Improving cash flow is essential for ensuring a business can meet its day-to-day financial commitments and remain solvent during challenging periods.
What Is Cash Flow and Why Is It Important?
Cash flow refers to the total amount of money being transferred into and out of a business, particularly in terms of liquidity – how readily a business can access funds to cover its short-term obligations. A cash flow statement is used to track and monitor these inflows and outflows over a set period, typically monthly or quarterly.
Importance of Cash Flow
Maintaining a positive cash flow is vital for the operational and strategic health of any business. Here’s why:
Business Survival: A business may show a profit on its income statement but still fail due to lack of cash. If a firm cannot pay suppliers, wages, rent, or utility bills on time, it risks default, legal action, or even bankruptcy.
Liquidity Management: Liquidity is a firm’s ability to pay off its short-term liabilities as they fall due. Cash flow directly impacts liquidity; poor cash flow management leads to a liquidity crisis, which is often a precursor to insolvency.
Day-to-Day Operations: Operating expenses such as payroll, inventory restocking, and lease payments require readily available cash. Cash flow ensures continuity.
Creditworthiness and Investment: Lenders, investors, and suppliers review a business's cash flow health before offering loans or credit terms. A strong cash flow may improve bargaining power and open opportunities for growth investment.
Methods of Improving Cash Inflow
Improving cash inflow involves increasing the amount and speed of incoming cash. This enhances liquidity and reduces dependence on external finance.
1. Encourage Early Payment from Customers
Businesses can attempt to accelerate the receipt of payments by prompting customers to settle invoices before the due date. This can be achieved through:
Sending prompt and clear invoices.
Establishing clear payment terms upfront.
Following up regularly with reminder emails or phone calls.
Including late payment penalties in contracts to deter delays.
Evaluation:
Advantages:
Improves cash inflow timing and reduces the risk of bad debt.
Strengthens working capital position.
Disadvantages:
Persistent follow-ups can harm customer relations.
Not effective with customers who themselves face liquidity constraints.
Example: A small B2B consultancy changes their invoice terms from 30 to 14 days and begins issuing invoices immediately after project completion. Within two months, they experience a 20% reduction in average debtor days.
2. Offer Discounts for Prompt Payment
Offering customers a small discount in exchange for quicker payment can be a powerful incentive. For instance, a business might offer a 2% discount if the invoice is paid within 10 days instead of the standard 30.
Evaluation:
Advantages:
Encourages quicker payment, improving cash flow without external borrowing.
Reduces the risk of bad debts.
Disadvantages:
Reduces overall revenue and profit margins.
May set a precedent that all customers expect discounts.
Worked Example:
If a company issues a £10,000 invoice with a 2% early payment discount, the customer pays £9,800 within 10 days instead of £10,000 in 30 days. The business trades £200 for 20 days of liquidity.
3. Sell Off Excess Stock
Stock tied up in inventory represents a cash outflow until the goods are sold. Selling off excess, outdated, or slow-moving stock — even at a discount — can convert dormant assets into cash.
Evaluation:
Advantages:
Generates immediate cash from unsold goods.
Frees up storage space and reduces holding costs.
Disadvantages:
May result in lower profit margins or losses.
Not a sustainable long-term strategy.
Scenario: A fashion retailer sells last season’s inventory at 50% discount during an off-season clearance sale, recovering £5,000 in cash which can be reinvested into new stock for the upcoming season.
4. Reduce the Credit Period Offered
Businesses often provide credit terms (e.g. 30 or 60 days) to attract or retain customers. Reducing this period means faster cash inflows.
Evaluation:
Advantages:
Shortens the cash cycle and improves liquidity.
Helps forecast cash flows more reliably.
Disadvantages:
Customers may be discouraged by stricter terms.
Could lose sales to competitors with more generous credit policies.
Example: A wholesaler reduces its credit terms from 60 to 30 days. While some customers negotiate for a longer period, average receivable days fall by 25%, and monthly cash inflow improves by 18%.
5. Secure Short-Term Finance
When internal methods are insufficient, businesses may turn to external short-term financing such as:
Overdrafts: A facility allowing firms to overdraw on their current account up to an agreed limit.
Factoring: A financial service where a business sells its accounts receivable to a third party (a factor) for immediate cash, typically at a discounted value.
Evaluation:
Advantages:
Provides quick access to cash without waiting for customer payment.
Can stabilise cash flow during seasonal downturns or emergencies.
Disadvantages:
Comes with interest, fees, or commission charges.
Factoring may affect customer relations if the factor handles collections.
Example: A business factoring a £20,000 invoice receives 85% (i.e., £17,000) upfront and the remaining £3,000 less a 2% fee after customer payment, improving liquidity but at a cost of £400.
Methods of Reducing Cash Outflow
Equally important as improving inflows is reducing how quickly and how much cash leaves the business.
1. Delay Payment to Suppliers
One strategy is to postpone paying suppliers until closer to the due date, improving working capital in the short term.
Evaluation:
Advantages:
Retains cash within the business for longer.
Can ease short-term liquidity pressures.
Disadvantages:
May damage supplier relationships or credit terms.
Risk of losing supplier discounts for early payment.
Example: A café delays payment to its milk supplier from 15 to 30 days. Although the supplier expresses concern, the café uses the saved cash to pay overdue utility bills.
2. Negotiate Better Payment Terms
Instead of delaying payments unilaterally, a business might proactively negotiate longer credit terms or staggered payment plans.
Evaluation:
Advantages:
Strengthens long-term relationships with suppliers.
Enhances cash flow predictability and reduces pressure.
Disadvantages:
May require volume commitments or compromise on other contract terms.
Some suppliers may reject longer terms, especially smaller ones.
