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282 SECTION 3 • BUILDING A BUSINESS PLAN: FINANCIAL ISSUES

from that cash flow statement. This is one step to assess howfinancially realistic your plan is based on the informationthat you have provided to date.

On the WebGo to the Companion Website at www.prenhall.com/scarborough and review the links associated with Chapter 8.These online resources may offer additional information re-garding the cash flow statement and the role it will play inyour business plan.

In the SoftwareReview the information that you have regarding your salesforecast and the expense information in your projectedProfit and Loss statement. Change any numbers that youhave determined to be unrealistic. Now go to the “FinancialStatement” section of the plan and look at your “ProjectedCash Flow Statement.” Do any of these months show a neg-ative cash flow? If this is the case, based on your projec-tions, you do not have an adequate cash cushion. The lowest,most negative amount indicates the minimal amount of ad-ditional cash your business needs. Make sure your projec-tions are realistic and that you have adequate cash to makeit through this negative period. Advanced planning is yourbest opportunity to avoid bankruptcy. Conversely, are theremonths where your projections indicate an excess amount ofcash? If so, have plans to use this cash to its best abilitywhen that time comes.

S ave any changes you have made in your plan. Assumethat this version of your plan represents your “most like l y ”outcome based on realistic expense and revenue projec-tions. Now create two additional “what if” scenarios—oneusing a pessimistic forecast and another using an optimisticforecast. Save this same file under a new name, for ex a m-ple, with the words “pessimistic” or “optimistic” after the

file name. This will enable you to make changes in yourplan and assess what that does to your cash flow. For ex-ample, lower your revenues by 25 percent. What does thatdo to your cash flow? Increase your expenses by 25 per-cent. What impact does that have regarding the amount ofcash you will need to get through the most nega t ive cashf l ow months? If you are extending credit to your customers,increase the accounts receivable lag time by 15 days, from30 to 45 days, for example. What does your cash flow state-ment look like now? Make the changes that could paint apotentially nega t ive picture for your venture and save theplan under the new “pessimistic” file name. Close that planand open your original so we can start with your “mostl i kely” scenario again.

Save your original under an “optimistic” file name. Ifyou are planning to extend credit, decrease the number ofcollection days by seven. What does that change do to yourcash flow? Increase your revenues by 15 percent. Decreaseyour projected expenses by 15 percent. Working throughthese scenarios can help test and validate your numbers andprepare you for contingencies as your plan becomes a real-ity. The goal is to create three scenarios that will provide abest, worst, and most likely view of your business.

Building Your Business PlanReview the data that affects your cash flow statement. Arethere revisions you need to make based on your pro formacash flow statement? What are some of the most significantcash demands of your business? Is it due to cash tied up ininventory? Is it your payroll? Are rent or lease expendituresdisproportionately high based on your projected revenues?Can you take steps to reduce or better control these expen-ditures as you build your revenue stream? Once you haveanswered these questions, again determine whether youhave adequate cash for your venture after allowing for po-tential cost overrun or revenues below your projections.

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L e a r n i n gO b j e c t i v e s

Business isn’t difficult—

be sure the incomings are

greater than the

outgoings.

—A wise Vermonter

No man’s credit is as

good as his money.

—E. W. Howe

Upon completion of this chapter, you will be able to:

1 Explain the importance of cash management to the success of a smallbusiness.

2 Differentiate between cash and profits.

3 Understand the five steps in creating a cash budget and use them to builda cash budget.

4 Describe the fundamental principles involved in managing the “Big Three”of cash management: accounts receivable, accounts payable, andinventory.

5 Explain the techniques for avoiding a cash crunch in a small company.

M a n a g i n g C a s h F l o w

8

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# 100890 Cust: Au: Scarborough Pg. No. 250Title: Effective Small Business Management Server: Jobs4

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DESIGN SERVICES OFS4CARLISLEPublishing Services

1. Explain the importance ofcash management to the successof a small business.

ash—a four-letter word that has become a curse for many small bu s i n e s s e s .Lack of this valuable asset has driven countless small companies into bank-r u p t cy. Unfortunately, many more firms will become failure statistics becausetheir owners have neglected the principles of cash management that can spellthe difference between success and failure. One small business consultant says

that “one of the most serious mistakes business owners make is trying to run their bu s i n e s s e swithout cash flow projections. This is like driving along on the freeway at 70 miles per hourwith a blindfold on. It’s not a question of whether you are headed for an accident. It’s a ques-tion of how serious the accident will be and whether or not you will survive it.”1

D eve l o p i n g c a s h f o r e c a s t s i s i m p o r t a n t f o r eve r y s m a l l bu s i n e s s bu t i s e s s e n t i a l f o r n ewbu s i n e s s e s i n p a r t i c u l a r b e c a u s e e a r l y s a l e s l eve l s u s u a l l y d o n o t g e n e r a t e s u ffi c i e n t c a s h t oke e p t h e c o m p a ny a f l o a t . To o o f t e n , e n t r e p r e n e u r s l a u n c h t h e i r c o m p a n i e s w i t h i n s u ffi c i e n tc a s h t o c ove r t h e i r s t a r t - u p c o s t s a n d t h e c a s h f l ow ga p t h a t r e s u l t s w h i l e ex p e n s e s o u t s t r i pr eve n u e s . T h e r e s u l t i s bu s i n e s s fa i l u r e . C o n t r o l l i n g t h e fi n a n c i a l a s p e c t s o f a bu s i n e s s w i t ht h e p r o fi t - p l a n n i n g t e c h n i q u e s d e s c r i b e d i n t h e p r ev i o u s c h a p t e r i s i m m e n s e l y i m p o r t a n t ;h ow eve r, b y t h e m s e l ve s , t h e s e t e c h n i q u e s a r e i n s u ffi c i e n t t o a c h i eve bu s i n e s s s u c c e s s . E n-t r e p r e n e u r s a r e p r o n e t o f o c u s o n t h e i r c o m p a n i e s ’ i n c o m e s t a t e m e n t s — p a r t i c u l a r l y s a l e sa n d p r o fi t s . T h e b a l a n c e s h e e t a n d t h e i n c o m e s t a t e m e n t , o f c o u r s e , s h ow a n i m p o r t a n t p a r to f a c o m p a ny ’s fi n a n c i a l p i c t u r e , bu t i t i s j u s t t h a t : o n l y p a r t o f t h e t o t a l p i c t u r e . I t i s e n t i r e l yp o s s i b l e f o r a bu s i n e s s t o h ave a s o l i d b a l a n c e s h e e t a n d t o m a ke a p r o fi t a n d s t i l l g o o u t o fbu s i n e s s b y r u n n i n g o u t o f c a s h. E ve n i f a c o m p a ny ’s r eve n u e ex c e e d s i t s ex p e n s e s f o r ag ive n p e r i o d , t h e c a s h f l owf r o m t h a t r eve n u e m a y n o t a r r ive i n t i m e t o p a y t h e c o m p a ny ’sc a s h ex p e n s e s . M a n a g i n g c a s h e ff e c t ive l y r e q u i r e s a n e n t r e p r e n e u r t o l o o k b ey o n d t h e “ b o t-p o r t a n t f o r eve r y s m a l l bu s i n e s s bu t i s e s s e n t i a l f o r n ew bu s i n e s s e s i n p a r t i c u l a r b e c a u s ee a r l y s a l e s l eve l s u s u a l l y d o n o t g e n e r a t e s u ffi c i e n t c a s h t o ke e p t h e c o m p a ny a f l o a t . To o o f-t e n , e n t r e p r e n e u r s l a u n c h t h e i r c o m p a n i e s w i t h i n s u ffi c i e n t c a s h t o c ove r t h e i r s t a r t - u p c o s t sa n d t h e c a s h f l ow ga p t h a t r e s u l t s w h i l e ex p e n s e s o u t s t r i p r eve n u e s . T h e r e s u l t i s bu s i n e s sfa i l u r e . C o n t r o l l i n g t h e fi n a n c i a l a s p e c t s o f a bu s i n e s s w i t h t h e p r o fi t - p l a n n i n g t e c h n i q u e sd e s c r i b e d i n t h e p r ev i o u s c h a p t e r i s i m m e n s e l y i m p o r t a n t ; h ow eve r, b y t h e m s e l ve s , t h e s et e c h n i q u e s a r e i n s u ffi c i e n t t o a c h i eve bu s i n e s s s u c c e s s . E n t r e p r e n e u r s a r e p r o n e t o f o c u s o nt h e i r c o m p a n i e s ’ i n c o m e s t a t e m e n t s — p a r t i c u l a r l y s a l e s a n d p r o fi t s .

Cash ManagementManaging cash flow is a struggle for many business owners (see Figure 8.1). In fact, re-search by the National Federation of Independent Businesses (NFIB) shows that managingcash flow consistently ranks among the top ten problems that small business owners face.Cash management involves forecasting, collecting, disbursing, investing, and planning forthe cash a company needs to operate smoothly. Managing cash is a matter of timing—ga i n-ing control over when a company collects cash and when it pays it out. Managing cash is an

C

FIGURE 8.1Causes of Cash FlowProblems Among SmallBusinessesSource: NFIB National SmallBusiness Poll: The Cash FlowProblem (National Federation ofIndependent Businesses:Washington, DC), 2003, p. 7.


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Paul Moore founded Cruise Control Ltd., a British company that sold travel cruises, in 1999and took the business on a fast-growth path, reaching sales of £3.4 million in just sevenmonths. Within five years, the company was generating £93 million in sales but was be-ginning to come apart at the seams under the strain of rapid growth. A year later CruiseControl Ltd. ran out of cash and folded.3

H. J. Heinz and the H. J. Heinz Company

Paul Moore and CruiseControl Ltd.

Shortly after H. J. Heinz and two partners launched theirfirst food business in 1875, their company’s rapidly gro w-ing sales outstripped their start-up capital, and the com-pany ran out of cash. A local newspaper called thee n t re p reneurs a “trio in a pickle.” After the company failed,Heinz personally was liable for $20,000, a huge sum in thatd a y. Undaunted, Heinz learned from his mistakes andlaunched a second food company the very next year. In thisv e n t u re, he added the product that would eventually makehim famous—ketchup—and with the help of careful cashmanagement, the H. J. Heinz Company has become one ofthe largest food companies in the world.2

important task because cash is the most important yet least productive asset that a small bu s i-ness owns. A business must have enough cash to meet its obligations as they come due or itwill experience bankruptcy. Creditors, employees, and lenders expect to be paid on time, andcash is the required medium of exchange. Some firms retain an ex c e s s ive amount of cash tomeet any unexpected circumstances that might arise. These dormant dollars have an income-earning potential that the owners are ignoring, and this restricts a company ’s growth and low-ers its profi t a b i l i t y. Proper cash management permits entrepreneurs to adequately meet thecash demands of their businesses, to avoid retaining unnecessarily large cash balances, andto stretch the profit-generating power of each dollar their companies own. Entrepreneursmust have the discipline to manage cash flow from their first day of operations.

Although cash flow problems afflict companies of all sizes and ages, young businessesare prone to suffering cash shortages because they act like “cash sponges,” soaking up everyavailable dollar and then some. The reason is that their cash-generating “engines” have nothad the opportunity to “rev up” to full speed and cannot generate sufficient power to pro-duce the cash necessary to cover rapidly climbing expenses.

Owners of fast growing businesses also must pay particular attention to cash manage-ment because the greatest potential threat to cash flow occurs when a company is ex p e r i e n c-ing rapid growth. If a company ’s sales are rising, the owner also must hire more employ e e s ,expand plant capacity, develop new products, increase the sales force and customer services t a ff, build inve n t o r y, and incur other drains on the fi r m ’s cash supply. How eve r, collectionsfrom the increased sales often slip as a company grows, and the result is a cash crisis.




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TABLE 8.1 Five Cash Management Roles of the Entre p re n e u r

Role 1. Cash finder. This is the entrepreneur’s first and foremost responsibility. You must makesure there is enough capital to pay all present (and future) bills. This is not a one-time task;it is an on-going job.

Role 2. Cash planner. As cash planner, an entrepreneur makes sure the company’s cash is usedproperly and efficiently. You must keep track of its cash, make sure it is available to paybills, and plan for its future use. Planning requires you to forecast the company’s cash in-flows and outflows for the months ahead with the help of a cash budget (discussed later inthis chapter).

Role 3. Cash distributor. This role requires you to control the cash needed to pay the com-pany’s bills and the priority and the timing of those payments. Forecasting cash disburse-ments accurately and making sure the cash is available when payments come due isessential to keeping the business solvent.

Role 4. Cash collector. As cash collector, your job is to make sure your customers pay theirbills on time. Too often, entrepreneurs focus on pumping up sales, while neglecting to col-lect the cash from those sales. Having someone in your company responsible for collectingaccounts receivable is essential. Uncollected accounts drain a small company’s pool of cashvery quickly.

Role 5. Cash conserver. This role requires you to make sure your company gets maximumvalue for the dollars it spends. Whether you are buying inventory to resell or computers tokeep track of what you sell, it is important to get the most for your money. Avoiding unnec-essary expenditures is an important part of this task. The goal is to spend cash so it willproduce a return for the company.

S o u r c e : Adapted from Bruce J. Blechman, “Quick Change Artist,” E n t r e p r e n e u r, January 1994, pp. 18–21.

John Fernsell recognizes the importance of cash man-agement because of the length of his company’s cashflow cycle. Fernsell, a former stockbroker, is the founderof Ibex Outdoor Clothing, a company that makes out-door clothing from high-quality European wool. Ibex’ssales are growing rapidly, but cash is a constant problembecause of its lengthy cash flow cycle. Fernsell orderswool from his European suppliers in February and paysfor it in June. The wool then goes to garment makers inCalifornia, who ship finished clothing to Ibex in July andAugust, when Fernsell pays for the finished goods. Ibexships the clothing to retailers in September and October

but does not get paid until November, December, and sometimes January! Ibex’s majorcash outflows are from June to August, but its cash inflows during those months are vir-tually nil, making it essential for Fernsell to manage the company’s cash balances carefully.6

John Fernsell and IbexOutdoor Clothing

Unfortunately, many small business owners do not engage in cash planning. One studyof 2,200 small businesses found that 68 percent performed no cash flow analysis at all!4

The result is that many successful, growing, and profitable businesses fail because they be-come insolvent; they do not have adequate cash to meet the needs of a growing businesswith a booming sales volume. The head of the National Federation of Independent Busi-nesses says that many small business owners “wake up one day to find that the price of suc-cess is no cash on hand. They don’t understand that if they’re successful, inventory andreceivables will increase faster than profits can fund them.”5 The resulting cash crisis mayforce an entrepreneur to lose control of the business or, ultimately, declare bankruptcy andclose. Table 8.1 describes the five key cash management roles every entrepreneur must fill.

