Chapter 09 Entrepreneurship by Zubair A Khan.

Chapter 9 - Managing Cash Flow A deficit is what you have when you haven't got as much as a s when you had nothing. --Gerald F. Lieberman

The law of cash flow: No matter how much cash you have coming in, it never comes in soon enough to cover your expenses. --Anonymous Learning Objectives Students will be able to: 1. Explain Explain the importanc importancee of cash managemen managementt to the success success of the small small business business.. 2. Differ Different entiat iatee between between cash cash and and profit profits. s. 3. Understan Understand d the five steps steps in creating creating a cash cash budget budget and use them them to create create a cash budget. budget. 4. Describe Describe fundament fundamental al principles principles involve involved d in managing managing the "Big Three" Three" of cash management management:: accounts receivable, accounts payable, and inventory. 5. Explain Explain the techniq techniques ues for avoidi avoiding ng a cash crunch crunch in in a small compan company. y. Instructor’s Outline I. Introduction A. Cash 1. A four-lett four-letter er word word that has become become a curse curse for for many small businesses businesses.. 2. Developing Developing a cash cash forecast forecast is essentia essentiall for new business businesses es because because in the early early stages stages businesses usually do not generate sufficient cash to keep afloat. 3. Controllin Controlling g the financial financial aspects aspects of of a business business with the techni techniques ques describ described ed in the previous chapter is immensely important. 4. However, However, by themselves themselves,, those techniques techniques are insuffi insufficient cient to achieve achieve business business success success.. Entrepreneurs are prone to focus on their companies' income statements--particularly sales and profits. a) It is entirely entirely possib possible le for a business business to have have a solid balance balance sheet sheet and to make make a profit and still go out of business by running out of cash.

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Cash Management A. Intr Introd oduc ucti tion on 1. Cash management management involve involvess forecasting, forecasting, collectin collecting, g, disbursing disbursing,, investing, investing, and planning planning for the cash a company needs to operate smoothly. 2. Managing Managing cash cash is an importan importantt task becaus becausee cash is the the most import important ant yet least least productive asset that a small business owns. a) A business business must have have enough enough cash to meet meet its obligat obligations ions as they they come due or or it will be declared bankrupt. b) Creditors Creditors,, employees, employees, and lenders lenders expect expect to be paid paid on time, time, and cash is the the required required medium of exchange. 3. But some firms firms retain retain an excessive excessive amount amount of cash cash to meet any unexpec unexpected ted circumst circumstances ances that might arise. 4. Proper cash cash managemen managementt permits permits entrepreneu entrepreneurs rs to adequately adequately meet meet the cash demand demandss of their businesses, to avoid retaining unnecessarily large cash balances, and to stretch the profit-generating power of each dollar their companies own. 5. Small busines businesss owners identif identified ied their their “greatest “greatest financial financial obstacle obstacle”” is “uneven cash cash flow.” 6. Managing Managing cash cash flow is an acute acute problem problem especiall especially y for young, young, rapidly rapidly growin growing g businesses. 181

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Section III Building the Business Plan: Marketing and Financial Considerations Considerations

a) Fast-track Fast-track compani companies es are most likely likely to suffer suffer cash short shortages ages because because they they act like “cash sponges,” soaking up every available dollar and then some. b) The result result is that many successfu successful, l, growing, growing, and profitab profitable le businesses businesses fail fail because they become insolvent; they do not have adequate cash to meet the needs of a growing business with a booming sales volume. c) If a compan company's y's sale saless are up, up, the owner owner also also must: must: (1) hire hire more more employ employees ees (2) expand expand plant plant capaci capacity ty (3) increase increase the sales force (4) build build inv invent entory ory (5) incur incur other drains drains on the the firm's cash cash supply. supply. d) The cash crisis crisis may may force the owner owner to lose lose equity equity control control of the business business or, or, ultimately, declare bankruptcy and close. (1) Table 9.1 describes the five key cash cash management roles roles every entrepreneur entrepreneur must fill. 7. Managi Managing ng cash cash more more effect effective ively: ly: a) First Step: Step: Cash flow flow cycle cycle – the the time time lag between between payin paying g suppliers suppliers for merchand merchandise ise and receiving payment from customers (see Figure 9.1). (1) The longer this this cash flow cycle, cycle, the more likely the business owner is to encounter a cash crisis. (2) Preparing a cash cash forecast that that recognizes this cycle, however, however, will help avoid a crisis. b) Second Second Step: Step: Begin cutting cutting down down the the length length of the the cash flow cycle. cycle. (1) Reducing the cycle cycle from 240 days to, say, 150 days days would free up incredible amounts of cash that this company could use to finance growth and dramatically reduce its borrowing costs. c) See Figure Figure 9.1 for steps steps in reduci reducing ng the length length of cash cash cycle. cycle. III. III.

Cash Cash and and Prof Profit itss Are Are No Not the the Sam Same A. Descr escrib ibed ed 1. Profit (or (or net income) income) is the differen difference ce between between a company's company's total total revenue revenue and its total total expenses. It measures how efficiently the business is r unning. a) As important important as earnin earning g a profit is, is, no business business owner owner can pay creditors creditors,, employees, employees, and lenders in profits; those payments require cash. b) Profits Profits are tied up in in many forms, forms, such as invento inventory, ry, computers computers,, or machinery. machinery. 2. Cash is the the money that that flows throug through h a business business in a continuou continuouss cycle without without being being tied tied up in any other asset. 3. Cash flow flow is the volume volume of of cash that that comes comes into and and goes out out of the busines businesss during during an accounting period. a) Figure Figure 9.2 shows shows the flow flow of cash cash through through a typica typicall small busines business. s. b) Decreases Decreases in cash cash occur when when a business business purchase purchases, s, on credit credit or for cash, cash, goods for inventory or materials for use in production. c) When cash cash is taken in or or when accounts accounts receiva receivable ble are collect collected, ed, the firm's firm's cash balbalance increases. d) Purchases Purchases for invento inventory ry and production production lead lead sales; sales; that is, these these bills typicall typically y must be paid before sales are generated. e) But, collect collection ion of of accounts accounts receivab receivable le lags behind behind sales. sales. However, However, custome customers rs who purchase goods on credit may not pay until a month or later. 4. No business business owner owner can pay credit creditors, ors, employees employees,, and lenders lenders in profits; profits; that that requires requires cash! a) Profits Profits are tied tied up in many many forms, forms, such as inventor inventory, y, computers computers,, or machinery machinery..

