Financial advisory

The ten commandments of cash flow management: how to keep a business viable in uncertain times?

Erik Suits ja Eve Lille Grant Thornton Baltic nõustamisteenused

In the past three years, the business environment has been significantly affected by COVID-19, Russia's invasion of Ukraine, high inflation, ever-rising interest rates, the energy crisis, as well as some instability in the world's banking sector in recent months.

Such negative events cloud the near future, because there is much that is indeterminate and the final impact on certain areas may not yet be visible at all. The unpredictable environment, restrictions on economic activity during the pandemic, and the end of trade with Russia due to the war have all changed the way supply chains operate, and the availability of certain products and materials is limited. All this shakes the confidence of entrepreneurs, which has already been buffeted.

The spring 2023 economic forecast recently released by the Ministry of Finance notes that in Estonia, the processing industry has been significantly affected, its competitiveness reduced by the limited availability of materials and the rapid price increase. This has significantly reduced Estonia's export capacity, as in certain sectors (e.g. timber) there is no longer a competitive advantage in terms of price. Exports are forecast to fall by 1% this year. Although construction has remained fairly stable, negative effects usually reach this sector with a lag time. At the same time, companies in ICT, entertainment and business services, and HoReCa have had seen a positive influence. Indeed, the latter areas have had a robust recovery despite the number of foreign tourists not yet returning to pre-pandemic levels. Although different sectors have been affected differently by the previously described external factors – depending on the cost structure, supply chains and loan financing rate of the respective sector – all entrepreneurs should think about proactively managing their company's cash flow to be more flexible in an uncertain environment.

Unfortunately, no one can predict with certainty what the situation will be in the economy in a year or two. According to the International Monetary Fund (IMF), global inflation in 2023 shows a downward trend from 8.7% (2022) to 7%. Although Estonia's inflation in 2022 was one of the highest in Europe (19.4%), the Ministry of Finance has forecasted 9.2% for 2023. At the same time, signs of wage growth slowing down this year are not yet expected, as the forecasted wage growth for 2023 is 9.0%. That means that price and wage pressure will continue for some time.

Uncertainty in the economy forces business leaders to make changes in their processes and think about optimization options for ensuring the company's liquidity and operational sustainability. The key word here is cash flow management, the aim being to achieve viability of the company and business. Below are some points that managements should consider to streamline adaptation to an uncertain situation.

Get incoming and outgoing cash flows under control

An inflationary and rising-interest-rate environment, where capital has a higher cost, can inevitably cause concerns about the company's liquidity. This forces management to find ways to manage cash flows more skilfully and avoid a decrease in liquidity.

1. Create a cash flow forecast model

A cash flow forecast model is a necessary planning tool. A well-designed one that is based on possible scenarios helps a company’s management come up with a more detailed action plan for both optimistic and pessimistic scenarios. Cash flow forecasting helps to plan income and expenses and thereby gives a better idea of future cash needs. Today's information technology solutions offer excellent tools for managing cash flows and automating processes, which creates an opportunity for management to monitor business cash flows in real time. It gives management a data-based tool for making smarter managerial decisions in the short term in particular. Regular monitoring and analysis of cash flows helps to identify patterns, trends and possible warning signs, which can be taken into account to prevent an unexpected shortage of funds.

2. Establish key metrics

In uncertain times, having available funds is extremely important. In order to determine the optimal cash needs for a company, it is necessary to understand company-specific factors that affect working capital. Management should set working capital management metrics (including accounts receivable turnover ratio, accounts payable turnover ratio and inventory turnover ratio). For comparison, it is worth keeping an eye on the corresponding metrics for competitors and know how they operate on the market. If the company's metrics differ significantly from those of competitors, find out the reason for the differences and whether there might be inefficiencies in working capital management.

3. Analyse the dynamics of cash receipts by monitoring accounts receivable

To ensure liquidity, understand the dynamics of cash receipts from accounts receivable and have a strategy for greater control over the amounts received from customers. To monitor the creditworthiness of customers, a company needs to put in place a system and conditions for credit sales. Also think through the process of monitoring customers and assessing their creditworthiness. Monitoring accounts receivable helps to identify customers with payment difficulties in time and proactively take steps to avoid more serious problems later. For the process to work, it must also be clearly communicated to the company's employees.