The first step to managing cash more effectively is to understand the company’s cash

flow cycle—the time lag between paying suppliers for merchandise and receiving paymentfrom customers (see Figure 8.2). The longer this cash flow cycle, the more likely the busi-ness owner is to encounter a cash crisis. Preparing a cash forecast that recognizes this cy-cle, however, will help avoid a crisis.




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FIGURE 8.2 The Cash Flow Cycle

2. Differentiate between cash andprofits.

The next step in eff e c t ive cash management is to begin cutting down the length of thecash flow cycle. In figure 8 . 2, reducing the cycle from 240 days to, say, 150 days wo u l dfree up incredible amounts of cash that this company could use to finance growth and dra-matically reduce its borrowing costs. What steps do you suggest the owner of the bu s i-ness whose cash flow cycle is illustrated in Figure 8 . 2 t a ke to reduce the cy c l e ’s length?

Cash and Profits Are Not the SameWhen analyzing cash flow, entrepreneurs must understand that cash and profits are not thesame. Both are important financial concepts for entrepreneurs, but they measure very dif-ferent aspects of a business. Profit (or net income) is the difference between a company’stotal revenue and its total expenses. It is an accounting concept designed to measure howefficiently a business is operating. On the other hand, cash is the money that is readily avail-able to use in a business. Cash flow measures a company’s liquidity and its ability to payits bills and other financial obligations on time by tracking the flow of cash into and out ofthe business over a period of time. Many factors determine a company’s cash flow, includ-ing its sales patterns, the timing of its accounts receivable and accounts payable, its inven-tory turnover rate, its debt repayment schedule, and its schedule of capital expenditures(e.g., fixtures, equipment, facilities expansion, and others).

F i g u r e 8 . 3 s h ow s t h e f l ow o f c a s h t h r o u g h a t y p i c a l s m a l l bu s i n e s s . D e c r e a s e s i nc a s h o c c u r w h e n a bu s i n e s s p u r c h a s e s , o n c r e d i t o r f o r c a s h , g o o d s f o r i nve n t o r y o r m a-t e r i a l s f o r u s e i n p r o d u c t i o n . T h e r e s u l t i n g i nve n t o r y i s s o l d e i t h e r f o r c a s h o r o n c r e d i t .W h e n i t t a ke s i n c a s h o r c o l l e c t s a c c o u n t s r e c e iva b l e , a c o m p a ny ’s c a s h b a l a n c e i n-c r e a s e s . N o t i c e t h a t p u r c h a s e s f o r i nve n t o r y a n d p r o d u c t i o n l e a d s a l e s ; t h a t i s , t h e s e b i l l st y p i c a l l y m u s t b e p a i d b e f o re s a l e s a r e g e n e r a t e d . H ow eve r, c o l l e c t i o n o f a c c o u n t s r e-c e iva b l e l ag s b e h i n d s a l e s ; t h a t i s , c u s t o m e r s w h o p u r c h a s e g o o d s o n c r e d i t m a y n o t p a yu n t i l a m o n t h o r m o r e l a t e r.

As important as earning a profit is, no business owner can pay creditors, employees,and lenders in profits; that requires cash! “Cash flow is more important than earnings,” saysEvan Betzer, founder of a financial services firm.7 A company can operate in the short runwith a net loss showing on its income statement, but if its cash flow becomes negative, thebusiness is in trouble. It can no longer pay suppliers, meet payroll, pay its taxes, or any otherbills. In short, the business is out of business!




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Content to Be a Small Giant

I t ’s a fact that sometimes growth gets the best of entre-p reneurs: Fast-growing companies consume cash fast,which makes these fast-growing companies most vul-nerable to cash crises. “If the money is coming in thef ront door at 100 miles per hour and going out the backdoor at 110 miles per hour, that’s not a good thing,”says entre p reneur Brian Hamilton, CEO of Sageworks, afinancial re s e a rch firm. Faced with the potential for fastg rowth in their companies, some entre p reneurs havedecided to forego it, choosing instead to make theirbusinesses “small giants,” companies that grow at theirown pace and place maximizing sales far below other,sometimes very diff e rent, goals.

Jay Goltz is one of those entrepreneurs. In 1997,Goltz, who founded Artists’ Frame Service in 1978 at theage of 21, had become the most successful independentretailer of picture frames in the United States. He was acelebrity among those in the industry, had been featuredin an article on “bizkids” in Forbes magazine, and had

been inducted into the Chicago Entrepreneurship Hall ofFame. Yet he was not content; he wanted his companyto grow as big as possible as fast as possible.

Like many hard-driving entrepreneurs, Goltz was notsatisfied with his accomplishments. He thought his com-pany, which employed 75 people and generated sales of$7 million, was “dinky,” especially when he compared itto really successful businesses like those founded byMichael Dell and Richard Branson. Because he was so fo-cused on what he saw as his own inadequacies—andthose of his company—Goltz could not see the contri-butions he had made to his industry, his local commu-nity, his customers, and his employees. Goltz’s push forincessant growth led him into situations that were mak-ing his life miserable. Cash flow problems kept himawake at night and forced him to work long hours try-ing to fix things rather than spend time with his family.“I can’t really describe it,” he recalls. “It was circuit over-load. I had so many things to worry about.”

It was one of Goltz’s employees, Lily Booker, whohelped him see the light and put things in proper per-

FIGURE 8.3Cash Flow

Competitive Edge


255


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spective. Lily was retiring after eight years with Artists’Frame Service, and she wanted to say a few words at herretirement party. She had come to work for Goltz afterworking for another custom frame company for 10 yearsand being laid off. “I was in my fifties,” she told Goltzwith tears in her eyes. “When you hired me, I neverthought I’d get another job. I just want to thank you forgiving me a chance.”

Lily’s heartfelt appreciation jolted Goltz into realizingthat even though he and his company had experiencedmany setbacks, they also had achieved many successes,including providing good jobs for dozens of employees.“I’d always thought that for me to be happy, I had tohave phenomenal growth [in my business] and turn thisinto a giant company,” says Goltz. “It didn’t occur to methat there are a lot of really happy people with very nice$10 million companies making good profits, and thatthose guys are way happier than guys with companies10 times their size. That’s what it comes down to. Hap-piness is not who’s got the biggest company. Happinessis a whole lot of other things.” It was a revelation forGoltz: He realized that he had a choice in how big andhow fast his company grew and that growth for its ownsake was not the ultimate achievement.

Many other entrepreneurs have come to the samerealization that Goltz made. After Fritz Maytag boughtAnchor Steam, a nearly bankrupt microbrewery in SanFrancisco, he worked hard to turn the company around.Within a few years, Anchor Steam’s beers were recog-nized by San Franciscans as among the best anywhere,and demand for them grew so fast that Maytag ran outof production capacity and had to ration its supplies todistributors. Naturally, Maytag was busy making plansfor his company to grow, including an initial public of-fering (IPO) of Anchor Steam stock. Just before the IPOwas finalized, Maytag changed his mind and pulled out.“I realized we were doing the IPO out of desperation—because we thought we had to grow,” he says. “It oc-curred to me that you could have a small, prestigious,profitable business, and it would be all right. We madethe decision not to grow. This is not going to be a giantcompany—not on my watch.”

Entrepreneurs who have made the decision to be“small giants” have five characteristics in common:

1. They know themselves and what they want out oftheir businesses. Rather than emphasize endlessg rowth, the entre p reneurs behind these small giantsfocus more on providing excellent customer service,

c reating workplaces that value employees and theircontributions, being the best in their niches, andleading satisfying business and personal lives.

2. They love their businesses. The entrepreneurs be-hind these small giants have great passion for theircompanies and care deeply about making themthe best businesses they can be.

3. They are rooted in their communities. Founders ofsmall giants give back to their communities, buttheir connection to their communities runs muchdeeper than that. The companies and their com-munities have symbiotic relationships in whicheach benefits from the other.

4. They cultivate and value relationships with theiremployees, customers, and suppliers. These com-panies create a sense of unity and common pur-pose in their relationships with these key playersand treat them with respect, dignity, and fairn e s s .

5. They stay pri v a te and closely held. Founders of small giants know that if they sell stock to largenumbers of outside investors, they will lose their in-dependence and their ability to focus on the goalsthat matter most to them and their employees.

Sources: Adapted from Amy Feldman, “The Cash-Flow Crunch,” Inc.,December 2005, pp. 51–52; Bo Burlingham, “There Is a Choice,” Inc.,February 2006, pp. 80–89.




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The Cash BudgetT h e n e e d f o r a r e l i a b l e c a s h f o r e c a s t a r i s e s b e c a u s e i n eve r y bu s i n e s s t h e c a s h f l ow i n g i n i sr a r e l y “ i n s y n c ” w i t h t h e c a s h f l ow i n g o u t . T h i s u n eve n f l ow o f c a s h c r e a t e s p e r i o d i c c a s hs u r p l u s e s a n d d e fi c i t s , m a k i n g i t n e c e s s a r y f o r e n t r e p r e n e u r s t o t r a c k t h e f l ow o f c a s h t h r o u g ht h e i r bu s i n e s s e s s o t h ey c a n p r o j e c t r e a l i s t i c a l l y t h e p o o l o f c a s h t h a t i s ava i l a b l e t h r o u g h o u tt h e y e a r. M a ny ow n e r s o p e r a t e t h e i r bu s i n e s s e s w i t h o u t k n ow i n g t h e p a t t e r n o f t h e i r c a s hf l ow s , b e l i ev i n g t h a t t h e p r o c e s s i s t o o c o m p l ex o r t i m e c o n s u m i n g . I n r e a l i t y, e n t r e p r e n e u r ss i m p l y c a n n o t a ff o r d t o i g n o r e c a s h m a n a g e m e n t . T h ey m u s t e n s u r e t h a t a n a d e q u a t e , bu t n o tex c e s s ive , s u p p l y o f c a s h i s o n h a n d t o m e e t t h e i r c o m p a n i e s ’ o p e r a t i n g n e e d s .

How much cash is enough? What is suitable for one business may be totally inadequatefor another, depending on each company’s size, sales, collections, expenses, and other fac-tors. Entrepreneurs should prepare a cash budget, which is nothing more than a “cashmap,” showing the amount and the timing of the cash receipts and the cash disbursementsweek-by-week or month-by-month. It is used to predict the amount of cash a company willneed to operate smoothly over a specific period of time, and it is a valuable tool in manag-ing a company successfully.

Preparing a Cash BudgetTypically, a small business should prepare a projected monthly cash budget for at least oneyear and quarterly estimates one or two years beyond that. To be effective, a cash budgetmust cover all seasonal sales fluctuations. The more variable a company’s sales pattern, theshorter its planning horizon should be. For example, a firm whose sales fluctuate widelyover a relatively short time frame might require a weekly cash budget rather than a monthlyone. The key to managing cash flow successfully is to monitor not only the amount of cashflowing into and out of a company but also the timing of those cash flows.

Regardless of the time frame selected, a cash budget must be in writing for an entre-preneur to visualize a company’s cash position. Creating a written cash plan is not an ex-cessively time-consuming task and can help the owner avoid unexpected cash shortages, asituation that can cause a business to fail. One financial consultant describes “a client whowon’t be able to make the payroll this month. His bank agreed to meet the payroll for him—but banks don’t like to be surprised like that,” he adds.8 Preparing a cash budget will helpbusiness owners avoid unpleasant surprises such as that. It will also let owners knowwhether they are keeping excessive amounts of cash on hand. Computer spreadsheets suchas Excel and Lotus 1-2-3 make the job fast and easy to complete and allow for instant up-dates and “what if” analysis.

A c a s h bu d g e t i s b a s e d o n t h e c a s h m e t h o d o f a c c o u n t i n g , w h i c h m e a n s t h a t c a s h r e-c e i p t s a n d c a s h d i s bu r s e m e n t s a r e r e c o r d e d i n t h e f o r e c a s t o n l y w h e n t h e c a s h t r a n s a c t i o n i sex p e c t e d t o t a ke p l a c e . Fo r ex a m p l e , c r e d i t s a l e s t o c u s t o m e r s a r e n o t r e p o r t e d u n t i l t h e c o m-p a ny ex p e c t s t o c o l l e c t t h e c a s h f r o m t h e m . S i m i l a r l y, p u r c h a s e s m a d e o n c r e d i t a r e n o tr e c o r d e d u n t i l t h e ow n e r ex p e c t s t o p a y t h e m . B e c a u s e d e p r e c i a t i o n , b a d d e b t ex p e n s e , a n do t h e r n o n c a s h i t e m s i nvo l ve n o c a s h t r a n s f e r s , t h ey a r e o m i t t e d e n t i r e l y f r o m t h e c a s h bu d g e t .

A c a s h bu d g e t i s n o t h i n g m o r e t h a n a f o r e c a s t o f a c o m p a ny ’s c a s h i n f l ow s a n d o u t f l ow sf o r a s p e c i fi c t i m e p e r i o d , a n d i t w i l l n eve r b e c o m p l e t e l y a c c u r a t e . H ow eve r, i t d o e s g ive as m a l l bu s i n e s s ow n e r a c l e a r p i c t u r e o f a c o m p a ny ’s e s t i m a t e d c a s h b a l a n c e f o r t h e p e r i o d ,p o i n t i n g o u t w h e r e ex t e r n a l c a s h i n f u s i o n s m a y b e r e q u i r e d o r w h e r e s u r p l u s c a s h b a l a n c e sm a y b e ava i l a b l e f o r i nve s t i n g . I n a d d i t i o n , b y c o m p a r i n g a c t u a l c a s h f l ow s w i t h p r o j e c t i o n s ,a n e n t r e p r e n e u r c a n r ev i s e h i s f o r e c a s t s o t h a t f u t u r e c a s h bu d g e t s w i l l b e m o r e a c c u r a t e .