Chapter 9 - Managing Cash Flow

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b) Cash is the the money that that flows flows through through a business business in a continuou continuouss cycle withou withoutt being tied up in any other asset. c) A company company can operate operate in in the short short run at at a negative negative profit, profit, but but if its cash cash flow flow is negative, the business is in trouble. d) It can no longer longer pay pay supplier suppliers, s, meet payrol payroll, l, pay its its taxes, taxes, or any other other bills. bills. In short, short, the business is headed for extinction. IV.

Cash Budget A. Descr escrib ibed ed 1. The need for for a cash budget budget arises arises because because in every business business the the cash flowin flowing g in is rarely “in sync” with the cash flowing f lowing out. a) Uneven Uneven flow of of cash creates creates period periodic ic cash surplu surpluses ses and shorta shortages. ges. b) Many owners owners operate operate their their business businesses es without without knowing knowing the the pattern pattern of their cash cash flows, believing that the process is too complex or time consuming. c) Entreprene Entrepreneurs urs must must ensure that that an adequate, adequate, but not not excessive, excessive, supply supply of cash cash is on hand to meet their companies’ operating needs. 2. How How muc much h cas cash h is is eno enoug ugh? h? a) What is suitabl suitablee for one business business may may be totally totally inadequat inadequatee for another, another, dependin depending g on each firm's size, nature, and particular situation. b) The small small business business manager manager should should prepare prepare a cash budget, budget, which which is nothing nothing more more than a "cash map," showing the amount and timing of cash receipts and cash disbursements day by day, week by week. or month by month. c) The cash cash budget budget is used used to predict predict the the amount amount of cash cash the firm firm will need need to operat operatee smoothly over a specific period of time, and it is a valuable tool in managing a company successfully.

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Preparing the Cash Budget A. Intr Introd oduc ucti tion on 1. Typically Typically,, a small business business should should prepar preparee a projected projected monthly monthly cash budget budget for for at least one year into the future and a quarterly estimate several years in advance. 2. It must must cover cover all season seasonal al sales sales fluctu fluctuati ations ons.. a) The more variabl variablee the firm's firm's sales pattern pattern,, the shorter shorter its plannin planning g horizon horizon should should be. 3. Regardless Regardless of the the time frame selecte selected, d, the cash budge budgett must be in writing writing for the the small business owner to properly visualize the firm's cash position. 4. The cash cash budget budget is based based on the cash cash method method of accoun accounting ting,, which means means that that cash receipts and cash disbursements are recorded in the forecast only when the cash transaction is expected to take place. 5. The cash budget budget is nothing nothing more more than a forecast forecast of the the firm's cash cash inflows inflows and outflow outflowss for a specific time period, and it will never be completely accurate. a) It does give give the small small business business manager manager a clear clear picture picture of the firm's firm's estimated estimated cash cash balance for the period, pointing out where external cash infusions may be required or where surplus cash balances may be available for investing. b) By comparing comparing actual actual cash cash flows with with projectio projections, ns, the owner owner can revise revise his forecast forecast so that future cash budgets will be more accurate. 6. Formats Formats for preparing preparing a cash budget budget vary vary depending depending on the the pattern pattern of a company's company's cash cash flow. a) See Table Table 9.2 for for a monthly monthly cash budge budgett for a small small department department store store over over a fourmonth period. 7. There are five five basic basic steps steps in in completi completing ng a cash budge budget: t: a) Determ Determine ine an adeq adequat uatee minimum minimum cash cash balan balance. ce.

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b) b) c) d) e)

Fore Foreca cast st sal sales es.. Fore Foreca cast st cas cash h rec recei eipt pts. s. Foreca Forecast st cash cash disbur disbursem sement ents. s. Determ Determine ine the the end-o end-of-m f-mont onth h cash cash balanc balance. e.

B. Step 1. Determin Determinee an Adequa Adequate te Minimum Minimum Cash Balanc Balancee 1. What is consid considered ered an excessiv excessivee cash balance balance for one small small business business may may be inadequat inadequatee for another, even though the two firms are in the same trade. 2. Some financia financiall analysts analysts suggest suggest that that a firm's cash cash balance balance should should equal equal at least one-fou one-fourth rth of its current debts, but this clearly will not work for all small businesses. 3. The most most reliable reliable method method of decid deciding ing cash cash balance balance is based based on experien experience. ce. C. Step Step 2. 2. Fore Forecas castt Sale Saless 1. The heart heart of the the cash cash budge budgett is the sales sales forecast. forecast. 2. For most busine businesses sses,, sales constitu constitute te the major major source source of the cash flowing flowing into into the the business. 3. The sales sales forecast forecast can be based based on past past sales, sales, but the owner owner must must be careful careful not not to be excessively optimistic in projecting sales. 4. The task task of forecasti forecasting ng sales sales for a new new firm is diffic difficult ult but but not imposs impossible. ible. a) Conduct Conduct research research on simila similarr firms and and their their sales patter patterns ns in the the first year year of operation to come up with a forecast. b) Marketing Marketing research research is another another source source of informatio information n that may be used used to estimate estimate annual sales for the fledgling firm. c) Table 9.3 9.3 gives gives an example example of how one one entrepren entrepreneur eur used used such marketi marketing ng information to derive a sales forecast for f or his first year of operation. 5. Even Even the best best sales sales estim estimate ate will will be be wrong. wrong. a) Many financia financiall analysts analysts suggest suggest that the owner owner create three three estimates--an estimates--an optimi optimistic, stic, a pessimistic, and a most likely sales estimate--and then make a separate cash budget for each forecast. D. Step Step 3. Fore Forecas castt Cash Cash Recei Receipts pts 1. Sales constitu constitute te the the major major source source of cash cash receip receipts. ts. 2. To project project accurately accurately the the firm's firm's cash receipts receipts,, the owner must must analyze analyze the accounts accounts receivable to determine the collection pattern. 3. In addition addition to cash cash and credit credit sales, sales, the small busines businesss may receive receive cash in a number number of forms: interest income, rental income, dividends, and others. 4. Some small small business business owners owners never never discover discover the hidden hidden danger danger in accounts accounts receivab receivable le until it is too late for their companies. a) Receivables Receivables act act as cash sponges sponges,, tying up valuabl valuablee dollars dollars until until the entrepren entrepreneur eur collects them. b) Figure Figure 9.3 demonstrat demonstrates es how vital vital it is to act prompt promptly ly once an account account become becomess past due. c) Table 9.4 9.4 illustrate illustratess the high cost cost of failing failing to collect collect accounts accounts receiva receivable ble on time. time. GAINING A COMPETITIVE EDGE Collecting International Accounts Selling globally is an excellent strategy for boosting sales and profits, but only if you get paid for what you sell! Collecting bills from foreign customers is more difficult than collecting collecting from customers next door. For instance, collecting accounts receivable from U.S. companies takes takes an average of 42 days. Collecting payment from foreign customers usually takes a good deal longer, however.