4. Review credit terms and talk these through with customers 

Negotiate the conditions for credit with every customer and continuously monitor compliance with conditions set by the client. The faster we receive funds from customers, the better, because business needs a constant stream of funds. For example, customers can be offered discounts for early payment or charged a certain advance payment before the delivery of goods or services. This helps to bring cash flow forward in time and avoids possible later delays in receipts. Invoice customers as soon as possible after the delivery of the product or service. If customers are late paying invoices, communicate with them and remind them.

5. Review payment terms and negotiate them with suppliers 

As with incoming cash flow, try to negotiate payment terms with suppliers to get control of outgoing cash flow. But ensure that the turnover rate of supplier payables is not faster than that of accounts receivable. Otherwise, money will flow out of the company faster than it comes in from customers. Also consider whether it is possible to replace some suppliers with cheaper sources of the same goods/services. Analyse critically whether the cheaper supplier also offers goods/services of the same quality and what their payment terms are.

6. Optimizing working capital needs with effective inventory management

Working capital management requires you to calculate the optimal inventory level in order not to have money tied up in inventory for too long and to reduce excess stock, which enables also to avoid the possible need for write-down later on. This can translate into a positive effect on cost savings, as it creates a possibility to reduce storage space costs, insurance expenses and other related costs. The inventory optimization process includes forecasting customer demand and optimizing order quantities. Above all, avoid buying a large amount of stock from the warehouse just because the supplier is offering a discount on bulk. A discount percentage might not be worth it if the purchased inventory cannot be sold in a reasonable amount of time.

Maximize efficiency and seize new opportunities: in uncertain times, business leaders must be flexible and adaptable, considering a variety of strategies and being prepared to make changes to the business in response to changing customer needs. Business leaders should not be afraid to ask for outside help. It is important to find partners who help to open up new perspectives and solutions that create an opportunity for management to ponder the success factors for their specific business.

7. Optimize the cost structure and implement smart solutions

It is critical for every company's management to optimize costs and having a detailed view of costs. Which costs could be reduced or completely eliminated? The company may have to take drastic measures to cut its costs, but that could also mean an opportunity to explore new business opportunities. For example, investments into automating work processes or the implementation of new technologies can be considered, which in the long run will help minimize running costs. For a company to be able to keep pace with the rise in interest rates and price pressure, it will also have to critically review the sales prices of the product or service portfolio and try to pass on any increased costs to the end consumer, i.e. the customer. Otherwise, it will be unable to carry on sustainably, and at some point payment problems may occur.

8. Turn the green transition to your advantage

When greening a company, consider changes that help the company reduce costs but also contribute to a more environmentally sustainable model of behaviour and increase the efficiency of the company's processes. For example, think about reducing the material used for packaging products, achieving energy efficiency by using equipment that consumes less energy, etc. Also consider financing solutions offered jointly by Kredex and Enterprise Estonia. In particular when it comes to sustainability and the green transformation, in order to encourage companies to be more innovative and to think better about different aspects of their business operations.

9. Invest wisely, always considering the impact on cash flow

When designing a cost-saving policy, don't forget about well-thought-out investments that help expand the market, increase competitiveness, improve the customer experience and achieve turnover growth. The creation of an investment plan should be part of the long-term strategy of business operations, and thus not neglected or significantly postponed. To understand the profitability of investments, management must pay attention to the internal rate of return on the investment and the company's cost of capital before deciding to make the investment. If the return on the investment is higher than the cost of capital, then the investment is worth making.

10. Grow the business through mergers and acquisitions to achieve greater base cash flow

Expanding your business in difficult times can be a challenge, but it can also be an opportunity to grow and become more competitive. If the current market or sector tends to be negatively affected by external factors, it may be useful to explore new markets or geographical areas where the company could expand. This can help to find new customers and/or reduce dependence on a single market. As an additional option, you can consider launching new products or services to better serve your customers. This can also contribute to expanding the customer base and stay competitive. Although in an uncertain economic situation, smaller companies can wind up in difficulty, bigger competitors can have the opportunity to consolidate the market and buy companies in distress.

Uncertain times inevitably force company management to review existing business models and adapt to cope with new challenges and changes in customer demand.

The text above cannot be interpreted as financial, legal and/or tax advice. This article is a generalized summary. Before making any decisions or approving actions, seek advice from experts in the relevant field.

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