The cash flow cycle in a business can be a lot like the workings of a four-cycle engine. Before an engine can produce any power, it must first consume energy. The fuel mixture must first be compressed in the cylinder. Similarly, a business needs an input of capital and labor before it can produce any profits.
The second stage is the power stroke, when the spark ignites the fuel in the engine. For a business, sales generate cash flow, starting its forward momentum. In the engine’s third stage, the piston again rises in the cylinder, expelling he exhaust gases. In the business, cash flows out to pay employees, suppliers, creditors, taxes, etc. With any luck, there is a little left for the owners!
The next stage in the engine’s cycle is the intake stroke, when it draws in another charge of fuel and air. In the business cash flow cycle, inventory is replenished and sales efforts set up the next “compression stroke” of investment.
Some businesses are fortunate in that all these elements of cash flow happen simultaneously. They run more like spinning turbines than reciprocating engines. The majority of enterprises however, experience some kind of cash flow cycle. Each industry has its own typical seasonal or periodic cycle of investment, activity, and cash flow.
A piston engine can keep running by using a flywheel. A flywheel conserves momentum and keeps the motor spinning through the three cycles that consume, rather than provide, power. Likewise, there are financial “flywheels” that a business can use to continue running smoothly through its cash flow cycles.
As chief financial officer for Business Bank of Texas, one of my jobs is to manage and monitor the bank’s cash flows. As a financial institution, cash is our main stock in trade. So you can imagine that we spend considerable time in budgeting and analyzing our liquidity, and making sure that our financial flywheels are all in place. The most obvious thing we do is to keep adequate cash reserves on hand to meet our day-to-day needs. We also make sure that we have in place the lines of credit and other secondary sources that we can use if needed. We look at both sides of our balance sheet, assets and liabilities, when managing our cash flow.
Non-financial businesses can take the same approach in managing and monitoring their cash flow. One of our contributors, Phillip Campbell, posted a classic article called The Secret to Understanding Cash Flow a while back. He explains a powerful but simple approach to analyzing and managing business cash flows. I recommend that you extend his method to estimate your future cash flows as well, so that you won’t be caught unprepared.
So what are the financial flywheels that can be utilized? The first is to maintain cash reserves that are sufficient to meet projected day-to-day needs. This is easier for firms that generate revenue steadily throughout the year and do not have deep cash flow cycles. Firms that build up excess cash reserves can choose to put some of their money to work in short-term investments and interest bearing accounts. Business Bank of Texas offers sweep arrangements to automate the transfer of excess balances into money market accounts. We even offer an Insured Cash Sweep account that provides full FDIC insurance on balances over the $250,000 limit. It is a convenient way to get some work from excess funds while keeping them available for any cash needs that might arise.
A revolving line of credit is another financial flywheel on the liability side that can be most effective in smoothing out seasonal and periodic cash flows. It can also be set up as an automated sweep to optimize its effectiveness. Revolving lines can also help save money by enabling early payment discounts to suppliers. Business Bank of Texas president Ed Lette posted an article last year on this topic.
An enterprise with pronounced cash flow cycles can even use both of these products together. After determining the appropriate cash balance to maintain for ongoing transactions, automated sweeps can be set up. They can be used to put excess cash to work when collections are flush, and to draw on a line of credit as needed.
Our Business Bank of Texas commercial relationship officers are part of a team that can help you manage your cash flow cycle. If your cash flow engine is running a little rough, they can help get you tuned up and humming on all cylinders!
Interested in starting to track your cash flow today? We've provided a free one-page worksheet to help your business start managing cash flow effectively. Get yours below!