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Uniform laws giving businesses the right to pursue late payers and to add interest charges to their accounts do not not exist across Europe. Europe. "U.S. companies make a big big mistake when they assume that that they can deal with problem foreign accounts the same way they do [in the United States], says the head of an international collection agency. Before they send thousands of dollars of merchandise halfway around the world, U.S. entrepreneurs must take some basic precautions precautions to make sure their foreign customers customers will pay their bills. bills. The following techniques have worked for many small businesses:     

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Require cash in advance. Purchase export credit insurance. Secure a letter of credit. Research a country's payment norms and creditor protection laws before shipping goods. Conduct thorough credit checks on all prospective foreign customers: Graydon America - http://www.graydonamerica.com o Veritas - http://www.veritas-usa.com/index_eng.html o Whitehall Consultants - http://www.whitehallusa.com/ o the International Trade Administration at the U.S. Department of Commerce will o prepare World Traders Data Reports. Bill only in American dollars and insist on payment in American currency.

E. Step Step 4. Forec Forecast ast Cash Cash Disb Disburs ursemen ements ts 1. Most owners owners of establis established hed business businesses es have a clear clear picture picture of the firm's firm's pattern pattern of cash disbursements. 2. The key factor factor in forecast forecasting ing disburs disbursement ementss for a cash budget budget is to record record them them in the month in which they will be paid, not when the obligation is incurred. 3. A common tenden tendency cy is to underest underestimate imate cash cash disbursem disbursements, ents, which which can result result in a cash cash crisis. a) A cushion cushion is particula particularly rly important important for for entrepreneur entrepreneurss opening opening new business businesses. es. b) Some financia financiall analysts analysts recommend recommend that that a new owner owner estimate estimate cash disburse disbursements ments as best he can and then add on another 25 to 50 percent. 4. One of the most most effective effective techniqu techniques es for overcomi overcoming ng the "I don't don't know where where to begin" begin" hurdle is to make a daily list of the items that generated cash (receipts) and those that consumed it (disbursements). F. Step 5. Determin Determinee the the End-ofEnd-of-Month Month Cash Balance Balance 1. To estimate estimate the firm's firm's cash cash balance balance for each month, month, the small small business business manager manager first first must determine the cash balance at the beginning of each month. 2. The beginnin beginning g cash balanc balancee includes includes cash cash on hand hand as well as as cash in checki checking ng and savings accounts. 3. As developmen developmentt of the cash cash budget budget progress progresses, es, the cash cash balance balance at the the end of a month month becomes the beginning balance for the succeeding month. 4. A firm's cash cash balance balance might fluctu fluctuate ate from month month to month, month, reflectin reflecting g seasonal seasonal sales patterns. a) Such fluctuat fluctuations ions are normal, normal, but but the small small business business owner owner must watch watch closely closely any increases and decreases in the cash balance over time. 5. A cash budget budget not only only illustrat illustrates es the flow of of cash into into and out of the the small busines business, s, but it also allows the owner to anticipate cash shortages and cash surpluses.

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6. By planning planning cash needs needs ahead ahead of time, the the small busines businesss is able to do the the following following:: a) Increase Increase the amount amount and and the speed speed of cash cash flowing flowing into into the company. company. b) Reduce Reduce the amount amount and the the speed speed of cash flowing flowing out of of the company. company. c) Develop Develop a sound borrowing borrowing and repayment repayment program. program. d) Impress Impress lenders lenders and investor investorss with its abili ability ty to plan for for and repay loans. loans. e) Reduce Reduce borrowing borrowing costs by borrowi borrowing ng only only when when necessary necessary..

IN THE FOOTSTEPS OF AN ENTREPRENEUR… Rowena’s Cash Budget

Rowena Rowdy had been in business for slightly more than two years, but she had never taken the time to develop a cash budget for her company. The business was growing fast, with sales more than tripling from the previous year, and profits profits were rising. However, Rowena often found it it difficult to pay all of the company’s bills on time. time. She didn’t know why why exactly, but she knew that the the company’s fast growth was requiring her to incur higher levels of expenses. Below are the information about the company: Current cash balance Sales pattern Collections of credit sales

$10,685 63% on credit and 37% in cash 61% in 1 to 30 days; 27% in 31 to 60 days; 8% in 61 to 90 days; 4% never collected (bad debts).

Sales forecasts: January (actual) February (actual) March (actual) April May June July August September

Pessimis Pess imistic tic ---$19,100 $21,300 $23,300 $23,900 $20,500 $18,500

Utilities expenses Rent Truck loan

Most Likely Like ly $24,780 $20,900 $21,630 $23,550 $24,900 $29,870 $27,500 $25,800 $21,500

Optimisti Optim isticc ---$25,750 $27,300 $30,000 $29,100 $28,800 $23,900

$950 per month. $2,250 per month $427 per month

The company's wages and salaries (including payroll taxes) estimates are: April $3,550 May $4,125 June $5,450 July $6,255 August $6,060 September $3,525 The company pays 66 percent of the sales price for the inventory it purchases, an amount that it actually pays in the following month. (Rowena has negotiated "net 30" credit terms with his suppliers.) suppliers.)