3. Understand the five steps increating a cash budget and usethem to build a cash budget.

Michael Koss, president and CEO of Koss Corporation, a manufacturer of stereo head-phones, now emphasizes cash flow management after his company’s brush with failure.In the 1980s, Koss Corporation expanded rapidly—so rapidly, in fact, that its cash flowcouldn’t keep pace. Debt climbed, and the company filed for reorganization underChapter 11 bankruptcy. Emergency actions saved the business, and today Koss manageswith the determination never to repeat the same mistakes. “I look at cash every singleday,” he says. “That is absolutely critical.”9

Michael Koss and Koss Corporation




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Formats for preparing a cash budget vary depending on the pattern of a company’s cashflow. Table 8.2 shows a monthly cash budget for a small department store over a four-monthperiod. Each monthly column should be divided into two sections—estimated and actual(not shown)—so that subsequent cash forecasts can be updated according to actual cashtransactions. There are five steps to creating a cash budget:

1. Determining an adequate minimum cash balance.2. Forecasting sales.3. Forecasting cash receipts.4. Forecasting cash disbursements.5. Estimating the end-of-month cash balance.

Step 1: Determining an Adequate Minimum Cash BalanceWhat is considered an excessive cash balance for one small business may be inadequate foranother, even though the two firms are in the same industry. Some suggest that a company’scash balance should equal at least one-fourth of its current liabilities, but this simple guide-line does not work for all small businesses. The most reliable method of deciding cash bal-ance is based on past experience. Past operating records should indicate the proper cashcushion needed to cover any unexpected expenses after all normal cash outlays are de-ducted from the month’s cash receipts. For example, past records may indicate that it is de-sirable to maintain a cash balance equal to five days’ sales. Seasonal fluctuations may causea company’s minimum cash balance to change. For example, the desired cash balance fora retailer in December may be greater than in June.

Step 2: Forecasting SalesThe heart of the cash budget is the sales forecast. It is the central factor in creating an ac-curate picture of a company’s cash position because sales ultimately are transformed intocash receipts and cash disbursements. For most businesses, sales constitute the primarysource of the cash flowing into the business. Similarly, sales of merchandise require entre-preneurs to use cash to replenish inventory. As a result, the cash budget is only as accurateas the sales forecast from which it is derived; an accurate sales forecast is essential to pro-ducing a reliable cash flow forecast.

Dean Kamen andSegway LLC

An overly optimistic sales forecast landed Segway LLC, the company that invented the fu-turistic upright motorized scooter, squarely in a cash flow bind. Known as the Segway Hu-man Transporter, the scooter uses computer-driven gyroscopes and sensors that allowriders to stand upright and steer with simple body movements. Unveiled on live televisionto huge amounts of press fanfare, founder and inventor Dean Kamen projected that thecompany would be able to sell 50,000 to 100,000 Segways in its first year. The scooter’s$4,000 price and lack of distribution outlets (People simply weren’t willing to spend$4,000 on something they could not test-drive!) limited sales to just a total of 10,000 unitstwo years after the Segway’s introduction. The cash flow problems meant that Kamen hadto raise $31 million to keep the company afloat in addition to the initial $100 million heraised to launch the company.10

For an established business, the sales forecast can be based on past sales, but entrepre-neurs must be careful not to be excessively optimistic in their projections. Economicswings, increased competition, fluctuations in demand, and other factors can drastically al-ter sales patterns. A good cash budget must reflect the seasonality of a company’s sales.Simply deriving a realistic annual sales forecast and then dividing it by 12 does not producea reliable monthly sales forecast. Most businesses have sales patterns that are “lumpy” andnot evenly distributed throughout the year. For instance, 40 percent of all toy sales takeplace during the last six weeks of the year, and companies that make fruitcakes typicallygenerate 50 percent to 90 percent of their sales during the holiday season.11 Super BowlSunday is the single largest revenue-generating day of the year for most pizzerias (and ranks




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TABLE 8.2 Cash Budget for Small Department Store

Assumptions:Cash balance on December 31 = $12,000Minimum cash balance desired = $10,000Sales are 75% credit and 25% cash.Credit sales are collected in the following manner:

j 60% collected in the first month after the sale.j 30% collected in the second month after the sale.j 5% collected in the third month after the sale.j 5% are never collected.

Sales Forecasts Are as Follows: Pessimistic Most Likely Optimistic

October (actual) $300,000November (actual) 350,000December (actual) 400,000January $120,000 150,000 $175,000February 160,000 200,000 250,000March 160,000 200,000 250,000April 250,000 300,000 340,000

The store pays 70% of sales price for merchandise purchased and pays for each month’s anticipated sales in the preceding month.Rent is $2,000 per month.An interest payment of $7,500 is due in March.A tax prepayment of $50,000 must be made in March.A capital addition payment of $130,000 is due in February.Utilities expenses amount to $850 per month.Miscellaneous expenses are $70 per month.Interest income of $200 will be received in February.Wages and salaries are estimated to be

January—$30,000February—$40,000March—$45,000April—$50,000

Cash Budget—Pessimistic Sales Fo re c a s t

Oct. Nov. Dec. Jan. Feb. Mar. Apr.

Cash Receipts:Sales $300,000 $350,000 $400,000 $120,000 $160,000 $160,000 $250,000Credit Sales 225,000 262,500 300,000 90,000 120,000 120,000 187,500

Collections:60%—1st month after sale $180,000 $ 54,000 $ 72,000 $ 72,00030%—2nd month after sale 78,750 90,000 27,000 36,0005%—3rd month after sale 11,250 13,125 15,000 4,500Cash Sales 30,000 40,000 40,000 62,500Interest 0 200 0 0

Total Cash Receipts $300,000 $197,325 $154,000 $175,000

Cash Disbursements:Purchases $112,000 $112,000 $175,000 $133,000Rent 2,000 2,000 2,000 2,000Utilities 850 850 850 850Interest 0 0 7,500 0




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Tax Prepayment 0 0 50,000 0Capital Addition 0 130,000 0 0Miscellaneous 70 70 70 70Wages/Salaries 30,000 40,000 45,000 50,000Total Cash Disbursements $144,920 $284,920 $280,420 $185,920

End-of-Month Balance:

Cash (beginning of month) $ 12,000 $167,080 $ 79,485 $ 10,000+ Cash Receipts 300,000 197,325 154,000 175,000– Cash Disbursements 144,920 284,920 280,420 185,920Cash (end of month) 167,080 79,485 (46,935) (920)Borrowing/Repayment 0 0 56,935 10,920Cash (end of month [after borrowing]) $167,080 $ 79,485 $ 10,000 $ 10,000

Cash Budget—Most Likely Sales Fo re c a s t



Collections:

60%—1st month after sale $180,000 $ 67,500 $ 90,000 $ 90,00030%—2nd month after sale 78,750 90,000 33,750 45,0005%—3rd month after sale 11,250 13,125 15,000 5,625Cash Sales 37,500 50,000 50,000 75,000Interest 0 200 0 0


Cash Disbursements:Purchases $140,000 $140,000 $210,000 $175,000Rent 2,000 2,000 2,000 2,000Utilities 850 850 850 850Interest 0 0 7,500 0Tax Prepayment 0 0 50,000 0Capital Addition 0 130,000 0 0Miscellaneous 70 70 70 70Wages/Salaries 30,000 40,000 45,000 50,000

Total Cash Disbursements $172,920 $312,920 $315,420 $227,920

End-of-Month Balance:Cash [beginning of month] $ 12,000 $146,580 $ 54,485 $ 10,000+ Cash Receipts 307,500 220,825 188,750 215,625– Cash Disbursements 172,920 312,920 315,420 227,920Cash (end of month) 146,580 54,485 (72,185) (2,295)Borrowing/Repayment 0 0 82,185 12,295Cash (end of month [after borrowing]) $146,580 $ 54,485 $ 10,000 $ 10,000

Cash Budget—Optimistic Sales Fo re c a s t



TABLE 8.2 C o n t i n u e d


(continued)




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second only to Thanksgiving as the largest food consumption day). In addition, as much as25 percent of the sales at companies that supply exotic dancers for parties occur on SuperBowl Sunday.12 Highly seasonal sales patterns such as these can make managing cash flowa challenge for entrepreneurs.

Collections:60%—1st month after sale $180,000 $ 78,750 $112,500 $112,50030%—2nd month after sale 78,750 90,000 39,375 56,2505%—3rd month after sale 11,250 13,125 15,000 6,563Cash Sales 43,750 62,500 62,500 85,000Interest 0 200 0 0


Cash Disbursements:Purchases $175,000 $175,000 $238,000 $217,000Rent 2,000 2,000 2,000 2,000Utilities 850 850 850 850Interest 0 0 7,500 0Tax Prepayment 0 0 50,000 0Capital Addition 0 130,000 0 0Miscellaneous 70 70 70 70Wages/Salaries 30,000 40,000 45,000 50,000

Total Cash Disbursements $207,920 $347,920 $343,420 $269,920

End-of-Month Balance:Cash [beginning of month] $ 12,000 $117,830 $ 14,485 $ 10,000+ Cash Receipts 313,750 244,575 229,375 296,125− Cash Disbursements 207,920 317,920 343,120 269,920Cash (end of month) 117,830 14,485 (99,560) 36,205Borrowing/Repayment 0 0 109,560 0Cash (end of month [after borrowing]) $117,830 $ 14,485 $ 10,000 $ 36,205

To combat a highly seasonal sales pattern and keep the Starlite Drive-In, one of only nineremaining drive-in theaters still in operation in North Carolina, owner Bob Groves hasadded sideline businesses to generate cash flow during the slow winter months. The ratherunusual combination of businesses includes a gun shop, a shooting range, a video rentalstore, and a flea-market-space rental business. Groves’s unique approach to boosting cashflow during months with the slowest theater ticket sales works, and the 1930s-era theaterhas become a landmark in the Research Triangle area.13

Bob Groves and theStarlite Drive-In

Several quantitative techniques for forecasting sales, which are beyond the scope ofthis text (e.g., linear regression, multiple regression, time series analysis, and exponentialsmoothing), are available to owners of existing businesses with an established sales pattern.These methods allow business owners to extrapolate past and present sales trends to arriveat a fairly accurate sales forecast.

T h e t a s k o f f o r e c a s t i n g s a l e s f o r a n ew fi r m i s d i ffi c u l t bu t n o t i m p o s s i b l e . Fo r ex a m p l e ,a n e n t r e p r e n e u r m i g h t c o n d u c t r e s e a r c h o n s i m i l a r fi r m s a n d t h e i r s a l e s p a t t e r n s i n t h e fi r s ty e a r o f o p e r a t i o n t o c o m e u p w i t h a f o r e c a s t . T h e l o c a l c h a m b e r o f c o m m e r c e a n d t r a d e a s-s o c i a t i o n s i n t h e va r i o u s i n d u s t r i e s a l s o c o l l e c t s u c h i n f o r m a t i o n . M a r ke t r e s e a r c h i s a n o t h e r

TABLE 8.2 C o n t i n u e d





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TABLE 8.3 F o recasting Sales for a Business Start-up

Robert Adler wants to open a repair shop for imported cars. The trade association for automo-tive garages estimates that the owner of an imported car spends an average of $485 per year onrepairs and maintenance. The typical garage attracts its clientele from a trading zone (the areafrom which a business draws its customers) with a 20-mile radius. Census reports show that thefamilies within a 20-mile radius of Robert’s proposed location own 84,000 cars, of which 24 percent are imports. Based on a local market consultant’s research, Robert believes he cancapture 9.9 percent of the market this year. Robert’s estimate of his company’s first year’s salesare as follows:

Number of cars in trading zone 84,000

× Percent of imports × 24%

= Number of imported cars in trading zone 20,160

Number of imports in trading zone 20,160

× Average expenditure on repairs and maintenance × $485

= Total import repair sales potential $9,777,600

Total import repair sales potential $9,777,600

× Estimated share of market × 9.9%

= Sales estimate $967,982

Now Robert Adler can convert this annual sales estimate of $967,982 into monthly sales esti-mates for use in his company’s cash budget.

s o u r c e o f i n f o r m a t i o n t h a t m a y b e u s e d t o e s t i m a t e a n n u a l s a l e s f o r t h e f l e d g l i n g fi r m . O t h e rp o t e n t i a l s o u r c e s t h a t m a y h e l p p r e d i c t s a l e s i n c l u d e : C e n s u s B u r e a u r e p o r t s ; n ew s p a p e r s ;r a d i o a n d t e l ev i s i o n c u s t o m e r p r o fi l e s ; p o l l s a n d s u r vey s ; a n d l o c a l g ove r n m e n t s t a t i s t i c s .Ta b l e 8 . 3 g ive s a n ex a m p l e o f h ow o n e e n t r e p r e n e u r u s e d s u c h m a r ke t i n g i n f o r m a t i o n t o d e-r ive a s a l e s f o r e c a s t f o r h i s fi r s t y e a r o f o p e r a t i o n i n t h e a u t o m o t ive r e p a i r bu s i n e s s .

No matter what techniques entrepreneurs use to forecast cash flow, they must recog-nize that even the best sales estimates will be wrong. Many financial analysts suggest thatentrepreneurs create three estimates—an optimistic, a pessimistic, and a most likely salesestimate—and then make a separate cash budget for each forecast (a very simple task witha computer spreadsheet). This dynamic forecast enables entrepreneurs to determine therange within which their sales and cash flows will likely fall as the year progresses. By us-ing the forecast that most closely reflects their sales patterns, entrepreneurs can project theircompanies’ cash flow more accurately.

Step 3: Forecasting Cash ReceiptsAs we mentioned earlier, sales constitute the major source of cash receipts. When a com-pany sells goods and services on credit, a cash budget must count for the delay between thesale and the actual collection of the proceeds. Remember: You cannot spend cash youhaven’t collected yet! For instance, a company might not collect the cash from the sale ofinventory made in February until March or April (or even later), and the cash budget mustreflect this delay. To project accurately a firm’s cash receipts, entrepreneurs must analyzetheir companies’ accounts receivable to determine the collection pattern. For example, anentrepreneur may discover that 20 percent of sales are for cash, 50 percent are paid in themonth following the sale, 20 percent are paid two months after the sale, 7 percent after threemonths, and 3 percent are never collected. In addition to cash and credit sales, a cash budgetmust include any other cash the company receives such as interest income, rental income,dividends, and others.

Some small business owners never discover the hidden danger in accounts receivableuntil it is too late for their companies. Receivables act as cash sponges, tying up valuabledollars until an entrepreneur collects them.




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Figure 8.4 demonstrates how vital it is to act promptly once an account becomes pastdue. Notice how the probability of collecting an outstanding account diminishes the longerthe account is delinquent. Table 8.4 illustrates the high cost of failing to collect accounts re-ceivable on time.

