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Cash Disbursement and Payables Management

As a business owner, you can often find yourself wondering where your money is going. Without systems, and the necessary checks and balances, your business can feel like a leaking sieve. In this section, we'll have an in-depth look at how and where cash exits your business.

Think of your working capital in terms of a circle. Your purchases for inventory and supplies, etc. are the first phase of the cycle. Your purchases generate payables and accruals. Very few businesses pay cash for all purchases and, in most cases, it makes sense to use cash as little as possible.

The second phase of the cycle is when your purchases are turned into cash or receiveables through sales.

The final phase of the working capital cycle is the payment of the payables and accruals. In the section on Receivables and Credit Management, we discussed how receivables are really an investment in working capital. When analyzing receivables as investments, payables and accruals are analyzed as the financing for those investments.

Payables and accruals are common sources of spontaneous financing; sources of financing that occur automatically as a result of operations.

Accounts Payable

Accounts Payable are automatically created every time your business purchases something and doesn't pay for it right away. Every time a payable is created, a spontaneous source of financing is used. Revenue generated later on (or accumulated past revenue in the form of cash) will then be used to fund the financing and pay it off.

The importance of keeping track of your accounts payable can't be over stated. You can get yourself into a real bind if you end up having to come up with cash that you weren't tracking.

The Cash Flow Timeline and Accounts Payable

When you purchase something on credit, you get to use the goods or services before you pay for them. The time period between receipt of the goods or services and the date that you pay for them is known as positive float. The longer the payment delay, the better off the business is, as long the payment is not made past the due date. Late payments can result in penalties, and can damage relationships with your suppliers.

There are four payment options a business has to choose from:

  1. Pay when the invoice arrives.

  2. Pay during the cash discount period if available.

  3. Pay after the discount period but before the credit term due date.

  4. Pay after the credit term due date.

The following payment principles will help you make decisions regarding how and when to pay:

  • A payable should never be paid until the last day of the discount period or at the end of the credit period, and should never be paid early.
  • A discount period should only be taken if the effective interest rate implied by the discount rate and payable terms exceed the opportunity cost of short-term funds over the same period.
  • A payable should never be stretched past the credit period.

Ethics and the Payment Decision

Of course, the principle of a business being obligated to pay its accounts payable should always prevail. The above rule only applies when a business has no choice in the matter. Whenever a business buys on credit, the business essentially enters a contract to pay no later than the credit period. Not paying within the designated period is similar to breaking a contract, and the seller should foresee a loss of goodwill with the supplier.

There are some industries where the buyers have more power than suppliers. Whether they decide to pay their obligations on time or late, the supplier must accept the decisions because they have little leverage in the matter. At times, it may appear that the NPV of stretching is a financially positive decision, especially when the late payment fee is less than the firm’s opportunity investment rate. As with all ethical decisions, there are different tiers of ethics when making a business decision. The lowest, most basic tier of decision making involves asking if the decision is legal. The middle tier asks if you could explain your business decisions and philosophy to the people you care about; your family, friends and close business associates. If you would feel uncomfortable, chances are you feel wrong about the decision you're making.

The final tier of ethical standards says to commit to enhance the well-being of the people you do business with, even if there is some cost to you. At a minimum, businesses should make decisions that are legal, but all businesses should strive to make decision that build relationships instead of weaken them. From a more practical perspective, stretching payables may put the business’ suppliers in financial danger. A business, especially one that buys raw materials, will find it more and more difficult to operate in an industry with few suppliers or supplier that are of low quality. Paying your payables in a timely basis ensures the financial viability of a business’ suppliers and their continued existence.

Monitoring Accounts Payable

Once a firm’s payment policy has been determined, the execution of that policy should be monitored on a regular basis. In essence, monitoring payables is very similar to monitoring receivables but from a reverse perspective. Now the business is monitoring outflows instead of inflows, and therefore the intuition is sometimes reversed.

Cash Management

In the long run, profit is essential, but in the short run, “cash is king.” Profit must be every business owner's goal, but a business can survive without profit as long as it has cash. In fact, a business can even survive with a negative profit, if it has enough cash. For example, many start-up companies manage to survive for years while losing millions upon millions of dollars in profit, because investors continue to meet their needs for cash. But run out of cash and even a profitable business will die.