Other expenses include: Insurance premiums Office supplies Maintenance Uniforms/cleaning Office cleaning service Internet and computer service Computer supplies Advertising Legal and accounting fees Miscellaneous expenses

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$1,200, payable in April and September. $125 per month $75 per month $80 per month $85 per month $225 per month $75 per month $450 per month $250 per month $95 per month

A tax payment of $3,140 is due in June. Rowena has established a minimum cash balance of $1,500. If Rowena must borrow money, she uses her line of credit at the bank which charges interest at an annual rate of 10.25%. 10.25%. Any money that Rowena borrows borrows must be repaid the next month.

1. Help Rowena Rowena put put together together a cash cash budget budget for for the six months months beginning beginning in April. April. Answer: Using an Excel template, the students need to create a cash flow analysis. 2. Does it appear appear that that Rowena’s Rowena’s business business will will remain remain solvent, solvent, or could could the company company be heading heading for a cash crisis? Answer: Yes – after calculating the cash flow analysis from the sales forecast, the company will be heading for a cash crisis. 3. What sugge suggestion stionss can you make make to help help Rowena Rowena improve improve her compa company's ny's cash cash flow? flow? vary. Most common answers will will be to cut costs and Answer: Student’s answers may vary. expenses.

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Take advantag advantagee of money-savin money-saving g opportuni opportunities, ties, such such as economic economic order order quantities quantities and cash discounts. g) Make the the most most efficien efficientt use of the the cash available. available. h) Financ Financee season seasonal al busi busines nesss needs needs.. i) Prov Provid idee fund fundss for for exp expan ansi sion on.. j) j) Plan Plan for for inves investi ting ng sur surpl plus us cas cash. h. 7. Manage cash flow effectively effectively,, and the business business works works.. VI.

The "Big "Big Three hree"" of of Cas Cash h Man Manag agem emen entt A. Acco Accoun unts ts Recei Receiva vabl blee 1. Selling Selling merchandis merchandisee and services services on credit credit is a necessary necessary evil evil for most most small busine businesses. sses. 2. However, However, selling selling to custome customers rs on credit credit is more expensiv expensivee than cash sales; sales; it requir requires es more paperwork, more staff, and more cash to service accounts receivable. 3. Selling Selling on credit credit is a common common practic practicee in business business.. a) One recent recent survey survey of small busine businesses sses in a variety variety of industr industries ies reported reported that that 77 percent extend credit to their customers. (1) An assertive collection collection program is essential to managing managing a company's cash flow. 4. How to to establi establish sh a credit credit and and collect collection ion policy. policy.

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a) Screen customers customers carefully carefully before before granti granting ng credit credit.. (1) According to one survey, nearly 95 95 percent of small small firms that sell on credit sell to anyone who wants to buy; most have no credit-checking procedure. b) The first first line of defense defense against against bad-debt bad-debt losses losses is a detailed credit credit applicati application. on. c) At a minimum, minimum, this this credit credit profil profilee should should include: include: (1) Name, address, address, Social Security number, number, and telephone number. (2) Form of ownership ownership (proprietorship, (proprietorship, S corporation, corporation, limited limited liability company, corporation, etc.) and number of years in business (3) Credit references (e.g., other suppliers) suppliers) including including contact names, addresses, and telephone numbers (4) Bank and credit credit card referen references ces 5. After collect collecting ing this this informatio information, n, the business business owner owner should should use it by checkin checking g the potential customer's credit references. a) On the Web, Web, entrepreneur entrepreneurss can gain access access to potenti potential al customers customers'' credit informat information ion at many sites. (1) The cost to check check a potential customer's credit at reporting services services such as these these ranges from $10 to several hundreds. b) The next step step involves involves establish establishing ing a firm written written credit policy policy and letting letting every every customer know in advance the company's credit terms. (1) The credit agreement should specify each customer's customer's credit limit (limits usually vary among customers, depending on their credit ratings) and any deposits required (often stated as a percentage of the purchase price). (2) It should state state clearly all the the terms the business business will enforce enforce if the account goes bad, including interest, late charges, attorney's fees, and others. c) The third third step in an effectiv effectivee credit policy policy is to send send invoices invoices promptly promptly because because customers rarely pay before they receive their bills. (1) Service companies should should keep track of billable hours hours daily or weekly weekly and bill as often as the contract or agreement with the client permits. (2) Some businesses use cycle billing, billing, in which a company company bills a portion of its credit customers each day of the month, to smooth out uneven cash receipts. 6. Small busines businesss owners can can take several several steps steps to encourage encourage prompt prompt payment payment of invoices invoices:: a) Ensure Ensure that that all invoices invoices are are clear, clear, accurate accurate,, and timely. timely. b) State clearly clearly a descript description ion of the goods goods or services services purchas purchased ed and an account account number, number, if possible. c) Make sure sure that prices prices on invoices invoices agree agree with the the price quotat quotations ions on purcha purchase se orders orders or contracts. d) Highligh Highlightt the terms terms of of sale (e.g., (e.g., "net "net 30') 30') on all all invoices invoices.. e) Include Include a telephone telephone number number and a contact contact person person in your your organizatio organization n in case the the customer has a question or a dispute. f) Respond Respond quickly quickly and and accurately accurately to customers’ customers’ questio questions ns about about their bills. bills. 7. When an accoun accountt becomes becomes overdue, overdue, the the small busin business ess owner owner must must take immedia immediate te action. a) The longer longer an account account is past past due, the lower lower is the probabi probability lity of collect collecting ing it. b) As soon soon as an accou account nt becomes becomes overdu overdue, e, many business business owners: owners: (1) Send a "second notice" notice" letter requesting immediate payment. payment. (2) Make a telepho telephone ne call if if the above above fails. fails. (3) A better system system is to call the the customer the day day after the payment is due to request payment. (4) If the customer still still refuses to pay the bill after 30 days, collection collection experts recommend the following: (a) Send a letter letter from from the company company's 's attorney attorney..