Step 4: Forecasting Cash DisbursementsMost owners of established businesses have a clear picture of a company’s pattern of cashdisbursements. In fact, many cash payments, such as rent, salaries, loan repayments, and in-surance premiums, are fixed amounts due on specified dates. The key factor in forecastingdisbursements for a cash budget is to record them in the month in which they will be paid,not when the debt or obligation is incurred. Of course, the number and type of cash dis-bursements varies with each particular business, but the following disbursement categoriesare standard: purchases of inventory or raw materials, wages and salaries, rent, taxes, loanrepayments, interest, marketing and selling expenses, insurance, utility expenses, and mis-cellaneous expenses.

When preparing a cash budget, one of the worst mistakes entrepreneurs can make is tounderestimate cash disbursements, which can result in a cash crisis. To prevent this, wiseentrepreneurs cushion their cash disbursements, assuming they will be higher than ex-pected. This is particularly important for entrepreneurs opening new businesses. In fact,

When Mary and Phil Baechler started Baby Jogger Company in 1983 to make strollers thatwould enable parents to take their babies along on their daily runs, Mary was in charge ofthe financial aspects of the business and watched its cash flow closely. As the companygrew, the couple created an accounting department to handle its financial affairs. Unfor-tunately, the financial management system could not keep up with the company’s rapidgrowth and failed to provide the necessary information to keep its finances under control.As inventory and accounts receivable ballooned, the company headed for a cash crisis. Toensure Baby Jogger’s survival, the Baechlers were forced to reduce their workforce by half.Then they turned their attention to the accounts receivable and discovered that customersowed the business almost $700,000! In addition, most of the accounts were past due. Fo-cusing on collecting the money owed to their company, the Baechlers were able to steerclear of a cash crisis and get Baby Jogger back on track.14

Mary and Phil Baechlerand Baby JoggerCompany

FIGURE 8.4Collecting DelinquentAccounts Source: Commercial CollectionAgency Section of the CommercialLaw League of America.




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some financial analysts recommend that people starting new businesses make the best esti-mates of their companies’ cash disbursements and then add another 25 to 50 percent of thattotal as a contingency, recognizing that business expenses often run higher than expected.When setting up his company’s cash budget, one entrepreneur included a line called “Mur-phy,” an additional amount each month to account for Murphy’s Law (“What can go wrong,will go wrong”). Whatever forecasting technique entrepreneurs use, the key is to avoid un-derestimating cash disbursements, which may lead to severe cash shortages and possiblybankruptcy.

Sometimes business owners have difficulty developing initial forecasts of cash receiptsand cash disbursements. One of the most effective techniques for overcoming the “I don’tknow where to begin” hurdle is to make a daily list of the items that generated cash (re-ceipts) and those that consumed it (disbursements).

TABLE 8.4 Managing Accounts Receivable

Are your customers who purchase on credit paying late? If so, these outstanding accounts re-ceivable probably represent a significant leak in your company’s profits. Regaining control ofthese late payers will likely improve your company’s profits and cash flow.

Slow-paying customers, in effect, are borrowing money from your business interest free!They are using your money without penalty while you forgo opportunities to put it to productiveuse in your company or to place it in interest-bearing investments. Exactly how much are poorcredit practices costing you? The answer may surprise you.

The first step is to compute the company’s average collection period ratio (See the“Operating Ratios” section in Chapter 7), which tells the number of days required to collect thetypical account receivable. Then you compare this number to your company’s credit terms. Thefollowing example shows how to calculate the cost of past-due receivables for a company whosecredit terms are “net 30”:

Average collection period 65 daysLess: credit terms 30 daysExcess in accounts receivable 35 days

Average daily sales of $21,500* × 35 days excess $752,500Normal rate of return on investment 10%Annual cost of excess $ 75,250

If your business is highly seasonal, quarterly or monthly figures may be more meaningful thanannual ones.

*Average daily sales 5Annual sales

5$7,487,500

5 $21,500365 365

Susan Bowen, CEO of Champion Awards, a $9-million T-shirt screen printer, monitors cashflow by tracking the cash that flows into and out of her company every day. Focusing onkeeping the process simple, Bowen sets aside a few minutes each morning to track up-dates from the previous day on four key numbers:

Accounts receivable: (1) What was billed yesterday? (2) How much was actuallycollected?Accounts payable: (3) What invoices were received yesterday? (4) How much in totalwas paid out?

If Bowen observes the wrong trend—more new bills than new sales or more money go-ing out than coming in—she makes immediate adjustments to protect her cash flow. Thebenefits produced (not the least of which is the peace of mind knowing no cash crisis islooming) more than outweigh the ten minutes she invests in the process every day. “I’vetried to balance my books every single day since I started my company in 1970,” saysBowen.15

Susan Bowen andChampion Awards


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Rowena’s Cash Budget

Rowena Rowdy had been in business for slightly morethan two years, but she had never taken the time to de-velop a cash budget for her company. Based on a seriesof recent events, however, she knew the time had cometo start paying more attention to her company’s cashflow. The business was growing fast, with sales morethan tripling from the previous year, and profits were ris-ing. However, Rowena often found it difficult to pay allof the company’s bills on time. She didn’t know why ex-actly, but she knew that the company’s fast growth wasrequiring her to incur higher levels of expenses.

Last night, Rowena attended a workshop on man-aging cash flow sponsored by the local chamber of com-

merce. Much of what the presenter said hit home withRowena. “This fellow must have taken a look at mycompany’s financial records before he came heretonight,” she said to a friend during a break in the pre-sentation. On her way home from the workshop,Rowena decided that she would take the presenter’s ad-vice and develop a cash budget for her business. Afterall, she was planning to approach her banker about aloan for her company, and she knew that creating a cashbudget would be an essential part of her loan request.She started digging for the necessary information, andthis is what she came up with:

Current cash balance $10,685Sales pattern 63% on credit and 37% in cashCollections of credit sales 61% in 1 to 30 days

27% in 31 to 60 days8% in 61 to 90 days4% never collected (bad debts)

Utilities expenses $950 per month.Rent $2,250 per monthTruck loan $427 per month

Sales Forecasts:Pessimistic Most Likely Optimistic

January (actual) — $24,780 —February (actual) — $20,900 —March (actual) — $21,630 —April $19,100 $23,550 $25,750May $21,300 $24,900 $27,300June $23,300 $29,870 $30,000July $23,900 $27,500 $29,100August $20,500 $25,800 $28,800September $18,500 $21,500 $23,900

The company’s wages and salaries (including payroll taxes) estimates are:

April $3,550 July $6,255May $4,125 August $6,060June $5,450 September $3,525




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Step 5: Estimating the End-of-Month Cash BalanceTo estimate a company’s final cash balance for each month, entrepreneurs first must deter-mine the cash balance at the beginning of each month. The beginning cash balance includescash on hand as well as cash in checking and savings accounts. The cash balance at the endof one month becomes the beginning balance for the following month. Next the owner sim-ply adds to that balance the projected total cash receipts for the month and then subtractsprojected total cash disbursements to obtain the end-of-month balance before any borrow-ing takes place. A positive balance indicates that the business has a cash surplus for themonth, but a negative balance shows a cash shortage will occur unless the entrepreneur isable to collect, raise, or borrow additional cash.

Normally, a company’s cash balance fluctuates from month to month, reflecting sea-sonal sales patterns. These fluctuations are normal, but entrepreneurs must watch closelyany increases and decreases in the cash balance over time. A trend of increases indicatesthat the small firm has ample cash that could be placed in some income-earning investment.On the other hand, a pattern of cash decreases should alert the owner that the business is ap-proaching a cash crisis.

Preparing a cash budget not only illustrates the flow of cash into and out of the smallbusiness, but it also allows a business owner to anticipate cash shortages and cash surpluses.By planning cash needs ahead of time, an entrepreneur is able to do the following:

j Increase the amount and the speed of cash flowing into the company.j Reduce the amount and the speed of cash flowing out of the company.j Develop a sound borrowing and repayment program.j I m p r e s s l e n d e r s a n d i nve s t o r s w i t h a p l a n f o r r e p a y i n g l o a n s o r d i s t r i bu t i n g d iv i d e n d s .j Reduce borrowing costs by borrowing only when necessary.j Take advantage of money-saving opportunities, such as economic order quantities

and cash discounts.j Make the most efficient use of the cash available.

A tax payment of $3,140 is due in June. Rowena has es-tablished a minimum cash balance of $1,500. If Rowenamust borrow money, she uses her line of credit at thebank which charges interest at an annual rate of 10.25percent. Any money that Rowena borrows must be re-paid the next month.

1. Help Rowena put together a cash budget for thesix months beginning in April.

2. Does it appear that Rowena’s business will remainsolvent, or could the company be heading for acash crisis?

3. What suggestions can you make to help Rowenaimprove her company’s cash flow?

The company pays 66 percent of the sales price for the inventory it purchases, an amount that it actually pays inthe following month. (Rowena has negotiated “net 30” credit terms with her suppliers.)

Other expenses include:Insurance premiums $1,200, payable in April and September.Office supplies $125 per monthMaintenance $75 per monthUniforms/cleaning $80 per monthOffice cleaning service $85 per monthInternet and computer service $225 per monthComputer supplies $75 per monthAdvertising $450 per monthLegal and accounting fees $250 per monthMiscellaneous expenses $95 per month




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j Finance seasonal business needs.j Provide funds for expansion.j Improve profitability by investing surplus cash.

The message is simple: Managing cash flow means survival for a business. Businesses tend tosucceed when their owners manage cash eff e c t ive l y. Entrepreneurs who neglect cash flow man-agement techniques are likely to see their companies fold; those who take the time to managetheir cash flow free themselves of worrying about their companies’ solve n cy to focus on whatt h ey do best: taking care of their customers and ensuring their companies’ success.

The “Big Three” of Cash ManagementIt is unrealistic for entrepreneurs to expect to trace the flow of every dollar through theirbusinesses. However, by concentrating on the three primary causes of cash flow problems,they can dramatically lower the likelihood of experiencing a devastating cash crisis. The“big three” of cash management are accounts receivable, accounts payable, and inventory.When it comes to managing cash flow, entrepreneurs’ goals should be to accelerate theircompanies’ accounts receivable and to stretch out their accounts payable. As one com-pany’s chief financial officer states, the idea is to “get the cash in the door as fast as youcan, cut costs, and pay people as late as possible.”16 Business owners also must monitor in-ventory carefully to avoid tying up valuable cash in an excess inventory. Figure 8.5 illus-trates the interaction of the “big three” in a company’s cash conversion cycle (inventory,accounts receivable, and accounts payable) and a measure for each one (days’ inventoryoutstanding, days sales’ outstanding, and days’ payable outstanding).

Accounts ReceivableS e l l i n g m e r c h a n d i s e a n d s e r v i c e s o n c r e d i t i s a n e c e s s a r y ev i l f o r m o s t s m a l l bu s i n e s s e s .M a ny c u s t o m e r s ex p e c t t o bu y o n c r e d i t , a n d e n t r e p r e n e u r s ex t e n d i t t o avo i d l o s i n g c u s-t o m e r s t o c o m p e t i t o r s . H ow eve r, s e l l i n g t o c u s t o m e r s o n c r e d i t i s ex p e n s ive ; i t r e q u i r e s m o r ep a p e r wo r k , m o r e s t a ff , a n d m o re c a s h t o s e r v i c e a c c o u n t s r e c e iva b l e . A l s o , b e c a u s e ex t e n d-i n g c r e d i t i s , i n e s s e n c e , l e n d i n g m o n ey, t h e r i s k i nvo l ve d i s h i g h e r. E ve r y bu s i n e s s ow n e rw h o s e l l s o n c r e d i t w i l l e n c o u n t e r c u s t o m e r s w h o p a y l a t e o r, wo r s t o f a l l , w h o n eve r p a y a ta l l . T h i s r eve n u e l e a k a g e c a n b e t h e s o u r c e o f s eve r e c a s h f l ow p r o b l e m s f o r a s m a l l bu s i n e s s .M u c h l i ke a l e a k i n a wa t e r p i p e , r eve n u e l e a k a g e s f r o m u n d i s c i p l i n e d c o l l e c t i o n p r o c e d u r e sc a n b e c o m e s i g n i fi c a n t ove r t i m e a n d c a u s e s e r i o u s d a m a g e . O n e ex p e r t e s t i m a t e s t h a t r ev-e n u e l e a k a g e s r o b c o m p a n i e s o f 2 p e r c e n t o f t h e i r s a l e s . H e a l t h c a r e a n d We b s e r v i c ep r ov i d e r s , f o r i n s t a n c e , t y p i c a l l y l o s e 5 t o 1 0 p e r c e n t o f t h e i r r eve n u e s e a c h y e a r.1 7

Selling on credit is a common practice in business. Experts estimate that 90 percent ofindustrial and wholesale sales are on credit and that 40 percent of retail sales are on account.“Extending credit is a [double]-edged sword,” says Robert Smith, president of his own pub-lic relations firm in Rockford, Illinois. “I give credit so more people can afford my public-ity services. I also have people who still owe me money—and who will probably neverpay.”18 Figure 8.6 shows that small business owners’ greatest cash management challengeis collecting accounts receivable.

FIGURE 8.5The Cash ConversionCycle

4. Describe the fundamentalprinciples involved in managingthe “big three” of cash manage-ment: accounts receivable, ac-counts payable, and inventory.




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Because so many entrepreneurs sell on credit, an assertive collection program is es-sential to managing a company’s cash flow. A credit policy that is too lenient can destroy abusiness’s cash flow, attracting nothing but slow-paying and “deadbeat” customers. On theother hand, a carefully designed credit policy can be a powerful selling tool, attracting cus-tomers and boosting cash flow. “A sale is not a sale until you collect the money,” warns thehead of the National Association of Credit Management. “Receivables are the second mostimportant item on the balance sheet. The first is cash. If you don’t turn those receivablesinto cash, you’re not going to be in business very long.”19

FIGURE 8.6Which Cash Flow ProcessIs the Most Challengingto Manage?Source: Visa Small Business CashManagement Survey, 2006.