Scenario: A construction company renegotiates its payment terms for raw materials from 30 to 60 days, aligning payment with the project milestone receipts.
3. Reduce Overheads or Delay Expansion
Reducing ongoing fixed costs, such as rent, utilities, and administrative expenses, is an effective way to cut cash outflows.
Common strategies include:
Downsizing office space.
Cutting travel or discretionary expenses.
Freezing recruitment or deferring planned capital expenditures.
Evaluation:
Advantages:
Immediate reduction in cash requirements.
Helps focus resources on core activities.
Disadvantages:
Could impact morale, efficiency, or customer service.
Delaying investment might hinder growth prospects.
Example: A start-up delays the opening of a second office and switches to remote working, saving £1,500 per month in rent and utilities.
Example Scenarios: Application in Context
Scenario A: Retail Business Facing Post-Holiday Slump
Business: High-street fashion store.
Problem: Cash reserves depleted after peak sales season.
Strategy:
Launches a clearance sale to liquidate leftover stock.
Negotiates 60-day credit terms with clothing suppliers.
Result: Cash inflow increases by £8,000 in January; outflows reduced through deferred payments.
Scenario B: Manufacturer Dealing with Late Invoices
Business: Furniture manufacturing firm.
Problem: Wholesale buyers take over 60 days to pay.
Strategy:
Implements factoring for larger accounts.
Introduces 2% early payment discount for smaller retailers.
Result: Factoring yields £50,000 immediate cash; 30% of smaller customers adopt prompt payment discount.
Scenario C: Tech Company with High Fixed Costs
Business: SaaS provider in early growth phase.
Problem: Monthly overheads exceeding revenue due to delayed subscriptions.
Strategy:
Moves to co-working space, saving £2,000 per month.
Secures overdraft facility of £10,000 for short-term cover.
Result: Positive net cash flow achieved within 3 months.
Scenario D: Service Provider with Slow-Paying Clients
Business: Marketing agency.
Problem: Cash flow issues due to clients delaying payment.
Strategy:
Reduces credit terms from 45 to 21 days.
Adds 3% penalty for late payment and 2% early payment discount.
Result: Average payment period drops to 25 days; agency recovers £15,000 faster than usual.
Key Formulas for Cash Flow
To support understanding, here are basic formulas used in cash flow analysis:
Net Cash Flow = Total Cash Inflows – Total Cash Outflows
Closing Balance = Opening Balance + Net Cash Flow
These calculations allow firms to prepare accurate cash flow forecasts and plan accordingly.
FAQ
Improving cash flow is crucial for small businesses because they often have limited access to finance and fewer cash reserves. Unlike large corporations, small firms typically cannot absorb prolonged periods of negative cash flow, making them more vulnerable to late payments or unexpected expenses. Delays in receiving payments or sudden increases in costs can quickly lead to insolvency. Therefore, managing cash inflows and outflows efficiently is essential for survival, especially in industries with seasonal demand or irregular income patterns.
Yes, a profitable business can face cash flow problems if income is not received in time to meet outgoings. For example, a company may report strong profits on its income statement but still be unable to pay suppliers or staff if customers delay payments. This is common in businesses that allow long credit terms or have large amounts tied up in unsold stock. Profitability measures long-term success, while cash flow reflects a firm’s short-term financial health and operational ability.
A cash flow forecast predicts the timing and amount of cash inflows and outflows, helping managers plan for periods of surplus or shortfall. It allows a business to identify potential liquidity issues in advance and take action, such as arranging short-term finance or delaying discretionary spending. Accurate forecasting also improves decision-making around investments, hiring, and inventory. It provides a framework to evaluate the effectiveness of strategies to improve cash flow and helps businesses maintain financial control and avoid insolvency.
Relying too much on short-term finance such as overdrafts or factoring can lead to higher interest payments and reduced profit margins. These sources often come with high fees and may not be sustainable if used repeatedly. Additionally, over-reliance can signal poor internal financial control, reducing investor confidence. If the short-term facility is withdrawn unexpectedly, it could cause a cash crisis. Businesses that depend on short-term finance risk becoming trapped in a cycle of borrowing to cover operational costs.
Poor cash flow can lead to delayed wage payments, reduced resources, or job insecurity, all of which negatively affect employee morale. Staff may become demotivated if they sense financial instability, potentially leading to lower productivity or higher turnover. In some cases, businesses may need to freeze hiring, cut hours, or delay training and development programmes, which can hinder long-term growth. A firm’s ability to attract and retain talent is closely linked to its financial health and stability.
Practice Questions
Explain one method a business could use to improve its cash inflow and analyse one possible disadvantage of this method. (6 marks)
One method to improve cash inflow is offering a discount for early payment. This encourages customers to settle invoices quicker, improving liquidity and reducing the risk of bad debt. However, this can reduce revenue as the business receives less than the invoice total. For example, offering a 5% discount on a £10,000 invoice would cost the firm £500. While cash comes in sooner, it may weaken profit margins, particularly if used frequently or with low-margin products. Businesses must weigh short-term liquidity benefits against the long-term impact on profitability, especially if customers begin to expect discounts as standard practice.
Analyse how delaying payments to suppliers could affect a business’s relationship with its stakeholders. (9 marks)
Delaying payments to suppliers improves cash flow by retaining funds within the business for longer, aiding short-term liquidity. This might allow a firm to cover other urgent costs, such as wages or rent. However, it may damage relationships with suppliers, especially if delays go beyond agreed terms. Suppliers might respond by tightening credit terms, demanding upfront payment, or even refusing future business. This tension can disrupt the supply chain and reduce operational efficiency. Additionally, ethical concerns may arise, with other stakeholders perceiving the firm as unreliable. Maintaining trust while managing cash flow is essential to balancing financial health with reputation.