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(b) Turn the the account account over to a collectio collection n agency. agency. (c) Hire a collect collection ion attorney. attorney. 8. Although Although collecti collection on agencies agencies and attorn attorneys eys will will take a portion portion of any accounts accounts they they collect, they are often worth the price paid. a) Only 5 percent percent of account accountss over 90 days days delinquent delinquent will will be paid volunt voluntarily arily.. 9. Business Business owners owners must must be sure sure to abide abide by the the provision provisionss of the federal federal Fair Debt Debt Collection Practices Act, which prohibits any kind of harassment when collecting debts (e.g., telephoning repeatedly, issuing threats of violence, telling third parties about the debt, or using abusive language). 10. Other techniques techniques for accelerating accounts accounts receivable. receivable. a) Speed up orders orders by having having customers customers fax them them to you. b) Send invoices invoices when when goods goods are shipped shipped rather rather than a day or a week week later; later; consider consider faxing invoices to reduce "in transit" time to a minimum. c) Indicate Indicate in conspic conspicuous uous print print the invoice invoice due due date and any late late payment payment penaltie penalties. s. (Check with an attorney to be sure all finance charges comply with state laws.) d) Restrict Restrict the the customer's customer's credit credit until until past-d past-due ue bills bills are paid. paid. e) Deposit Deposit custome customerr checks checks and credit credit card receipts receipts daily. daily. f) Identify Identify the the top 20 percen percentt of your custo customers mers (by sales volume volume), ), create create a separate separate file system for them, and monitor them closely. Twenty percent of the typical company's customers generate 80 percent of all accounts receivable. g) Ask custom customers ers to pay pay a portio portion n of the the purchase purchase price price up front. front. h) Watch for for signs signs that that a customer customer may be about about to to declare declare bankrupt bankruptcy. cy. i) Consider Consider using using a bank's bank's lockbox lockbox colle collection ction servic servicee (located (located near near customers) customers) to reduce reduce mail time on collections. (1) In a lockbox arrangement, arrangement, customers send send payments to a post office box box the bank maintains. (2) The bank collects the payments several several times each day and deposits them them immediately into the company account. a ccount. j) Track the results results of the company’s company’s collection collection efforts. efforts. 11. Combining a lockbox lockbox with other other cash management services services from banks--such banks--such as zero balance accounts (ZBAs) and sweep accounts--can dramatically improve a small firm's ability to get the most out of its available cash. a) A zero balance balance account account is a checking checking account account that that technicall technically y never has funds funds in it but is tied to a master account such as payroll. B. Acco Accoun unts ts Paya Payabl blee 1. The second second element element of of the Big Three Three of cash cash managemen managementt is accounts accounts payab payable. le. 2. The timing timing of payabl payables es is just just as crucial crucial to proper proper cash cash managemen managementt as the timing timing of receivables, but the objective is exactly the opposite. 3. An entrepren entrepreneur eur should should strive strive to stretch stretch out payables payables as long long as possible possible withou withoutt damaging the company's credit rating. 4. A simple simple five-p five-poin ointt account accountss payable payable syst system. em. a) Set Set sch sched edul ulin ing g goa goals ls.. b) Keep Keep pape paperwo rwork rk organi organized zed.. c) Prioritize. d) Be cons consis iste tent nt.. e) Look Look for for war warni ning ng sign signs. s. 5. Business Business owners owners shoul should d verify verify all invoices invoices before before paying paying them. them. 6. In general, general, it is a good idea idea for owners owners to take take advantage advantage of cash cash discounts discounts that that vendors vendors offer.

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a) A clever cash cash manager manager also will will negotiat negotiatee the best possib possible le credit credit terms with with his suppliers. b) Almost Almost all vendors vendors grant their their customers customers trade trade credit, and the the small business business owner owner should take advantage of it. 7. Favorable Favorable credit credit terms terms can make make a tremendou tremendouss difference difference in a firm's cash cash flow. flow. a) Table 9.6 9.6 shows shows the same most most likely likely cash cash budget budget as that that shown shown in Table Table 9.2, with with one exception: Instead of purchasing on C.O.D. terms (Table 9.2), the owner has negotiated "net 30" payment terms (Table 9.6). Notice the drastic improvement in the company's cash flow resulting from improved credit terms. 8. Owners Owners who do find themselv themselves es financially financially strapp strapped ed should should discuss discuss openly the the situation situation with the vendor. 9. Small busines businesss owners also also can improve improve their firm's firm's cash flow by schedul scheduling ing controll controllable able cash disbursements so that they do not come due at the same time. a) Schedulin Scheduling g insurance insurance premiums premiums monthl monthly y or quarterly quarterly rather rather than annuall annually y also improves cash flow. C. Invent entory 1. Inventory Inventory is a signific significant ant investme investment nt for many many small business businesses es and can create create a severe severe strain on cash flow. 2. Although Although inventor inventory y represents represents the largest largest capital capital investment investment for for most businesses businesses,, few owners use any formal methods for managing it. 3. Surplus Surplus inventory inventory yields yields a zero rate rate of return and and unnecessar unnecessarily ily ties up up the firm's firm's cash. a) A typical typical manufactu manufacturing ring company company pays pays 25 percen percentt to 30 percent percent of of the value value of the the inventory for the cost of borrowed money, warehouse space, materials handling, staff, lift-truck expenses, and fixed costs. 4. Marking Marking down items items that don't don't sell sell will keep inven inventory tory lean lean and allow allow it to turn turn over frequently. a) Even though though volume volume discoun discounts ts lower lower inventory inventory costs, costs, large large purchases purchases may tie tie up the company's valuable cash. b) Only 20 percent percent of of a typical typical business's business's invento inventory ry turns turns over quickly quickly,, so the owner owner must watch constantly for stale items. 5. Carrying Carrying too much much inventory inventory increas increases es the chances chances that that a business business will run run out of cash. cash. IN THE FOOTSTEPS OF AN ENTREPRENEUR . . . A Cash Flow Dilemma

Lance Redmond had this in mind: What should he do with the check he had just received as an up-front payment from a large customer for a job the the customer wanted Redmond’s company company to do? In light of the fact that Redmond’s company, Stallion Manufacturing, a maker of industrial equipment, did not have the cash to meet a payroll due in just 20 days, the answer seemed simple: Cash the check. Redmond knew that his company was not capable of doing the job the customer was requesting. requesting. The scope of the job required engineering skills, equipment, and financing that Stallion Manufacturing simply did not not have. Redmond called a meeting to talk about the situation situation with his his top managers. The Chief Financial Officer, Sandy Camanetti, suggested they cash the check, meet with the managers from the company, and bluff, pretending to consider accepting the job. Later that evening at dinner, dinner, Redmond happened to see an old friend. Redmond explained the scenario, scenario, and then asked the friend, “What should I do?” 1. Assume Assume the role of Lance Lance Redmond’ Redmond’ss friend. friend. What advice advice would would you you offer offer him? him? Explain Explain your your reasoning.