Bill Seidel, the second-generation owner of Seidel Flags and Flagpoles based in Spartan-burg, South Carolina, won a contract for the installation of several flagpoles at a newlyconstructed downtown hotel and conference center. Three months after completing thework, Seidel, whose mother had started the company in 1971 in the family garage, wasstill waiting to be paid and was growing increasingly concerned after hearing rumors thatthe developer of the project was on the verge of bankruptcy. “I was really worried,” saysSeidel. “We’re a small company, and that was a big project for us.” To collect his cash, Sei-del began calling the developer several times a day, asking for payment. His persistence fi-nally paid off, and the developer paid most (but not all) of the pro j e c t ’s cost. “If [thedeveloper] had not paid me,” says Seidel, “we would have been forced to file for bank-r u p t c y.” Seidel was fortunate because shortly after he received payment for the flagpoles, thedeveloper declared bankruptcy, leaving creditors with more than $25 million in unpaid b i l l s .2 0

Bill Seidel and SeidelFlags and Flagpoles

HOW TO ESTABLISH A CREDIT AND COLLECTION POLICY. The first step to establishinga workable credit policy that preserves a company’s cash flow is to screen customers care-fully before granting credit. Unfortunately, few small businesses conduct any kind of creditinvestigation before selling to a new customer. According to one study, nearly 95 percentof small firms that sell on credit sell to anyone who wants to buy.21 If a debt becomes pastdue and a business owner has gathered no information about the customer, the odds of col-lecting the account are virtually nil.

The first line of defense against bad debt losses is a detailed credit application. Beforeselling to any customer on credit, a business owner should have the customer fill out a cus-tomized application designed to provide the information needed to judge the potential cus-tomer’s creditworthiness. At a minimum, this credit profile should include the followinginformation about customers:

j Name, address, social security number or tax identification number, and telephonenumber.

j Form of ownership (proprietorship, S corporation, LLC, corporation, etc.) andnumber of years in business.

j Credit references (e.g., other suppliers), including contact names, addresses, andtelephone numbers.

j Bank and credit card references.




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Bob Dempster, cofounder of American Imaging Inc., a distributor of X-ray tubes, once han-dled receivables the same way most entrepreneurs do: When customers ignored the “net30” terms on invoices, he would call them around the forty-fifth day to ask what the prob-lem was. Payments usually would trickle in within the next two weeks, but by then 60 dayshad elapsed, and American Imaging’s cash flow was always strained. Then Dempster de-cided to try a different approach. Now he makes a “customer relations call” on the twen-

Bob Dempster andAmerican Imaging Inc.

After collecting this information, the business owner should use it by checking the po-tential customer’s credit references! The savings from lower bad debt expenses can morethan offset the cost of using a credit reporting service. Companies such as Dun & Bradstreet(D&B, www.dnb.com), Experian (www.experian.com), Equifax (www.equifax.com),TransUnion (www.transunion.com), Veritas Credit Corporation (www.veritas-usa.com),and KnowX (www.knowx.com) enable entrepreneurs to gather credit information on po-tential customers. For entrepreneurs who sell to other business, D&B offers many usefulservices, including a Small Business Risk New Account Score, a tool for evaluating the credit risk of new businesses. The National Association of Credit Management (www.nacm.org) is another important source of credit information because it collects in-formation on many small businesses that other reporting services ignore. The cost to checka potential customer’s credit at reporting services such as these ranges from $15 to $85, asmall price to pay when a small business is considering selling thousands of dollars worthof goods or services to a new customer.

T h e n ex t s t e p i nvo l ve s e s t a b l i s h i n g a fi r m w r i t t e n c r e d i t p o l i cy a n d l e t t i n g eve r y c u s t o m e rk n ow i n a d va n c e t h e c o m p a ny ’s c r e d i t t e r m s . T h e c r e d i t a g r e e m e n t m u s t b e i n w r i t i n g a n ds h o u l d s p e c i f y a c u s t o m e r ’s c r e d i t l i m i t ( w h i c h u s u a l l y va r i e s f r o m o n e c u s t o m e r t o a n o t h e r,d e p e n d i n g o n t h e i r c r e d i t r a t i n g s ) a n d a ny d e p o s i t s r e q u i r e d ( o f t e n s t a t e d a s a p e r c e n t a g e o ft h e p u r c h a s e p r i c e ) . I t s h o u l d s t a t e c l e a r l y a l l o f t h e t e r m s t h e bu s i n e s s w i l l e n f o r c e i f t h e a c-c o u n t g o e s b a d , i n c l u d i n g i n t e r e s t , l a t e c h a rg e s , a t t o r n ey ’s f e e s , a n d o t h e r s . Fa i l u r e t o s p e c i f yt h e s e t e r m s i n t h e c o n t r a c t m e a n s t h ey c a n n o t b e a d d e d l a t e r a f t e r p r o b l e m s a r i s e . W h e n w i l ly o u s e n d i nvo i c e s ? H ow s o o n i s p a y m e n t d u e : i m m e d i a t e l y, 3 0 d a y s , 6 0 d a y s ? Wi l l y o u o ff e re a r l y - p a y m e n t d i s c o u n t s ? Wi l l y o u a d d a l a t e c h a rg e ? I f s o , h ow m u c h ? T h e c r e d i t p o l i c i e ss h o u l d b e a s t i g h t a s p o s s i b l e bu t r e m a i n w i t h i n f e d e r a l a n d s t a t e c r e d i t l aw s . A c c o r d i n g t o t h eA m e r i c a n C o l l e c t o r s A s s o c i a t i o n , i f a bu s i n e s s i s w r i t i n g o ff m o r e t h a n 5 p e r c e n t o f s a l e s a sb a d d e b t s , t h e ow n e r s h o u l d t i g h t e n i t s c r e d i t a n d c o l l e c t i o n p o l i cy.22

The third step in an eff e c t ive credit policy is to send invoices promptly because customersrarely pay before they receive their bills. The sooner a company sends invoices, the sooner itscustomers will send payments. Manufacturers and wholesalers should make sure the invoice isen route to the customer as soon as the shipment goes out the door (if not before). Service com-panies should keep track of billable hours daily or weekly and bill as often as the contract oragreement with the client permits. Some businesses use cycle billing, in which a company billsa portion of its credit customers each day of the month to smooth out uneven cash receipts.

Small business owners can take several steps to encourage prompt payment of invoices:

j Ensure that all invoices are clear, accurate, and timely.j State clearly a description of the goods or services purchased and an account number,

if possible.j Make sure that prices on invoices agree with the price quotations on purchase orders

or contracts.j Highlight the terms of sale (e.g., “net 30”) on all invoices. One study by Xerox

Corporation found that highlighting the “balance due” section of invoices increasedthe speed of collection by 30 percent.23

j Include a telephone number and a contact person in your organization in case thecustomer has a question or a dispute.

j Respond quickly and accurately to customers’ questions about their bills.

Invoices that are well organized, easy to read, and allow customers to identify what is be-ing billed are much more likely to get paid than those that are not. The key to creating “user-friendly” invoices is to design them from the customer’s perspective.




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W h e n a n a c c o u n t b e c o m e s ove r d u e , e n t r e p r e n e u r s m u s t t a ke i m m e d i a t e a c t i o n . T h el o n g e r a n a c c o u n t i s p a s t d u e , t h e l ow e r i s t h e p r o b a b i l i t y o f c o l l e c t i n g i t . A s s o o n a s a n a c-c o u n t b e c o m e s ove r d u e , m a ny bu s i n e s s ow n e r s s e n d a “ s e c o n d n o t i c e ” l e t t e r r e q u e s t i n g i m-m e d i a t e p a y m e n t . I f t h a t fa i l s t o p r o d u c e r e s u l t s , t h e n ex t s t e p i s a t e l e p h o n e c a l l . A b e t t e rs y s t e m i s t o c a l l t h e c u s t o m e r t h e d a y a f t e r t h e p a y m e n t i s d u e t o r e q u e s t p a y m e n t . I f t h e c u s-t o m e r s t i l l r e f u s e s t o p a y t h e b i l l a f t e r 3 0 d a y s , c o l l e c t i o n ex p e r t s r e c o m m e n d t h e f o l l ow i n g :

j Send a letter from the company’s attorney.j Turn the account over to a collection agency.j Hire a collection attorney.

A l t h o u g h c o l l e c t i o n a g e n c i e s a n d a t t o r n ey s w i l l t a ke a p o r t i o n o f a ny a c c o u n t s t h ey c o l l e c t( t y p i c a l l y a r o u n d 3 0 p e r c e n t ) , t h eya r e o f t e n wo r t h t h e p r i c e . C o l l e c t i o n a g e n c i e s c o l l e c t m o r et h a n $ 3 9 . 3 b i l l i o n a n n u a l l y f o r bu s i n e s s e s .2 5 A c c o r d i n g t o t h e A m e r i c a n C o l l e c t o r ’s A s s o c i-a t i o n , o n l y 5 p e r c e n t o f a c c o u n t s ove r 9 0 d a y s d e l i n q u e n t w i l l b e p a i d vo l u n t a r i l y.2 6

B u s i n e s s ow n e r s m u s t b e s u r e t o a b i d e b y t h e p r ov i s i o n s o f t h e f e d e r a l Fa i r D e b t C o l l e c-t i o n P r a c t i c e s A c t , w h i c h p r o h i b i t s a ny k i n d o f h a r a s s m e n t w h e n c o l l e c t i n g d e b t s ( e . g . , t e l e-p h o n i n g r e p e a t e d l y, i s s u i n g t h r e a t s o f v i o l e n c e , t e l l i n g t h i r d p a r t i e s a b o u t t h e d e b t , o r u s i n ga bu s ive l a n g u a g e ) . W h e n c o l l e c t i n g p a s t - d u e a c c o u n t s , t h e p r i m a r y r u l e i n d e a l i n g w i t h c u s-t o m e r s i s , “ N eve r l o s e y o u r c o o l .” E ve n i f t h e d e b t o r l a u n c h e s i n t o a n X - r a t e d t i r a d e w h e nq u e s t i o n e d a b o u t a n ove r d u e b i l l , t h e w o rs t t h i n g a c o l l e c t o r c a n d o i s r e s p o n d o u t o f a n g e r.Ke e p t h e c a l l s t r i c t l y bu s i n e s s , a n d b eg i n b y i d e n t i f y i n g y o u r s e l f , y o u r c o m p a ny, a n d t h ea m o u n t o f t h e d e b t . A s k t h e c r e d i t o r w h a t h e o r s h e i n t e n d s t o d o a b o u t t h e p a s t - d u e b i l l .

TECHNIQUES FOR ACCELERATING ACCOUNTS RECEIVABLE. Small business ownerscan rely on a variety of techniques to speed cash inflow from accounts receivable:

j Speed up orders by having customers fax them to you.j Subscribe to an electronic check conversion service that not only transfers purchase

amounts immediately from customers’ accounts to the company’s account but alsominimizes losses from check fraud.

j Send invoices when goods are shipped rather than a day or a week later; considerfaxing or e-mailing invoices to reduce “in transit” time to a minimum.

j Indicate in conspicuous print or color the invoice due date and any late paymentpenalties imposed. (Check with an attorney to be sure all finance charges complywith state laws.)

j Restrict the customer’s credit until past-due bills are paid. Salespeople should knowwhich of their customers are behind in their payments. If not, they will continue tosell (most likely on credit) to those delinquent customers!

j Deposit customer checks and credit card receipts daily.j Identify the top 20 percent of your customers (by sales volume), create a separate file

system for them, and monitor them closely. Twenty percent of the typical company’scustomers generate 80 percent of all accounts receivable.

j Ask customers to pay a portion of the purchase price up front. Tired of chasing latepayers after completing their public relations projects, Mike Clifford, founder ofC l i fford Public Relations, began checking potential clients’ credit ratings andrequiring an up-front payment of one-third of the cost of a job. Clifford also instituteda monthly billing system that tracks billable hours and related expenses. Sinceimplementing the new system, Clifford has not experienced a single past-duea c c o u n t .27

j Wa t c h f o r s i g n s t h a t a c u s t o m e r m a y b e a b o u t t o d e c l a r e b a n k r u p t cy. L a t e p a y m e n t sf r o m p r ev i o u s l y prompt payers a n d u n r e t u r n e d p h o n e c a l l s c o n c e r n i n g l a t e p a y m e n t s

tieth day of the billing period to determine whether the customer is satisfied with the com-pany’s performance on the order. Before closing, he reminds the customer of the invoicedue date and asks if there will be any problems meeting it. Dempster’s proactive approachto collecting receivables has cut his company’s average collection period by at least 15days, improved cash flow, and increased customer satisfaction!24




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u s u a l l y a r e t h e fi r s t c l u e s t h a t a c u s t o m e r m a y b e h e a d i n g f o r b a n k r u p t cy. I f t h a th a p p e n s , c r e d i t o r s t y p i c a l l y c o l l e c t o n l y a s m a l l f r a c t i o n , o n ave r a g e j u s t 1 0 p e r c e n t ,o f t h e d e b t ow e d .28 C y n t h i a M c K a y, ow n e r o f a L e G o u r m e t G i f t B a s ke t f r a n c h i s el o s t t h o u s a n d s o f d o l l a r s w h e n five o f h e r c o r p o r a t e c l i e n t s fi l e d f o r b a n k r u p t cyw i t h i n a 1 0 - m o n t h p e r i o d . “ T h a t m o n ey i s a w e e k l y p a y r o l l f o r s eve r a l e m p l oy e e s ,”s a y s M c K a y.29

j If a customer does file for bankruptcy, the bankruptcy court notifies all creditors witha “Notice of Filing” document. If an entrepreneur receives one of these notices, he orshe should create a file to track the events surrounding the bankruptcy and takeaction immediately. To have a valid claim against the debtor’s assets, a creditor mustfile a proof-of-claim form with the bankruptcy court within a specified time, often90 days. (The actual time depends on which form of bankruptcy the debtor declares.)If, after paying the debtor’s secured creditors, any assets remain, the court willdistribute the proceeds to unsecured creditors who have legitimate proof-of-claim.

j Consider using a bank’s lockbox collection service (located near customers) toreduce mail time on collections. In a l o c k b o x arrangement, customers sendpayments to a post office box the bank maintains. The bank collects the paymentss everal times each day and deposits them immediately into the company account.The procedure sharply reduces processing and clearing times from the usual two tothree days to just hours, especially if the lockboxes are located close to thec o m p a ny ’s biggest customers’ business addresses. The system can be ex p e n s ive tooperate and is most economical for companies with a high volume of large checks(at least 200 checks each month).

j Track the results of the company’s collection efforts. Managers and key employees(including the sales force) should receive a weekly report on the status of thecompany’s outstanding accounts receivable.