How is this possible? What could possibly cause a profitable business to run into cash problems? The answer is the same one we have talked about throughout this entire program. The answer is “unmanaged growth.” Ironically, unmanaged growth can have a negative effect on cash flow. In fact, it can have so large an effect that it can easily sink an otherwise successful business. Of course growth is desirable, but unmanaged growth is dangerous. Why? Because it promotes an environment in which cash is spent faster than it is received.

When a business grows quickly, its sales increase. More often than not, those sales are made on payment terms, so the money may not come in for 30, 60, or even 90 days. In the mean-time, variable expenses, such as inventory and production wages, increase in response to this rapid growth. Fixed expenses may even increase if the business suddenly finds itself in need of more warehouse space, for example. If the business is new or smaller, it may need to pay many of its bills up front. So while accounts receivables are increasing rapidly, accounts payables are not only increasing, they are coming due faster than the money is coming in.

To make matters worse, a new business will often extend credit to customers that are less than credit worthy because they are hungry for the business. As a result, some of the receivables may never come in at all. If the business continues to grow at this rate, it could run out of cash before enough of its receivables come in to cover its expenses, causing a cash crunch. This can leave a company in the ironic position of having orders they cannot afford to fill, causing customers to lose confidence them.

The long and short of it is your business needs cash in order to grow. Cash, not profit, is your primary fuel for growth. Of course the two are related, indeed, profit is your best source of cash, but to operate as if they are the same thing is a dangerous presumption. If you currently have enough cash to run your business, there are two reasons you may eventually need access to additional funds. The first is to handle emergency cash shortages and the second is to fund growth.

One way to prepare for emergencies is to establish a “rainy day fund.” This is a cash reserve you can call on to support your cash needs for several months, should your business experience hard times. If you don't already have one, consider putting some money aside into a secure investment. The type of investment is up to you, so long as your money is secure and readily accessible.

Cash for the purpose of growth can come from several sources. When you use credit to grow your business, you are leveraging the value of that money for your own purposes. In fact, it is often a good idea to accept credit when times are good, even if you don't need it right away.

Should some unexpected event, such as your supplier going out of business, cause your sales to temporarily decline, how much cash would it take to keep your business alive while you sort things out? Imagine your worst-case scenario and plan on a three to six month turnaround.

Of course there is nothing wrong with using profit to fund growth. In fact, it's often preferable to credit. Just watch your cash flow and avoid depleting your rainy day fund. Even the best-laid plans can result in a short-term dry spell. If your business is highly profitable, you might consider creating additional accounts to fund your growth at a later date. You might establish a “research and development fund,” for example.

Revisit your Cash Budget and your Strategic Objective. Will you have a need for cash for the purposes of growth over the next few years? If yes, how much will you need and when will you need it?

If appropriate, visit your lender and increase your line of credit.

Unless you already have all of the cash you need for your rainy day and growth funds, you'll need to create a plan for getting there. How much cash will you set aside on a monthly basis for this purpose? Pick both a fixed amount as well as a variable percentage. That way you will continue to save something no matter how low your sales go, but when sales pick up, your savings will increase as well.

Update your budget to reflect your rainy day and growth savings plans.

Managing Your Cash Reserves

Keep your business lean and mean.

Can you have too much of a good thing? If your business operates with a large excess of cash in reserve, you've got the kind of problem most people would like to have. Nonetheless, excess cash is sometimes a sign of inefficiency. You need quick access to cash to run your business, but that doesn't mean your money should be doing nothing. Cash sitting in the bank, even for a short time, represents lost opportunity. Money only has value when it is doing something. At the very least, excess cash should be invested until it is needed. If you think you may need your money in the near future, invest it someplace secure and accessible. If it represents part of a longer-term plan, you might accept a little more risk in return for a better return. A good financial advisor can help you here. You should also consider the benefits of investing it back into your business, perhaps into real estate or new equipment that can be borrowed against in the future. Excess cash represents potential value. It's up to you to decide how to best invest that value.

Cash Reserve System

The following questions are designed to get you thinking about what to do with your excess or reserve cash.

How will you invest the money you need quick access to?

How will you invest the money you will not need access to for some time?

How will you ensure that this happens on a regular basis? For example, who is accountable for making the investment decisions? When is this done? How is this done?

Create your Cash Reserve System.

In this chapter you should have designed, shared, and made a plan to review your:

  • 12-month budget for your business.
  • Cash Flow Budget for your business.
  • Budget Variance Report for your Income Statement.
  • Budget Variance Report for your Cash Budget (if applicable).
  • Budgeting System.
  • "Worst-Case Scenario" plan.
  • Cash Reserve System (as necessary).