Making a profit is a good thing. Being able to spend it is better. Too many profitable new businesses have difficulty because their profits are all on paper and not in the bank. They are cash-poor.
Your consulting business must have a healthy flow of working capital to survive. Cash flow is the amount of working capital available in your business at any given time. It is your income less expenses, in cash. To keep tabs on cash flow, forecast the funds you expect to receive and disburse over a specific time. Then you can predict deficiencies or surplus in cash and decide how best to respond.
Cash Flow Forecasting
A cash flow forecast serves one other very useful purpose in addition to planning. As the actual information becomes available to you, compare it to the monthly cash flow estimates you previously made to see how accurately you are estimating. As you do this, you will give yourself on-the-spot business training in making more accurate estimates and plans for the coming months. As your ability to estimate improves, your financial control of the business will increase.
Every time you have to purchase on credit, you add interest costs to your business. If you had more cash, you would be able to save more on interest expense. For this and other reasons, you can reduce your costs — and increase profitability — by increasing cash flow.
The cash flow forecast identifies when cash is expected to be received and when it must be spent to pay bills and debts. It shows how much cash will be needed to pay expenses and when it will be needed. The cash flow forecast enables you to plan for shortfalls in cash resources so short-term working capital loans or a line of credit may be arranged in advance. Also, if you have excess cash, it allows you to put this cash to productive use and earn a return. It allows you to schedule purchases and payments so you can borrow as little as possible. Because not all sales are cash sales, you must be able to forecast when accounts receivable will be cash in the bank as well as when regular and seasonal expenses must be paid.
The cash flow forecast may also be used as a budget, helping you increase your control of the business through comparing actual receipts and payments against forecasted amounts. This comparison helps you identify areas where you can manage your finances even better.
A cash flow forecast or budget can be prepared for any period of time. However, a one-year budget matching the fiscal year of your business is the most useful. Many successful consulting services prepare their cash flow forecasts on a monthly basis for the next year. It should be revised no less frequently than quarterly to reflect actual performance in the previous three months of operations and verify projections.
Importance of Cash
All businesses, no matter how small or large, function on cash. Many businesses become insolvent because they don't have enough cash to meet their short-term obligations. Bills must be paid in cash, not potential profits. Sufficient cash is, therefore, one of the keys to maintaining a successful business.
Consulting services face a continual cycle of events that may increase or decrease the cash balance. Cash is decreased in the acquisition of equipment or supplies. It is reduced in paying off the amounts owed to suppliers (accounts payable). Services are sold and these sales generate money owed from clients (accounts receivable). When clients pay, accounts receivable is reduced and the cash account is increased. However, the cash flows are not necessarily related to the sales in that period because clients may pay in the next period.
Net Working Capital
Consulting services must be continually alert to changes in working capital accounts, the cause of these changes, and their implications for the financial health of the company. The change in the cash can be readily determined if you know net working capital and the changes in current liabilities and current assets other than cash.
NWC = net working capital
CA = change in current assets other than cash
CL = change in current liabilities
Cash = change in cash
NWC is the difference between the change in current assets and current liabilities:
NWC = CA + Cash - CL
This relationship shows that if we know the net working capital, the change in current liabilities, and the change in current assets less cash, we can calculate the change in cash. The change in cash is then added to the beginning balance of cash to determine the ending balance.
At any given level of sales, it's easier to forecast the required accounts payable and receivable than net working capital. To forecast this net working capital account, you must trace the source and application of funds. Sources of funds increase working capital. Application of funds decrease working capital. The difference between the source and application of funds is the net working capital.
Balancing Cash Flow
The following calculation is based on the fact that the balance sheet is indeed in balance. That is, the total assets equal total liabilities plus owner's equity.
Current Assets + Noncurrent Assets + Retained Earnings = Current Liabilities + Long-term Liabilities + Equity
Rearranging this equation:
Current Assets - Current Liabilities = Long-term Liabilities + Equity-Noncurrent Assets - Retained Earnings
Because the left side of the equation is working capital, the right side must also equal working capital. A change in either side affects the net working capital. If long-term liabilities and equity increase of noncurrent assets decrease, net working capital increases. This change would be a source of funds. If noncurrent assets increase or long-term liabilities and equity decrease, net working capital decreases. This change would be an application of funds.
Typical sources of funds or net working capital are funds provided by operations, disposal of fixed assets, issuance of stock, and borrowing from a long-term source. The typical applications of funds or net working capital are purchase of fixed assets, payment of dividends, retirement of long-term liabilities, and repurchase of equity.
Experienced consultants advise that managing cash flow is one of the most critical business skills they must develop. Some use spreadsheets; others rely on computerized accounting systems to track income and expenses. To minimize borrowing on credit, smart consultants make sure that there is always sufficient incoming cash to pay expenses when due. Your business's future depends on cash flow.
Developing Business Credit
Credit is simply someone's faith that the client will keep a promise. You buy a computer system on credit, and the lender believes that you will pay back what you've borrowed. Or, in the case of secured loans, you have assets that can be sold to cover what you've borrowed. So how do you build credit? Easy. You borrow a small amount, pay it back, borrow a larger amount, and pay it back, and so on.
A good way to start building your business credit is to use personal assets — signature, real estate equity — as collateral for your business. One enterprising consulting service owner simply applied for a credit card in his business name from the same company that sponsored his long-standing personal credit card. He asked for a small credit limit, used it and paid it off, then asked for an increased credit limit. In the meantime, he used the credit card as a reference for a new account with a supplier. Other new business people use equity in their homes or investment land as collateral for credit with banks and suppliers.
To increase your business's profitability, understand and track income, expenses, and — especially important — cash flow. Your consulting business must not only be profitable, it must manage cash to minimize the cost of credit.