A n o t h e r s t r a t eg y t h a t s m a l l c o m p a n i e s , p a r t i c u l a r l y t h o s e s e l l i n g h i g h - p r i c e d i t e m s , c a nu s e t o p r o t e c t t h e c a s h t h ey h ave t i e d u p i n r e c e iva b l e s i s t o c o u p l e a s e c u r i t y a g r e e m e n t w i t h afi n a n c i n g s t a t e m e n t . T h i s s t r a t eg y fa l l s u n d e r A r t i c l e 9 o f t h e U n i f o r m C o m m e r c i a l C o d e( U C C ) , w h i c h g ove r n s a w i d e va r i e t y o f bu s i n e s s t r a n s a c t i o n s , f r o m t h e s a l e o f g o o d s t o s e c u-r i t y i n t e r e s t s . A s e c u r i t y a g re e m e n t i s a c o n t r a c t i n w h i c h a bu s i n e s s s e l l i n g a n a s s e t o n c r e d i tg e t s a s e c u r i t y i n t e r e s t i n t h a t a s s e t ( t h e c o l l a t e r a l ) , p r o t e c t i n g t h e c o m p a ny ’s l ega l r i g h t s i n c a s et h e bu y e r fa i l s t o p a y. To g e t t h e p r o t e c t i o n i t s e e k s i n t h e s e c u r i t y a g r e e m e n t , t h e s e l l e r m u s tfi l e a fi n a n c i n g s t a t e m e n t c a l l e d a U C C - 1 f o r m w i t h t h e p r o p e r s t a t e o r c o u n t y o ffi c e ( a p r o c e s st h e U C C c a l l s “ p e r f e c t i o n ” ) . T h e U C C - 1 f o r m g ive s n o t i c e t o o t h e r c r e d i t o r s a n d t o t h e g e n e r a lp u b l i c t h a t t h e s e l l e r h o l d s a s e c u r e d i n t e r e s t i n t h e c o l l a t e r a l n a m e d i n t h e s e c u r i t y a g r e e m e n t .T h e U C C - 1 f o r m m u s t i n c l u d e t h e n a m e , a d d r e s s , a n d s i g n a t u r e o f t h e bu y e r ; a d e s c r i p t i o n o ft h e c o l l a t e r a l ; a n d t h e n a m e a n d a d d r e s s o f t h e s e l l e r. I f t h e bu y e r d e c l a r e s b a n k r u p t cy, t h e s m a l lbu s i n e s s t h a t s e l l s t h e a s s e t i s n o t g u a ra n t e e d p a y m e n t , bu t t h e fi l i n g p u t s i t s c l a i m t o t h e a s s e ta h e a d o f t h o s e o f u n s e c u r e d c r e d i t o r s . A s m a l l c o m p a ny ’s d eg r e e o f s a f e t y o n a l a rg e c r e d i t s a l ei s m u c h h i g h e r w i t h a s e c u r i t y a g r e e m e n t a n d a p r o p e r l y - fi l e d fi n a n c i n g s t a t e m e n t t h a n i f i t d o e sn o t fi l e t h e s e c u r i t y a g r e e m e n t .

Accounts PayableThe second element of the “big three” of cash management is accounts payable. The tim-ing of payables is just as crucial to proper cash management as the timing of receivables,but the objective is exactly the opposite. An entrepreneur should strive to stretch outpayables as long as possible without damaging the company’s credit rating. Paying latecould cause suppliers to begin demanding prepayment or C.O.D. (cash on delivery) terms,which severely impair a company’s cash flow. Small business owners should regulate theirpayments to vendors and suppliers to their companies’ advantage. Ideally, a company willpurchase an item on credit, sell it, and collect payment for it before the company must paythe supplier’s invoice. In that case, the vendor’s credit terms amount to an interest-free loan.That is exactly the situation that Dell Inc., the fast-growing computer maker, puts itself in.




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Its extremely high inventory turnover ratio of 76 times a year coupled with its ability to ne-gotiate favorable credit terms with its suppliers and to collect customers’ payments quicklymeans that the company enjoys an industry-leading cash conversion cycle of negative 36days. On average, Dell collects payments from its customers and gets to use that cash be-fore having to pay its suppliers 36 days later (see Figure 8.7)!30

Even when the cash flow timing isn’t ideal, efficient cash managers benefit by settingup a payment calendar each month that allows them to pay their bills on time and to takeadvantage of cash discounts for early payment.

Nancy Dunis, CEO of Dunis & Associates, a Portland, Oregon, marketing firm, recognizesthe importance of controlling accounts payable. “Our payables must be functioning justright to keep our cash flow running smoothly,” says Dunis. She has set up a simple five-point accounts payable system:

1. Set scheduling goals. Dunis strives to pay her company’s bills 45 days after receivingthem and to collect all her receivables within 30 days. Even though “it doesn’t alwayswork that way,” her goal is to make the most of her cash flow.

2. Keep paperwork organized. Dunis dates every invoice she receives and carefully filesit according to her payment plan. “This helps us remember when to cut the check,”she says, and, “it helps us stagger our payments over days or weeks,” significantly im-proving the company’s cash flow.

3. Prioritize. Dunis cannot stretch out all of her company’s creditors for 45 days; somedemand payment sooner. Those suppliers are at the top of the accounts payable list.

4. Be consistent. “Companies want consistent customers,” says Dunis. “With a few ex-ceptions,” she explains, “most businesses will be happy to accept 45-day payments,so long as they know you’ll always pay your full obligation at that point.”

5. Look for warning signs. Dunis sees her accounts payable as an early warning systemfor cash flow problems. “The first indication I get that cash flow is in trouble is whenI see I’m getting low on cash and could have trouble paying my bills according to mystaggered filing system,” she says.31

Nancy Dunis and Dunis& Associates

Business owners should verify all invoices before paying them. Some unscrupulousvendors send out invoices for goods they never shipped, knowing that many bu s i n e s sowners will simply pay the bill without checking its authenticity. Someone in thec o m p a ny—for instance, the accounts payable clerk—should have the responsibility ofverifying every invoice received. In a common scam targeting small businesses, the ac-counts payable clerk at one company caught a bogus invoice for $322 worth of copier pa-per and toner it never ordered nor receive d .3 2

Generally, it is beneficial for owners to take advantage of cash discounts vendors offer.A cash discount (e.g., “2/10, net 30”—take a 2 percent discount if you pay the invoicewithin ten days; otherwise, total payment is due in 30 days) offers a price reduction if theowner pays an invoice early. The savings the discount provides usually exceed the cost ofgiving up the use of a company’s cash by paying early.

FIGURE 8.7 Dell Inc.’s Cash Conversion Cycle




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J e ff Schre i b e r, owner of Hansen Wholesale, a company that distributes home products, is inthe habit of taking advantage of the cash discounts vendors offer his company. In one yearalone, Schre i b e r, whose company generates $3.5 million in annual sales, saved $15,000 withcash discounts. “Your money works better if you take advantage of the discounts,” saysS c h re i b e r.3 3

Jeff Schreiber andHansen Wholesale

Clever cash managers also negotiate the best possible credit terms with their suppliers.Almost all vendors grant their customers trade credit, and entrepreneurs should take ad-vantage of it. However, because trade credit is so easy to get, entrepreneurs must be care-ful not to abuse it, putting their businesses in a precarious financial position. Favorablecredit terms can make a tremendous difference in a firm’s cash flow. Table 8.5 shows thesame most likely cash budget (from Table 8.2) with one exception: Instead of purchasingon C.O.D. terms (Table 8.2), the owner has negotiated “net 30” payment terms (Table 8.5).Notice the drastic improvement in this small company’s cash flow that results from the im-proved credit terms.

If owners do find themselves financially strapped when payment to a vendor is due, theyshould avoid making empty promises that “the check is in the mail.” Instead, they should dis-cuss openly the situation with the ve n d o r. Most suppliers are willing to work out payment termsfor extended credit. One small business owner who was experiencing a cash crisis claims:

One day things got so bad I just called up a supplier and said, ‘I need your stuff, butI’m going through a tough period and simply can’t pay you right now.’ They said

TABLE 8.5 Case Budget,a Most Likely Sales Fore c a s t

Jan. Feb. Mar. Apr.

Cash Receipts:Sales $150,000 $200,000 $200,000 $300,000Credit Sales 112,500 150,000 150,000 225,000Collections:60%—1st month after sale $180,000 $ 67,500 $ 90,000 $ 90,00030%—2nd month after sale 78,750 90,000 33,750 45,0005%—3rd month after sale 11,250 13,125 15,000 5,625Cash Sales 37,500 50,000 50,000 75,000Interest 0 200 0 0

Total Cash Receipts $307,500 $220,825 $188,750 $215,625Cash Disbursements:

Purchasesa $105,000 $140,000 $140,000 $210,000Rent 2,000 2,000 2,000 2,000Utilities 850 850 850 850Interest 0 0 7,500, 0Tax Prepayment 0 0 50,000 0Capital Addition 0 130,000 3 0Miscellaneous 70 70 70 70Wage/Salaries 30,000 40,000 45,000 50,000

Total Cash Disbursementsa $137,920 $312,920 $245,420 $262,920End-of-Month Balance:Cash (beginning of month)a $ 12,000 $181,580 $ 89,485 $ 32,815

1Cash Receipts 307,500 220,825 188,750 215,625

2Cash Disbursementsa 137,920 312,920 245,420 262,920

Cash (end of month)a 181,580 89,485 32,815 (14,480)Borrowing 0 0 0 24,480Cash (end of month [after borrowing])a $181,580 $ 89,485 $32,815 $ 10,000

aAfter negotiating “net 30” trade credit terms.




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they wanted to keep me as a customer, and they asked if it was okay to bill me inthree months. I was dumbfounded: They didn’t even charge me interest.34

Entrepreneurs also can improve their firms’ cash flow by scheduling controllable cashdisbursements so that they do not come due at the same time. For example, paying em-ployees every two weeks (or every month) rather than every week reduces administrativecosts and gives the business more time to use its available cash. Owners of fledgling busi-nesses may be able to conserve cash by hiring part-time employees or by using freelanceworkers rather than full-time, permanent workers. Scheduling insurance premiums monthlyor quarterly rather than annually also improves cash flow.

InventoryI nve n t o r y i s a s i g n i fi c a n t i nve s t m e n t f o r m a nys m a l l bu s i n e s s e s a n d c a n c r e a t e a s eve r e s t r a i no n c a s h f l ow i f n o t m a n a g e d p r o p e r l y. A l t h o u g h i nve n t o r y r e p r e s e n t s t h e l a rg e s t c a p i t a l i n-ve s t m e n t f o r m o s t bu s i n e s s e s , m a nye n t r e p r e n e u r s d o n o t u s e f o r m a l m e t h o d s f o r m a n a g i n gi t . A s a r e s u l t , t h e t y p i c a l s m a l l bu s i n e s s n o t o n l y h a s t o o m u c h i nve n t o r y bu t a l s o t o o m u c ho f t h e w r o n g k i n d o f i nve n t o r y ! B e c a u s e i nve n t o r y i s i l l i q u i d , i t c a n q u i c k l y s i p h o n o ff a c o m-p a ny ’s p o o l o f ava i l a b l e c a s h . S m a l l bu s i n e s s e s n e e d c a s h t o g r ow a n d t o s u r v ive , w h i c h i sd i ffi c u l t t o d o i f t h eyh ave m o n ey t i e d u p i n ex c e s s i nve n t o r y, w h i c h y i e l d s a z e r o r a t e o f r e-t u r n . “ T h e c o s t o f c a r r y i n g i nve n t o r y i s ex p e n s ive ,” s a y s o n e s m a l l bu s i n e s s c o n s u l t a n t . “At y p i c a l m a n u fa c t u r i n g c o m p a ny p a y s 2 5 p e r c e n t t o 3 0 p e r c e n t o f t h e va l u e o f t h e i nve n t o r yf o r t h e c o s t o f b o r r ow e d m o n ey, wa r e h o u s e s p a c e , m a t e r i a l s h a n d l i n g , s t a ff , l i f t - t r u c k ex-p e n s e s , a n d fi xe d c o s t s . T h i s s h o c k s a l o t o f p e o p l e . O n c e t h ey r e a l i z e i t , t h eyl o o k a t i nve n-t o r y d i ff e r e n t l y.”3 5 Tr a c k i n g i nve n t o r y c o n s i s t e n t l y e n a b l e s a bu s i n e s s ow n e r t o avo i dp u r c h a s i n g o r m a n u fa c t u r i n g g o o d s u n n e c e s s a r i l y. E x p e r i e n c e d e n t r e p r e n e u r s o f t e n m a i n-t a i n d i ff e r e n t l eve l s o f i nve n t o r y f o r d i ff e r e n t i t e m s d e p e n d i n g o n h owc r i t i c a l t h ey a r e t o t h ec o m p a ny ’s o p e r a t i o n a n d o n h ow q u i c k l y t h ey c a n b e r e p l e n i s h e d . Fo r i n s t a n c e , t h e ow n e ro f o n e s m a l l l a n d s c a p e c o m p a ny k n ew t h a t h a r d wo o d m u l c h wa s o n e o f h i s b e s t - s e l l i n gi t e m s i n t h e s p r i n g , bu t h e r e f u s e d t o p u r c h a s e ex c e s s ive a m o u n t s o f i t b e c a u s e h i s p r i m a r ys u p p l i e r wa s n e a r b y a n d c o u l d d e l ive r m u l c h w i t h i n t wo h o u r s o f r e c e iv i n g a n o r d e r.

Marking down items that don’t sell will keep inventory lean and allow it to turn overfrequently. Even though volume discounts lower inventory costs, large purchases may tieup the company’s valuable cash. Wise business owners avoid overbuying inventory, recog-nizing that excess inventory ties up valuable cash unproductively. In fact, only 20 percentof a typical business’s inventory turns over quickly, so owners must watch constantly forstale items.3 6 Carrying unsold inventory costs U.S. businesses an estimated $332 billion ayear.3 7

Carrying too much inventory increases the chances that a business will run out of cash.

When Tom Meredith joined Dell Inc. as its chief financial off i c e r, he quickly discovered thatexcessive inventory was a major source of the cash flow problems the company was expe-riencing at the time. Because the company was focusing on growth, it held large invento-ries of costly computer components to make sure it could meet every sales opportunity.M e re d i t h ’s top priority in his first few months at Dell was to cut inventory levels. “Low in-ventory equals high profit; high inventory equals low profit,” he declares. Because the in-ventory that Dell carries becomes technologically obsolete so rapidly, losing 1 percent of itsvalue each week, high inventory levels increase the likelihood of wasted cash.3 8

Dell Inc.

