These are the basic rudiments of a well-managed business. This also represents the simplest and basic explanation of an income statement and balance sheet. It is also the most efficient approach to the achievement of one of the most important rules in business; “Cash is King”.
Business is generally an input-output activity. Buying low and selling high is the most logical rationale for doing business. Profit is simply the difference between your sales and cost. Profit is generally a notional gain and normally mistakenly equated to cash. Profit is realized and is equal to cash when the buyer pays you immediately for the product or service delivered.
Inappropriately, most business owners equate profit to cash, forgetting that revenues can either be realized in the form of cash or credit. The conversion of profit to cash depends largely on a company’s cash management policy. This policy simply defines the speed with which bills are paid, against the collection of bills. Companies tend to have a higher cash position when they collect their bills faster than they pay. This should actually be the ideal situation. This is what most petty traders who operate “cash and carry” models do. Lenders are very happy with such businesses.
Anything contrary to this model can easily plunge companies into a liquidity crunch, as they invariably end up financing other people’s businesses or operations. A company may or may not be able to control its cash cycle. The cash cycle is influenced mostly by the type of business and industry one finds himself in. The dynamic mix of client profiles, in most cases, drives companies’ cash position. A typical example is in the healthcare industry where most patients pay on credit through various insurance schemes.
Most companies have a mix of cash and credit sales. This principle is same with business expenses; they are either settled with cash or credit. The mismatch in the cash flow of revenue and expenses is what creates challenges for most businesses. They report profits but face significant challenges that ultimately reverse these profit positions. Being trapped in a liquidity crunch can be likened to having legs but being unable to walk.
This is not to “demonize” credit as a payment option. Without it, the global economic system will grind to a halt. Credit allows businesses to grab impulse buyers, compete with other players by attracting more customers and increase revenues. The challenge is how quickly these bills or receivables are collected and converted into cash. It is very important for businesses to set up structures or systems for prompt credit settlements and secure the time value of the business funds. We recommend the following cash management approaches:
- Client Profiling: Perform a risk analysis on customers to determine their ability and willingness to pay.
- Good Record Keeping: Keep good records of creditors and undertake regular ageing analysis of your receivables for cash planning/management purposes;
- Risk Transfer: Transfer risk of major contract or orders against defaults to insurance companies by insuring major risk such as injury or death to your customers. This is very typical in the healthcare sector
- Payment Terms: Mark up credit sales by a reasonable margin and clearly outline payback periods and consequence for defaults. Typically, most payments periods range from 30 to 90 days.
A great business achieves profitability and consistently remains liquid on cash. Written by Isaac Ocquaye-Allotey (Senior Associate) and Laila Duwiejua (Analyst).