Your sales numbers are great, but your bank balance isn't keeping up. You've always had this problem, but you're not sure why it happens.
This blog post is for service-based business that don't bill for services or products immediately or use a POS (point-of-sale) system. I will touch on cash flow for POS-based businesses in my next post.
SALES ≠ CASH
Sales (or revenue, depending on what you call it in your business) don't equal cash. There are multiple steps in between when you make a sale and when you actually receive the payment for your services.
Step 1: Invoicing | Sending the bill
Invoicing is the process of sending your customer a bill for the service you are providing. The first question to ask is: how quickly are we sending invoices out to our customers? Perhaps you're sending them out to customers weekly.
Step 2: Terms | When's the payment due?
Technically, terms are part of invoicing, but I've broken this step out because you may have terms that state that payment is not due immediately, but rather within 30 days of making the sale.
Step 3: Invoice Status | Have we been paid?
This is the step that businesses neglect most often. Sending out an invoice, doesn't guarantee you'll get paid within the terms. It's important to have a process in place where outstanding invoices are routinely followed up on so you can ensure timely collection of payment. Which leads me to my next point.
Step 4: Collection | Receiving payment
Sales don't equal cash until you actually receive payment.
SCENARIO: Let's map this out
You make a sale on May 5. Your company sends out invoices twice a month, every other Thursday. The invoice gets sent along with the next batch of invoices, which are processed on May 18 – the following Thursday. Most of your invoices are due in 30 days, so this invoice has a due date of June 17. June 17 is a Saturday and your customer is out of the office till Monday, June 19.
Your customer processes bill payments every Friday afternoon – the next bill pay date being June 23. Except on June 23, your customer's accountant was on vacation and doesn't process the payment until the following Friday, June 30. You receive the check in the mail on Tuesday, July 4. However, accounting only makes bank deposits on Fridays. On Friday, July 7 you make the deposit the check in the bank. On Monday, July 10, the check clears and the cash is available in the bank.
How many days did it take to receive cash?
From May 5 to July 10 is 66 days. 66! So although the invoice may have stated 30 days terms, it actually took 66 days to receive the cash. And guess what? During that time, you incurred two months of normal operating costs (payroll, rent, insurance, etc) that call came out of your business bank account. Unsurprisingly, this is a very typical scenario for many businesses that receive payments via checks.
HOW TO FIX THIS (in 1 step):
Hire a outsourced CFO who can help you not only with cash flow, but also profitability, business performance, financial statement accuracy, and several other things that will help you do business better.
HOW TO FIX THIS (in 3 steps):
First, determine your Days Sales Outstanding (DSO).
There's a KPI (key performance indicator) called 'Days Sales Outstanding' that tells you the time it takes, on average, for you to collect on your sales. There a few ways to calculate this, but let's say that number is currently 55 days.
Second, review and make the appropriate changes to lower your DSO.
Review steps 1-4 (above) and determine where the problems are. Invoicing? Terms? Invoice Status? Collection? A combination? Make the appropriate changes to shorten the time it takes to collect cash.
Third, monitor this KPI every month.
Let's say you determine that your DSO should never be above 45. Then every month, when you review your company's DSO, if it exceeds 45, you'll know there was a problem that needs to be addressed.
MORE ON CASH FLOW
A lot of businesses operate without tracking various aspects of their financial performance. Cash flow is one of them. It's important to have the right strategies in place for your business so it can be successful, grow, and everything you dream it could be.
The DSO KPI can be different from business to business, depending industry, size, business model, or a host of other things. There are ways to increase cash flow by 2-3x using technology instead of checks. There are ways to automate processes instead of processing things manually. Reach out for help on how to improve cash flow in your business.
accountant / financial consultant