In addition to the cost of the inventory itself, the activities required to purchase, store,m o n i t o r, and control inventory are themselves costly. Efficient cash management calls fora business to commit just enough cash to inventory to meet demand. Paring down thenumber of suppliers enables a business to gain more bargaining pow e r, minimize paper-work, and perhaps earn quantity discounts. Scheduling inventory deliveries at the latestpossible date will prevent premature payment of invoices. Finally, given goods of com-parable quality and price, entrepreneurs should purchase goods from those suppliers whoare best at making fast, frequent deliveries to keep inventory levels low.


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n Watch Those Accounts Receivable!

When Randy Ringer developed the cash flow forecastsfor the business plan he created for Verse Group, a NewYork City-based marketing and branding company, heassumed that the company’s clients would pay their in-voices in 30 days. As Ringer and his business partnerlearned more about the industry, however, they discov-ered that companies in their industry typically did not seeany cash flow until 60 or more days after completing a

job and billing the client. They quickly revised their busi-ness plan and increased the minimum cash balance theywould keep on hand from three months’ worth of ex-penses to six months’ worth. They also established a pol-icy that requires clients to prepay a portion of anyprojects that require Verse Group to pay substantial up-front costs. Their industry’s collection patterns “havechanged the way we do business,” says Ringer.

Do you know the typical collection pattern for ac-counts receivable for the industry in which you are aboutto launch a business? Not knowing this important num-ber could create significant cash flow problems for yourcompany and even cost you your business. The follow-

Days’ Payables Outstanding by Industry

Industry DPO Industry DPO

Aerospace and defense 29.5 Industrial technology 26.5Airlines 16.5 Industrial diversified 28.1Apparel retailers 22.4 Land transportation 28.0Auto manufacturers 49.9 Machinery makers 39.6Auto parts and suppliers 38.3 Medical devices 17.5Biotechnology 15.8 Medical supplies 20.2Building materials 26.3 Newspaper publishers 14.0Chemicals, commodity 29.6 Oil drilling 32.1Chemicals, specialty 30.0 Oil secondary 37.9Clothing, fabrics 27.6 Other food 19.5Communications technology 30.0 Other industrial and commercial services 16.0Computer makers 38.7 Other oil equipment and services 32.8Consumer and household services 10.7 Other recreational services 16.8Containers and packaging 33.3 Other specialty retailers 27.0Distributors 39.4 Paper and forest 23.0Drug retailers 27.3 Pharmaceuticals 18.0Electrical components 33.1 Pipelines 41.2Food producers 19.9 Restaurants 13.2Food retailers 16.5 Retailers, broadline 27.5Footwear 21.6 Semiconductors 22.8Healthcare providers 12.2 Soft drinks 18.0Heavy construction 28.4 Software 10.8Home construction 19.3 Steel 26.6Home furniture 18.1 Telecom operators 21.1Household products, nondurable 25.5 Trucking 13.2

ing table shows the day’s payable outstanding (DPO) ra-tio (which is calculated by dividing 365 days per year by

the industry’s average collection period ratio).

S p o t l i g h tIn the Entrepreneurial

Palette_X_Sample.QXD 2/16/09 3:20 PM 4



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Monitoring the big three of cash management can help every business owner avoid acash crisis while making the best use of available cash. According to one expert, maximiz-ing cash flow involves “getting money from customers sooner; paying bills at the last mo-ment possible; consolidating money in a single bank account; managing accounts payable,accounts receivable, and inventory more effectively; and squeezing every penny out of yourdaily business.”39

Avoiding the Cash CrunchN e a r l y eve r y s m a l l bu s i n e s s h a s t h e p o t e n t i a l t o i m p r ove i t s c a s h p o s i t i o n w i t h l i t t l e o r n o i n-ve s t m e n t . T h e key i s t o m a ke a n o b j e c t ive eva l u a t i o n o f a c o m p a ny ’s fi n a n c i a l p o l i c i e s , s e a r c h-i n g f o r i n e ffi c i e n cy i n i t s c a s h f l ow a n d for wa y s t o s q u e e z e m o r e c a s h o u t o f t h e i r o p e r a t i o n s .Yo u n g fi r m s c a n n o t a ff o r d t o wa s t e r e s o u r c e s , e s p e c i a l l y o n e a s v i t a l a s c a s h . B y u t i l i z i n g t h e s et o o l s , a n e n t r e p r e n e u r c a n g e t m a x i m u m b e n e fi t f r o m t h e c o m p a ny ’s p o o l o f c a s h .

BarterBartering, the exchange of goods and services for other goods and services, is an effectiveway to conserve cash. An ancient concept, bartering began to regain popularity during re-cent recessions. More than 500 barter exchanges operate across the United States, catering

Note that a customer in the software industry with aDPO of 16 days would raise a red flag, but a customer inthe pipeline business with a DPO of 36 days is paying itsbills faster than the industry average.

What can entrepreneurs who operate businesses inindustries characterized by longer payment periods doto protect their companies’ cash flow? The following tipswill help:

j Increase your company’s cash reserves. Just asRandy Ringer did, entrepreneurs should plan tokeep more cash on hand from the beginning toavoid being caught short. In addition, smart entre-preneurs establish a line of credit with a bank orother lending institution just in case they en-counter a cash crisis. Note: The time to establish aline of credit is well before you need it!

j Establish your company’s credit and collection pol-icy, tell your customers about it, and stick to it asclosely as possible. Doing so gives you more lever-age when customers fall behind on their pay-ments, as they inevitably will.

j Monitor accounts receivable regularly—daily, ifnecessary. Before Mike Edwards, founder of 5Stones Group, a film production company based inColumbus, Ohio, starts a project, he creates con-tracts that require clients to pay one-third of theprice up front, one-third at mid-project, and one-third on completion. Still, to keep his company’scash flow positive, Edwards and his wife Tiffany,who manages 5 Stones Group’s finances, have to

monitor clients’ accounts closely. “If the client saysthat [he] will make a payment next Friday, youhave to call next Friday,” he says. “You have tocontinually track payments.”

j Consider offering discounts for early payment.These discounts, called cash discounts, will reducea small company’s total revenue, but that cost of-ten is more than offset by the benefits of speedingup cash inflows.

j If customers still won’t comply with your terms,consider raising prices. That’s what Mitch Miller,president of Dynamic Computer Solutions ofTopeka (DCST), a computer systems integrator thatgenerates $3 million in annual sales, did when sev-eral of his long-time customers decided to paytheir invoices in 45 days instead of the 20 days inDCST’s selling terms. Although a few clients men-tioned the price increase, none left. “You have tobe bold,” says Miller.

1. Why is it so important for small companies tomonitor their accounts receivable? What are theimplications for companies that fail to do so?

2. Contact a local entrepreneur whose company sellsgoods or services on credit. Ask him or her toexplain the company’s credit and collection policy.Are slow-paying customers a problem? How doesthe company deal with customers whose accountsare past due?

3. Why are some entrepreneurs hesitant to take boldactions to collect the money that customers owe

5. Explain the techniques foravoiding a cash crunch in a smallcompany.




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primarily to small- and medium-sized businesses and many of them operating on the WorldWide Web. Some 400,000 companies, most of them small, engage in bartering transactionsworth more than $9 billion each year, trading everything from accounting services and com-puters to carpets and meals.40 Every day, entrepreneurs across the nation use bartering tobuy much needed materials, equipment, and supplies—without using cash. The presidentof one barter exchange estimates that business owners can save “between $5,000 and$150,000 in yearly business costs.”41 In addition to conserving cash, companies using bar-tering can transform slow-moving and excess inventory into much-needed goods and ser-vices. Often business owners who join barter exchanges find new customers for theproducts and services they sell.

Of course, there is a cost associated with bartering, but the real benefit is that entre-preneurs “pay” for products and services at their wholesale cost of doing business and getcredit in the barter exchange for the retail price. In a typical arrangement, businesses accu-mulate trade credits when they offer goods or services through the exchange. Then they canuse their trade credits to purchase other goods and services from other members of the ex-change.

Carlos Collins, president of CCI Industries, a Chicago-based wholesaler of sterling silverjewelry, says that bartering has saved his company thousands of dollars. “I use the barterdollars to purchase advertising for my business. Bartering allows CCI to “purchase muchmore advertising than I could afford to buy with cash. [Bartering is] one of the best thingsto happen to my business,” says Carlos.42

Carlos Collins and CCI Industries

The typical exchange charges a $500 membership fee and a 10 percent transaction fee(5 percent from the buyer and 5 percent from the seller) on every deal. The exchange tracksthe balance in each member’s account and typically sends a monthly statement summariz-ing account activity. Rather than join a barter exchange, many enterprising entrepreneurschoose to barter on an individual basis. The natural place to start is with the vendors, sup-pliers, and customers with whom a company normally does business.

Trim Overhead CostsHigh overhead expenses can strain a small company’s cash supply to the breaking point.Frugal small business owners can trim their overhead in a number of ways:

WHEN PRACTICAL, LEASE INSTEAD OF BUY. Of the $850 million that U.S. businessesspend annually on productive assets, 27 percent is obtained through leases.43 By leasing au-tomobiles, computers, office equipment, machinery, and other assets rather than buyingthem, entrepreneurs can conserve valuable cash. The value of such assets is not in owningthem but in using them. Leasing is popular among entrepreneurs because of its beneficialeffects on a company’s cash flow; a study by the Equipment Leasing Association found that80 percent of U.S. businesses use leasing as a cash management strategy.44 Leasing alsogives business owners maximum flexibility when acquiring equipment and protectionagainst the risk of purchasing assets that become obsolete quickly.

Andy Fleischer, chief financial officer of the Web hosting business Alabanza Corporation,recently switched from purchasing the company’s servers to leasing them. Not only doesleasing conserve the fast-growing company’s precious cash, but it also enables it to keepits technology up-to-date, a vital factor given the nature of Alabanza’s business. “In thepast, we bought large blocks of servers up front,” explains Fleischer. Leasing, however, al-lows Alabanza to spread the payment terms over 36 months, freeing up sizable amountsof cash the company can use elsewhere.45

Andy Fleischer andAlabanza Corporation

Although total lease payments often are greater than those for a conventional loan,most leases offer 100 percent financing, which means the owner avoids the large capital out-lays required as down payments on most loans. Also, leasing is an “off-the-balance-sheet”




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TABLE 8.6 Lease, Borro w, or Pay Cash?

When faced with the need to purchase equipment, many entrepreneurs wonder whether theyshould choose to lease the asset, borrow the money, or use the company’s available cash topurchase it. The following table describes some of the characteristics of each option.

Characteristic Lease Loan Cash

Capital Cost Net present value oflease payments typi-cally is less thanoriginal equipmentcost

Equipment cost plusinterest expense

Equipment cost plusopportunity cost oftying up cash

Initial Cash Outlay Small or no downpayment

Significant downpayment

100% of equipmentcost

Payments Fixed monthly payments

Fixed monthly payments

None. Entire costpaid up front

Impact on Borrowing Capacity

None Reduced borrowingcapacity

None

Risk of Obsolescence Low. Company returns equipmentto lessor at end of lease

High. Companyowns equipment af-ter repaying loan

High. Companyowns equipment up front

Tax impact Lease expenses usu-ally deductible as abusiness expense

Interest expenses de-ductible; equipmentdepreciated over time

Equipment depreci-ated over time

Ownership Company does notown asset at end of lease

Company owns assetafter paying off loan

Company owns assetimmediately

Source: Adapted from Hewlett-Packard, “Leasing Gives You More IT Bang for Your Buck,”www3.hp.com/news_article.php?topiccode=20061212.

method of financing; the lease is considered an operating expense on the income statement,not a liability on the balance sheet. Thus, leasing conserves not only a company’s cash flowbut also its borrowing capacity. Leasing companies typically allow businesses to stretchpayments over a longer time period than those of a conventional loan. Lease agreementsalso are flexible; entrepreneurs can customize their lease payments to coincide with the sea-sonal fluctuations in their companies’ cash balances.

Entrepreneurs can choose from two basic types of leases: operating leases and capitalleases. At the end of an operating lease, a business turns the equipment back over to theleasing company with no further obligation. Businesses often lease computer and telecom-munications equipment through operating leases because it becomes obsolete so quickly.At the end of a capital lease, a business may exercise an option to purchase the equipment,usually for a nominal sum. Table 8.6 compares the characteristics of leasing, borrowing,and paying cash for business assets.

AVOID NONESSENTIAL OUTLAYS. Smart entrepreneurs spend cash only when it is nec-essary. By forgoing costly ego indulgences such as ostentatious office equipment, first-classtravel, and flashy company cars, business owners can make efficient use of their companies’cash. Before putting scarce cash into an asset, every business owner should put the decisionto the acid test by asking “What will this purchase add to the company’s ability to competeand to become more successful?” Making across-the-board spending cuts to conserve cashis dangerous, however, because the owner runs the risk of cutting expenditures that literallydrive the business. One common mistake during business slowdowns is cutting marketingand advertising expenditures. “As competitors pull back,” says one adviser, “smart mar-keters will keep their ad budgets on an even keel, which is sufficient to bring increased at-tention to their products.”46 The secret to success is cutting nonessential expenditures. “If




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the lifeblood of your company is marketing, cut it less,” advises one advertising executive.“If it is customer service, that is the last thing you want to cut back on. Cut from areas thatare not essential to business growth.”47

NEGOTIATE FIXED LOAN PAYMENTS TO COINCIDE WITH YOUR COMPANY’S CASHFLOW CYCLE. Many banks allow businesses to structure loans so that they can skip spe-cific payments when their cash flow ebbs to its lowest point. Negotiating such terms givesbusinesses the opportunity to customize their loan repayments to their cash flow cycles. Forexample, Ted Zoli, president of Torrington Industries, a construction-materials supplier andcontracting business, consistently uses “skipped payment loans” in his highly seasonal busi-ness. “Every time we buy a piece of construction machinery,” he says, “we set it up so thatwe’re making payments for eight or nine months, and then skipping three or four monthsduring the winter.”48

BUY USED OR RECONDITIONED EQUIPMENT, ESPECIALLY IF IT IS “BEHIND-THE-SCENES” MACHINERY. M a ny shrewd entrepreneurs purchase their office furniture at fleam a r kets and garage sales! One restaurateur saved significant amounts of cash in the start-upphase of his business by purchasing used equipment from a restaurant equipment broke r.