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Answer: Student’s answers may vary.

2. Explain Explain the the ethical ethical dimension dimensionss of Redmon Redmond’s d’s situat situation. ion. Answer: Student’s answers may vary. 3. What other other recommen recommendati dations ons can you you make to to Redmond Redmond for resolvi resolving ng this this problem? problem? Develop Develop a list of at least three suggestions that would help Redmond manage his company’s cash flow more effectively. Answer: Student’s answers may vary.

VII. Avoiding Avoiding tile Cash Cash Crunch Crunch A. Bart Barter erin ing g 1. Bartering, Bartering, the the exchange exchange of goods goods and and services services for other other goods goods and and services, services, is an effective way to conserve cash. 2. An ancient ancient concept, concept, bartering bartering began to regain regain popularit popularity y during recent recent recessions recessions.. Over the last decade, nearly 700 barter exchanges have cropped up, catering primarily to small and medium-sized businesses and many of them operating on the World Wide Web. 3. More than 475,00 475,000 0 companies companies--most --most of of them small--eng small--engage age in more than than $12 billion billion worth of barter each year. 4. There is a cost cost associated associated with with bartering bartering,, but the real benefi benefitt is that entrepre entrepreneurs neurs "pay" "pay" for products and services at their wholesale cost of doing business and get in the barter exchange for the retail price. 5. In a typical typical arrangement, arrangement, busines businesses ses accumulat accumulatee trade credits credits when when they offer offer goods goods or services through the exchange. Then, they can use their trade credits to purchase other goods and services from other members of the exchange. 6. The typical typical exchange exchange charges charges a $500 $500 membership membership fee and a 10 percent percent transa transaction ction fee fee (5 percent from the buyer and 5 percent from the seller) on every deal. The exchange tracks the balance in each member's account and typically sends a monthly statement summarizing account activity. 7. Rather than than join a barter barter exchange exchange,, many enterpris enterprising ing entrepren entrepreneurs eurs choose choose to barter barter on an individual basis. a) The place place to start is is with the people people the the company company normally normally does busines businesss with. with. B. Trimmi Trimming ng Overh Overhead ead Costs Costs 1. When When pract practica ical, l, lease lease inst instead ead of of buy. buy. a) By leasing leasing automobil automobiles, es, computers, computers, office office equipment equipment,, machinery, machinery, and other other assets assets rather than buying them, an entrepreneur can conserve valuable cash. b) The value value of such such assets assets is not in in owning owning them them but in using using them. them. c) Approximat Approximately ely 80 percen percentt of U.S. compani companies es use leasing leasing as as a cash managem management ent strategy. d) Although Although total total lease payments payments typicall typically y are greater greater than those those for a conventional conventional loan, most leases offer 100 percent financing, which means the owner avoids the large capital outlays required as down payments on most loans. e) Also, Also, leasing leasing is an "off-the-b "off-the-balanc alance-she e-sheet" et" method method of financing financing;; the lease is is considered an operating expense on the income statement, not a liability on the balance sheet. f) Lease Lease agreem agreement entss also also are flexib flexible. le. (1) Operating lease at which at the end of the lease, a business turns the equipment back over to the leasing company with no further obligation.

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(a) Businesses often often lease computer and telecommunications equipment through through operating leases because it becomes obsolete so quickly. (2) Capital lease at which which at the end of the lease, a business business may exercise exercise an option to purchase the equipment, usually for a nominal sum. 2. Avoid Avoid non noness essent ential ial outlay outlays. s. a) By forgoing forgoing costly costly indulgenc indulgences es such as ostentati ostentatious ous office office equipment, equipment, first-cla first-class ss travel, and flashy company cars, business owners can make efficient use of the company's cash. b) Before puttin putting g scarce cash cash into an asset, asset, every every business business owner owner should should put the decision to the acid test: What will this purchase add to the company's ability to compete and to become more successful? 3. Negotiate Negotiate fixed fixed loan payment paymentss to coincide coincide with with your company company's 's cash flow flow cycle. cycle. a) Many banks banks allow busin businesses esses to struct structure ure loans loans so that they they can skip specifi specificc payments when their cash flow ebbs to its lowest point. b) Negotiati Negotiating ng such terms terms gives business businesses es the opportun opportunity ity to customize customize their their loan repayments to their cash flow cycles. 4. Buy used or recondit reconditione ioned d equipment, equipment, especiall especially y if it is "behind-the"behind-the-scen scenes" es" machinery. machinery. 5. Look Look for for simpl simplee ways ways to cut costs. costs. 6. Hire part-ti part-time me employees employees and and freelance freelance specia specialist listss whenever whenever possib possible. le. a) Hiring Hiring part-timer part-timerss and freelancer freelancerss rather than than full-time full-time workers workers saves saves on the cost cost of both salaries and benefits. 7. Contro Controll employ employee ee advan advances ces and loans loans.. a) A manager manager should should grant only only those those advances advances and loans loans that that are necessary necessary and should should keep accurate records on payments and balances. 8. Establish Establish an intern internal al securi security ty and and control control system. system. a) Reconcilin Reconciling g the bank bank statement statement monthly monthly and and requiring requiring special special approva approvall for checks checks over a specific amount, say $1,000, will help minimize losses. b) Separating Separating recordkeep recordkeeping ing and check-writi check-writing ng responsibil responsibilities ities,, rather than assigning assigning them to a single employee also offers protection. 9. Develo Develop p a syste system m to batt battle le check check fraud. fraud. a) Merchants Merchants take take in more than than $13 billion billion in bad checks checks each each year. year. b) Losses Losses from check check fraud will will grow by 25 25 percent percent annually annually in the coming coming years. years. c) About About 70 percent percent of all "bounced" "bounced" checks checks occur occur because because nine nine out of of ten customer customerss fail to keep their checkbooks balanced; the remaining 30 percent of bad checks are the result of fraud. 10. Change Change your shippin shipping g terms. terms. a) Changing Changing the the firm's firm's shipping shipping terms terms from "FOB "FOB (free on on board) board) buyer," buyer," in which which the seller pays the cost of freight, to "FOB seller," in which the buyer absorbs all shipping costs, will improve cash flow. 11. Switch Switch to zero-based zero-based budgeting budgeting.. a) Zero-based Zero-based budgetin budgeting g (ZBB) primaril primarily y is a shift in the the philosoph philosophy y of budgeting budgeting.. b) ZBB starts starts from from a budget budget of zero and and evaluates evaluates the the necessit necessity y of every every item. item. 12. Keep your your business business plan curren current. t. a) Smart owners owners keep keep their their plans up up to date date in case an an unexpecte unexpected d cash crisis crisis forces forces them to seek emergency financing. b) Revising Revising the plan plan annually annually also also forces the the owner to focus focus on managing managing the the business business more effectively. C. Inve Invest stin ing g Surpl Surplus us Cash Cash 1. Because Because of the uneven uneven flow flow of receip receipts ts and disbur disbursemen sements, ts, a company company will will often often temporarily have more cash than it needs for a week, a month, a quarter, or longer.


