necessarily. If you don’t carefully monitor your cash flow and take corrective action when necessary,
your business may find itself in trouble. If cash flow is carefully monitored, you should be able to forecast how much
cash will be available on hand at any given time, and plan your business activities to ensure there is always cash to
meet upcoming payments.

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Improving cash flow using credit management
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Advantages of managing cash flow
Having a clear view of where your businesses’ cash is tied up, unpaid invoices, stock and so on, what cash is coming in
(and when) and what cash commitments you have coming up is hugely beneficial:
• you can spot potential cash flow gaps and act to reduce their impact, for example, by negotiating new terms with
suppliers, fresh borrowing or chasing overdue invoices.
• you can plan ahead – allowing you to make investments without worrying that existing commitments will not be
met.
• you can reduce your dependence on your bankers – and save interest charges by paying down debt.
• you can identify surpluses which can be invested to earn interest.
• you can reassure your bankers, investors, customers and suppliers that your business is healthy in times of a
liquidity squeeze.
• you can be reassured that your accounts can be drawn up on a ‘going concern’ basis and, if your accounts are
subject to audit, you can also reassure your auditors.
Customer purchase decision and ordering
The credit decision
Order fulfilment, shipping and handling
Invoicing the customer
The average accounts receivable collection period
Payment and deposit

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Improving cash flow using credit management
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Cash conversion period
The cash conversion period measures the amount of time it takes to convert your product or service into cash inflows.
There are three key components, which will be familiar as constituents of working capital.
1. Inventory conversion – the time taken to transform raw materials into a state where they are ready to fulfil
customers’ requirements. A manufacturer will have funds tied up in physical stocks while service organisations will
have funds tied up in work-in-progress that has not been invoiced to the customer.
. Receivables conversion – the time taken to convert sales into cash.
. Payable deferment – the time between taking delivery of input goods and services and paying for them.
The net period of (1+2)-3 gives the cash conversion period (or working capital cycle). The trick is to minimise (1) and (2) and
maximise (3), but it is essential to consider the overall needs of the business.
The chart below is an illustration of the typical receivables conversion period for many businesses.
The flow chart represents each event in the receivables conversion period. Completing each event takes a certain
amount of time. The total time taken is the receivables conversion period. Shortening the receivables conversion period
is an important step in accelerating your cash inflows.
Ask yourself:
• how much cash does my business have right now?
• how much cash does my business generate each month?
• when do we aim to get cash in for completed transactions?
• and how does this compare to the real situation for cash in?
• how much cash does my business need in order to operate?
• when is it needed?
• how do my income and expenses affect my capacity to expand my business?
If you can answer these questions, you can start to plot your cash flow profile. We return to this important discipline
in some detail under the budgeting section which can be viewed in the section four. But if you can plan a response in
accordance with these answers, you are then starting to manage your cash flow!

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Improving cash flow using credit management
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. Accelerating cash inflows
The quicker you can collect cash, the faster you can spend it in pursuit of further profit or to meet cash outflows such
as wages and debt payments. Accelerating your cash inflows involves streamlining all the elements of cash conversion:
• the customer’s decision to buy
• the ordering procedure
• credit decisions
• fulfilment, shipping and handling
• invoicing the customer
• the collection period
• payment and deposit of funds.
Customer purchase decision and ordering
Without a customer, there will be no cash inflow to manage. Make sure that your business is advertising effectively and
making it easy for the customer to place an order. Use accessible, up-to-date catalogues, displays, price lists, proposals
or quotations to keep your customer informed. Provide ways to bypass the postal service. Accept orders over the
Internet, by telephone, or via fax. Make the ordering process quick, precise and easy.
Credit decisions
Dun and Bradstreet has calculated that more than 90% of companies grant credit without a reference. If credit terms
and conditions are not agreed in advance and references checked, you risk trading with `can’t pay’ customers as well
as `won’t pay’ ones. Salespeople, in particular, need to remember that a sale is not a sale until it’s been paid for – and
extending credit haphazardly might look good for their figures (and the P&L, at least initially), but can be disastrous for
cash flow. (See section three on credit management for more details.)
Fulfilment, shipping and handling
The proper fulfilment of your customers’ orders is most important. Terms and conditions apply as much to you as
they do your customers. The cash conversion period is increased significantly if your business is unable to supply to
specification or within the agreed timetable, whether that’s because you have a problem with inventory or production
processes; or because you lack the skilled resources to provide the services requested.
Metrics such as inventory turnover, inventory levels or stock to sale ratios will help measure the efficiency of your
inventory process. Benchmarking against industry standards can provide additional guidance on where you stand and
highlight potential opportunities for process improvement.
Invoicing the customer
If you don’t invoice, you won’t be paid. Design an invoice that is better than any coming into your own company, or
copy the best ones you see. Keep it brief and clear. Get rid of any advertising clutter, the invoice is for accounts staff,
not purchasers. Invoice within 4 hours of the chargeable event. Remember that you won’t get paid until your bill gets
into the customer’s payment process.
An invoice includes the following information:
• customer name and address
• description of goods or services sold to the customer
• delivery date
• payment terms and due date
• date the invoice was prepared
• price and total amount payable
• to whom payable
• customer order number or payment authorisation
• you own details, including address, contact numbers and emails, company registration and VAT reference.

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