Mark Eshelman, cofounder of Smarte Solutions Inc., a company that markets anti-piracysoftware, purchases the diverse array of computers he needs to test the company’s soft-ware from a used PC Web site. He was so impressed with the deal he got on those sys-tems that he purchased another 30 used computers at drastically reduced prices for hisprogrammers and office staff to use.49

Mark Eshelman andSmarte Solutions Inc.

LOOK FOR SIMPLE WAYS TO CUT COSTS. Smart entrepreneurs are always on the look-out for ways to cut the cost of operating their businesses every day. One useful technique isto sit down with employees periodically with a list of company expenses and brainstormways the company could conserve cash without endangering product quality or customerservice. Ideas might range from installing more energy-efficient equipment to adding morefuel-efficient cars to the company fleet.

HIRE PART-TIME EMPLOYEES AND FREELANCE SPECIALISTS WHENEVER POSSIBLE.Hiring part-timers and freelancers rather than full-time workers saves on both the cost ofsalaries and employee benefits. Robert Ross, president of Xante Corporation, a maker oflaser printer products, hires local college students for telemarketing and customer supportpositions, keeping his recruiting, benefits, and insurance costs down.

OUTSOURCE. One way that many entrepreneurs conserve valuable cash is to outsourcecertain activities to businesses that specialize in performing them rather than hiring some-one to do them in-house (or doing the activities themselves). In addition to saving cash, out-sourcing enables entrepreneurs to focus on the most important aspects of running theirbusinesses.

CONTROL EMPLOYEE ADVANCES AND LOANS. A manager should grant only thosea d vances and loans that are necessary and should keep accurate records on payments andb a l a n c e s .

USE E-MAIL OR FAXES RATHER THAN MAIL. Whenever appropriate, entrepreneursshould use e-mails or faxes rather than mail to communicate with customers, suppliers, andothers to reduce costs.

USE CREDIT CARDS TO MAKE SMALL PURCHASES. Using a credit card to make smallpurchases from vendors who do not offer credit terms allows entrepreneurs to defer pay-ment for up to 30 days. Entrepreneurs who use this strategy must be disciplined, how eve r,and pay off the entire credit card balance each month. Carrying a credit card balance from




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month to month exposes an entrepreneur to annual interest rates of 15 percent to 30 p e r-c e n t —n o t a cash conserving technique!

ESTABLISH AN INTERNAL SECURITY AND CONTROL SYSTEM. Too many owners en-courage employee theft by failing to establish a system of controls. Reconciling the bankstatement monthly and requiring special approval for checks over a specific amount, say$1,000, will help minimize losses. Separating record-keeping and check-writing responsi-bilities, rather than assigning them to a single employee, offers more protection.

D E V E L O P A S Y S T E M T O B AT T L E C H E C K F R A U D . A c c o r d i n g t o t h e A m e r i c a n C o l l e c t o r sA s s o c i a t i o n , A m e r i c a n s w r i t e a b o u t 1 . 7 m i l l i o n b a d c h e c k s e a c h d a y, t o t a l i n g m o r e t h a n $ 5 0m i l l i o n p e r d a y i n b a d c h e c k l o s s e s f o r U . S . bu s i n e s s e s . A b o u t 7 0 p e r c e n t o f a l l “ b o u n c e d ”c h e c k s o c c u r b e c a u s e n i n e o u t o f t e n c u s t o m e r s fa i l t o ke e p t h e i r c h e c k b o o k s b a l a n c e d ; t h er e m a i n i n g 3 0 p e r c e n t o f b a d c h e c k s a r e t h e r e s u l t o f f r a u d . C o m p a n i e s l o s e m o r e t h a n $ 1 0b i l l i o n p e r y e a r b e c a u s e o f f o rg e d o r f r a u d u l e n t c h e c k s .5 0 T h e m o s t e ff e c t ive wa y t o b a t t l eb a d o r f r a u d u l e n t c h e c k s i s t o s u b s c r i b e t o a n e l e c t r o n i c c h e c k a p p r ova l s e r v i c e . T h e s e r v i c ewo r k s a t t h e c a s h r eg i s t e r, a n d a p p r ova l t a ke s a b o u t a m i n u t e . T h e f e e a s m a l l bu s i n e s s p a y st o u s e t h e s e r v i c e d e p e n d s o n t h e vo l u m e o f c h e c k s . Fo r m o s t s m a l l c o m p a n i e s , c h a rg e sr a n g e f r o m a b a s e o f $ 2 5 t o $ 1 0 0 p e r m o n t h p l u s a p e r c e n t a g e o f t h e c l e a r e d c h e c k s ’ va l u e .

CHANGE YOUR SHIPPING TERMS. Changing a company’s shipping terms from “F.O.B.(free on board) buyer,” in which the seller pays the cost of freight, to “F.O.B. seller,” inwhich the buyer absorbs all shipping costs, will improve cash flow.

SWITCH TO ZERO-BASED BUDGETING. Zero-based budgeting (ZBB) primarily is ashift in the philosophy of budgeting. Rather than build the current year budget on increasesfrom the previous year’s budget, ZBB starts from a budget of zero and evaluates the neces-sity of every item. The idea is to start the budget at zero and review all expenses, askingwhether each one is necessary.

START SELLING GIFT CARDS. Prepaid gift cards can be a real boost to a small company’scash flow. Customers pay for the cards up front, but the typical recipient does not redeemthe gift card until later, sometimes much later, giving the company the use of the cash dur-ing that time. Gift cards are appropriate for many businesses, especially those in the retailor service sectors.

INVEST SURPLUS CASH. Because of the uneven flow of receipts and disbursements, acompany will often temporarily have more cash than it needs—for a week, month, quarter,or even longer. When this happens, most small business owners simply ignore the surplusbecause they are not sure how soon they will need it. They believe that relatively smallamounts of cash sitting around for just a few days or weeks are not worth investing. How-ever, this is not the case. Small business owners who put surplus cash to work immediatelyrather than allowing it to sit idle soon discover that the yield adds up to a significant amountover time. This money can help ease the daily cash crunch during business troughs. “Yourgoal . . . should be to identify every dollar you don’t need to pay today’s bills and to keepthat money invested to improve your cash flow,” explains a consultant.51

H ow eve r, when investing surplus cash, an entrepreneur’s primary objective should n o tbe to earn the highest yield (which usually carries with it high levels of risk); instead, thefocus should be on the safety and the liquidity of the investments. Making high-risk in-vestments with a company ’s cash cushion makes no sense and could jeopardize its future.The need to minimize risk and to have ready access to the cash restricts an entrepreneur’si nvestment options to just a few such as money market accounts, zero balance accounts,and sweep accounts. A money market account is an interest-bearing account offered bya variety of financial institutions ranging from banks to mutual funds. Money market ac-counts pay interest while allowing depositors to write checks (most have minimum checkamounts) without tying their money up for a specific period of time. After surviving a cashcrisis shortly after launching their branding and communications company, Jaye Donald-




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son and her partner Chester Makoski now keep enough cash invested in a money marke taccount to cover at least three to six months of ex p e n s e s .5 2

A zero balance account (ZBA) is a checking account that technically never has anyfunds in it but is tied to a master account. The company keeps its money in the master ac-count where it earns interest, but it writes checks on the ZBA. At the end of the day, the bankpays all of the checks drawn on the ZBA; then it withdraws enough money from the masteraccount to cover them. ZBAs allow a company to keep more cash working during the floatperiod, the time between a check being issued and its being cashed. A sweep account au-tomatically “sweeps” all funds in a company’s checking account above a predeterminedminimum into an interest-bearing account, enabling it to keep otherwise idle cash investeduntil it is needed to cover checks.

BE ON THE LOOKOUT FOR EMPLOYEE THEFT. Because small business owners often relyon informal procedures for managing cash (or no procedures at all) and often lack propercontrol procedures, they are most likely to become victims of employee theft, embezzle-ment, and fraud by their employees. Experts estimate that employee theft costs small busi-nesses $40 billion a year and that as much as 75 percent of all employee theft goesunnoticed!53 Although any business can be a victim of employee theft, retailers are partic-ularly vulnerable. Retailers lose 1.5 percent of the value of their merchandise to employeetheft and shoplifting each year.54 One source of the problem is the entrepreneur’s attitudethat “we’re all family here; no one would steal from family.”

K E E P Y O U R B U S I N E S S P L A N C U R R E N T. B e f o r e a p p r o a c h i n g a ny p o t e n t i a l l e n d e r o r i n-ve s t o r, a bu s i n e s s ow n e r m u s t p r e p a r e a s o l i d bu s i n e s s p l a n . S m a r t ow n e r s ke e p t h e i r p l a n s u p -t o - d a t e i n c a s e a n u n ex p e c t e d c a s h c r i s i s f o r c e s t h e m t o s e e k e m e rg e n cyfi n a n c i n g . R ev i s i n gt h e p l a n a n n u a l l y a l s o f o r c e s t h e ow n e r t o f o c u s o n m a n a g i n g t h e bu s i n e s s m o r e e ff e c t ive l y.

ConclusionS u c c e s s f u l ow n e r s r u n t h e i r bu s i n e s s e s “ l e a n a n d m e a n .” Tr i m m i n g wa s t e f u l ex p e n d i t u r e s ,i nve s t i n g s u r p l u s f u n d s , a n d c a r e f u l l y p l a n n i n g a n d m a n a g i n g t h e c o m p a ny ’s c a s h f l ow e n-a b l e t h e m t o c o m p e t e e ff e c t ive l y i n a h o s t i l e m a r ke t . T h e s i m p l e bu t e ff e c t ive t e c h n i q u e s c ov-e r e d i n t h i s c h a p t e r c a n i m p r ove eve r y s m a l l c o m p a ny ’s c a s h p o s i t i o n . O n e bu s i n e s s w r i t e rs a y s , “ I n t h e d a y - t o - d a y c o u r s e o f r u n n i n g a c o m p a ny, o t h e r p e o p l e ’s c a p i t a l f l ow s p a s t a ni m a g i n a t ive C E O a s o p p o r t u n i t y. B y l o o k i n g f o r wa r d a n d ke e p i n g a n a n a l y t i c a l ey e o n y o u rc a s h a c c o u n t a s eve n t s u n f o l d ( r e m e m b e r i n g t h a t i f t h e r e ’s n o r e a l c a s h t h e r e w h e n y o u n e e di t , y o u ’r e h i s t o r y ) , y o u c a n g e n e r a t e l eve r a g e a s s u r e l y a s i f t h a t c a p i t a l w e r e y o u r s t o ke e p .”55

Chapter Review1. Explain the importance of cash management to the success of a small business.

• Cash is the most important but least productive asset the small business has.Entrepreneurs must maintain enough cash to meet a company’s normal operat-ing requirements (plus a reserve for emergencies) without retaining excessivelylarge, unproductive cash balances.

• Without adequate cash, a small business will fail.2. Differentiate between cash and profits.

• Cash and profits are not the same. More businesses fail for lack of cash thanfor lack of profits.

• P r o fit, the difference between total revenue and total expenses, is an account-ing concept. Cash flow represents the flow of actual cash (the only thing bu s i-nesses can use to pay bills) through a business in a continuous cycle. Abusiness can be earning a profit and be forced out of business because it runsout of cash.


3. Understand the five steps in creating a cash budget and use them to build a cashbudget.• The cash budgeting procedure outlined in this chapter tracks the flow of cash

through the business and enables the owner to project cash surpluses and cashdeficits at specific intervals.

• The five steps in creating a cash budget are as follows: forecasting sales, fore-casting cash receipts, forecasting cash disbursements, and determining the end-of-month cash balance.

4. Describe the fundamental principles involved in managing the “Big Three” ofcash management: accounts receivable, accounts payable, and inventory.• Controlling accounts receivable requires business owners to establish clear,

firm credit and collection policies and to screen customers before grantingthem credit. Sending invoices promptly and acting on past-due accountsquickly also improve cash flow. The goal is to collect cash from receivables asquickly as possible.

• When managing accounts payable, an entrepreneur’s goal is to stretch outpayables as long as possible without damaging the company’s credit rating.Other techniques include: verifying invoices before paying them, taking advan-tage of cash discounts, and negotiating the best possible credit terms.

• Inventory frequently causes cash headaches for small business managers. Ex-cess inventory earns a zero rate of return and ties up a company’s cash unnec-essarily. Owners must watch for stale merchandise.

5. Explain the techniques for avoiding a cash crunch in a small company.• Trimming overhead costs by bartering, leasing assets, avoiding nonessential

outlays, using zero-based budgeting, and implementing an internal control sys-tem boost a firm’s cash flow position.

• In addition, investing surplus cash maximizes a company’s earning power. Theprimary criteria for investing surplus cash are security and liquidity.



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Discussion Questions1. Why must small business owners concentrate on ef-

fective cash flow management?2. Explain the difference between cash and profit.3. Outline the steps involved in developing a cash

budget.4. How can an entrepreneur launching a new business

forecast sales?5. Outline the basic principles of managing a small

firm’s receivables, payables, and inventory.6. How can bartering improve a company’s cash

position?7. One entrepreneur says, “We lease our equipment

and technology because our core business is de-ploying it, not owning it.” What does he mean? Is

leasing a wise cash management strategy for smallbusinesses? Explain.

8. What steps should business owners take to con-serve cash in their companies?

9 . W h a t s h o u l d b e a s m a l l bu s i n e s s ow n e r ’s p r i m a r yc o n c e r n w h e n i nve s t i n g s u r p l u s c a s h ?

10. Fritz Maytag, owner of Anchor Steam, says, “Justbecause you are the best around doesn’t mean thatyou have to franchise or even expand. You can stayas you are and have a business that’s profitable andrewarding and a great source of pride.” Do youagree? Do you think that most entrepreneurs wouldagree? Explain.

Managing cash flowis a task that many en-trepreneurs initiallyignore—until theyface a cash crisis.

Cash is the resource that sustains a company, enabling it togrow and survive. Without cash, a business fails. Creating a

cash flow forecast and using it to manage your company iscritical. As this chapter points out, cash and profit are not thesame, and there are aspects of understanding cash flow thatare nonintuitive. In addition to being a valuable planningtool, your cash flow statement can help you assess the futurehealth and potential of your venture. We will review the cashflow aspects of your plan and determine what you can learn

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