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2. Entreprene Entrepreneurs urs who put put surplus surplus cash to work work immediatel immediately y rather rather than allowing allowing it to sit sit idle soon discover that the yield adds up to a significant amount over time. 3. However, However, when investi investing ng surplus surplus cash, cash, the owner's owner's primary primary objecti objective ve should should not be to earn the maximum yield (which usually carries with it maximum risk); instead, the focus should be on the safety and the liquidity of the investments. 4. Asset-manag Asset-management ement accounts accounts,, which integrate integrate checking, checking, borrowing borrowing,, and investing investing services services under one umbrella and were once available only to large businesses, now help small companies conserve cash. VIII. VIII. Conclu Conclusio sion n 1. Successful Successful owners-r owners-run un their busin businesses esses "lean "lean and mean." mean." Trimming Trimming wastefu wastefull expenditures, investing surplus funds, and carefully planning and managing the company's cash flow enables them to compete effectively in a hostile market. 2. The simple simple but effective effective techniq techniques ues covered covered in this this chapter chapter can improve improve every every small company's cash position. One business writer says, "In the day-to-day course of running a company, other people's capital flows past an imaginative CEO as opportunity." 3. By looking looking forward forward and keeping keeping an analyt analytical ical eye on your your cash account account as events events unfold unfold (remembering that if there's no real cash there when you need it, you're history), you can generate leverage as surely as if that capital were yours to keep.

Chapter Summary ♦ Explain the importance of cash management to the success of the small business. Cash is the most important but least productive asset the small business has. The manager must maintain enough cash to meet the firm's normal requirements (plus a reserve for emergencies) without retaining excessively large, unproductive cash balances. Without adequate cash, a small business will fail. 

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Differentiate between cash and profits. Cash and profits are not the same. More businesses fail for lack of cash than for lack of profits. Profits, the difference between total revenue and total expenses, are an accounting concept. Cash flow represents the flow of actual cash (the only thing businesses can use to pay bills) through a business in a continuous cycle. A business can be earning a profit and be forced out of business because it runs out of cash. 

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Understand the five steps in creating a cash budget and use them to create a cash budget. The cash budgeting procedure tracks the flow of cash through the business and enables the owner to project cash surpluses and cash deficits at specific intervals. The five steps in creating a cash budget are determining an adequate minimum cash balance, forecasting sales, and forecasting cash receipts, forecasting cash disbursements, and determining the end-of-month cash balance. 

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Describe fundamental principles involved in managing the "Big Three" of cash 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 granting them credit. Sending invoices promptly and acting on past-due accounts quickly also improve cash flow. The goal is to collect cash from receivables as quickly as possible. 

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When managing accounts payable, a manager's goal is to stretch out payables as long as possible without damaging the company's credit rating. Other techniques include verifying invoices before paying them, taking advantage of cash discounts, and negotiating the best possible credit terms. Inventory frequently causes causes cash headaches for small business business managers. Excess inventory earns a zero rate of return and ties up a company's cash unnecessarily. Owners must watch for stale merchandise. 

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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 system boost a firm's cash f low position. Investing surplus cash maximizes the firm's earning power. The primary criteria for investing surplus cash are security and liquidity. 

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Discussion Questions

1. Why must must small busines businesss owners owners concentrate concentrate on effecti effective ve cash flow flow management? management? Answer - Cash is the most important yet least productive asset that a small business owns. A business must have enough cash to meet me et its obligations or it will be declared bankrupt. Proper cash management enables the owner to adequately meet the cash demands of the business, to avoid retaining unnecessarily large cash balances, and to stretch the profit-generating power of each dollar the business owns. 2. Explain Explain the difference difference between between cash and profit. profit. Answer - Profit (or net income) is the difference between a company's total revenue and its total expenses. It measures how efficiently the business is running. As important as earning a profit is, no business owner can pay creditors, employees, and lenders with the business' profits; those payments require cash. Profits are tied up in many forms, such as inventory, computers, or machinery. Cash is the money that flows through a business in a continuous cycle without being tied up in any other asset. 3. Outline Outline the the steps steps invol involved ved in in develop developing ing a cash budget. budget. Answer - There are five basic steps in completing a cash budget: Determine an adequate minimum cash balance. • Forecast sales. • • Forecast cash receipts. • Forecast cash disbursements. Determine the end-of-month cash balance. • 4. How can can an entrepr entrepreneur eneur launch launching ing a new new business business forecast forecast sales? sales? Answer - The heart of the cash budget is the sales forecast. For most businesses, sales constitute the major source of the cash flowing into the business. The sales forecast can be based on past sales, but the owner must be careful not to be excessively optimistic in projecting sales. The task of forecasting sales for a new firm is difficult but not impossible. The owner can conduct research on similar firms and their sales patterns in the first year of operation to come up with a forecast. Or he/she can use marketing research as another source of information that may be used to estimate annual sales for the fledgling firm. 5. Outline Outline the basic basic principles principles of managing managing a small firm's firm's receivable receivables, s, payables, payables, and inventor inventory. y.


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Answer - Managing receivables. Selling merchandise and services on credit is a necessary evil for most small businesses. An assertive collection program is essential to managing a company's cash flow. The owner should have a credit and collection policy. Small business owners can take several steps to encourage prompt payment of invoices. Ensure that all invoices are clear, accurate, and timely. State clearly a description of the goods or services purchased and an account number, if possible. Make sure that prices on invoices agree with the price quotations on purchase orders or contracts. Highlight the terms of sale (e.g., "net 30") on all invoices and reinforce them, if necessary. Include a telephone number and a contact person in your organization in case the customer has a question or a dispute.  

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The second element of the Big Three of cash management is accounts payable. The timing 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 out payables as long as possible without damaging the company's credit rating. Business owners should verify all invoices before paying them. In general, it is a good idea for owners to take advantage of cash discounts that vendors offer. Small business owners also can improve their firm's cash flow by scheduling controllable cash disbursements so that they do not come due at the same time. Inventory is a significant investment for many small businesses and can create a severe strain on cash flow. Surplus inventory yields a zero rate of return and unnecessarily ties up the firm's cash. A typical manufacturing company pays 25 percent to 30 percent of the value of the inventory for the cost of borrowed money, warehouse space, materials handling, staff, lift-truck expenses, and fixed costs. Only 20 percent of a typical business's inventory turns over quickly, so the owner must watch constantly for stale items. Carrying too much inventory increases the chances that a business will run out of cash. 6. How can barte bartering ring improve improve a company's company's cash position? position? Answer - Bartering, the exchange of goods and services for other goods and services, is an effective way to conserve cash. There is a cost associated with bartering, but the real benefit is that entrepreneurs "pay" for products and services at their wholesale cost of doing business and get credit in the barter exchange for the retail price. In a typical arrangement, businesses accumulate trade credits when they offer goods or services through the exchange. Then, they can use their trade credits to purchase other goods and services from other members of the exchange. 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 tracks the balance in each member's account and typically sends a monthly statement summarizing account activity. Rather than join a barter exchange, many enterprising entrepreneurs choose to barter on an individual basis. The place to start is with the people the ccompany ompany normally does business with. 7. What steps steps should should busines businesss owners owners take to conserve conserve cash in in their their companies? companies? Answer - Business owners can take a number of steps to conserve cash. When practical, lease instead of buy. Avoid nonessential outlays. Negotiate fixed loan payments to coincide with your company's cash flow cycle. Buy used or reconditioned equipment, especially if it is "behind-the-scenes" machinery. Look for simple ways to cut costs.     

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Section III Building the Business Plan: Marketing and Financial Considerations Considerations      

Hire part-time employees and freelance specialists whenever possible. Control employee advances and loans. Establish an internal security and control system. Develop a system to battle check fraud. Change shipping terms. Switch to zero-based budgeting.

8. Alan Ferguso Ferguson, n, owner of of Nupremis, Nupremis, Inc., a Web-based Web-based applica application tion service service provid provider, er, says, says, “We lease our equipment and technology because our core business is deploying it, not owning it.” What does he mean? Is leasing a wise cash management management strategy for small businesses? businesses? Explain. Answer: By leasing computers and other assets rather than buying them, an entrepreneur can conserve valuable cash. The value value of such assets is not in owning owning them but in using using them. Ap proximately 80 percent of U.S. companies use leasing as a cash management strategy. Although total lease payments typically are greater than those for a conventional loan, most leases offer 100 percent financing, which means the owner avoids the large capital outlays required as down payments on most loans. Also, leasing is an "off-the-balance-sheet" "off-the-balance-sheet" method of financing; financing; the lease is considered considered an operating expense on the the income statement, not a liability liability on the balance sheet. There are two types of lease: Operating lease at which at at the end of the lease, a business turns turns the equipment back over to the leasing company with with no further obligation. obligation. Capital lease at which at the end of the lease, a business may exercise an option to purchase the equipment, usually for a nominal sum. 9. What should should be a small small business business owner's owner's primary primary concern concernss when investi investing ng surplus surplus cash? cash? Because of the uneven flow of receipts and disbursements, a company will often Answer temporarily have more cash than it needs a for a week, a m onth, a quarter, or longer. Entrepreneurs who put surplus cash to work immediately rather than allowing it to sit idle soon discover that the yield adds up to a significant amount over time. However, when investing surplus cash, the owner's primary objective should not be to earn the maximum yield (which usually carries with it maximum risk); instead, the focus should be on the safety and the liquidity of the investments. Assetmanagement accounts, which integrate checking, borrowing, and investing services under one umbrella and were once available only to large businesses, now help small companies conserve cash. Step into the Real World 1. Ask several several local local small small business business owners owners about about their cash cash managemen managementt policies. policies. Do they know how how much cash their businesses businesses have during during the month? month? How do they track their cash flows? Do they use some type of cash budget? If not, ask if you you can help the the owner develop one. Does the owner owner invest surplus cash?

2. Volunteer Volunteer to help help a small small business business owner develo develop p a cash budget budget for for his or her her company. company. What patterns do you detect? What recommendations recommendations can you make for for improving the company's cash management system? 3. Use the resourc resources es available available in your your local local library library and on the World World Wide Wide Web to prepare prepare a brief report report on bartering. What benefits does does barter offer business business owners? How does the the typical barter exchange exchange operate? What fees are involved? involved? How are barter transactions transactions taxed? taxed? A useful source of information is the International Reciprocal Trade Association's Web site at: http://www.irta.com 4. Interview Interview several several local local business business owners owners about about their their policies policies on acceptin accepting g payments payments by check. check. How much do they typically lose lose in a year's time to bad checks? What safeguards do they use use to combat check fraud? Contact the American Collectors Collectors Association at P.O. Box 39106, 39106, Minneapolis, MN 55439-0106 or access the ACA's Web site at:


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http://www.collector.com/ How prevalent is is check fraud? What can business business owners do to prevent it? Using these resources resources and those in your local library, develop a set of recommendations for the owners you interviewed to reduce their losses to check fraud.

Chapter 09 Entrepreneurship by Zubair A Khan.

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