Cash flow management for SMEs
Khalid Allam, Ph.D.
Outline
• Background
• Working capital management: The theory
• Cash Flow management: Best practices for
SMEs.
Background
• Definition of SMEs differs from country to
country
• In the USA, companies with less than 500
employees, Europe: less than 250 and sales not
exceeding 50 million Euro (OECD,2019)
• SMEs play a pivotal role in the creation of jobs,
the alleviation of poverty and the overall
enhancing of the economy.
• In Morocco, SMEs represent 93% of the total
number of firms in the private sector (HCP, 2019).
Background
• SMEs face high failure rate around the globe
• SMEs are more vulnerable because they tend to
have smaller sources of resources, fewer assets,
and smaller production levels than larger
companies (OECD, 2020).
• In 2017, more than 8,000 SMEs went bankrupt in
2017 and 8,439 in 2019.
• A survey of 174 SMEs in Morocco, monitoring
and managing cash flow is the main concern for
these companies.
Background
Sizes of Moroccan companies Shuting down due to Covid-19
(HCP, 2020)
Working capital management: The theory
•
•
•
•
•
Working Capital Concepts
Working Capital Issues
Conservative vs Aggressive strategy of WCM
Liquidity measured using Financial ratios
Statement of Cash Flows
Working Capital Concepts
Net Working Capital
Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The administration of the firm’s current assets and the
financing needed to support current assets.
One of the most important challenges facing small to
medium enterprises (Mazzarol, 2014)
Working Capital Issues
• In a typical manufacturing firm, current assets
exceed one-half of total assets.
• Excessive levels can result in a substandard
Return on Investment (ROI).
• Current liabilities are the principal source of
external financing for small firms.
• Requires continuous, day-to-day managerial
supervision.
• working capital management affects the
profitability and consequently the value of the
firm (Smith, 1980)
Working Capital Issues
• Optimal Amount (Level) of Current Assets
Assumptions
• 50,000 maximum units of production
• Three different policies for current asset levels are possible
Working Capital Issues
Optimal Amount (Level) of Current Assets
Liquidity Analysis
Policy
Liquidity
A
High
B
Average
C
Low
Greater current asset levels generate more
liquidity; all other factors held constant
Working Capital Issues
Optimal Amount (Level) of Current Assets
Expected Profitability
Return on Investment = Net Profit
Total Assets
Total Assets = Current Assets + Fixed Assets
Profitability Analysis
Policy
Profitability
A
Low
B
Average
C
High
As current asset levels decline, total assets will decline and the ROI will
rise.
Working Capital Issues
Optimal Amount (Level) of Current Assets
Risk Analysis
* Decreasing cash reduces the firm’s ability to
meet its financial obligations. More risk!
* Stricter credit policies reduce receivables and
possibly lose sales and customers. More risk!
* Lower inventory levels increase stock outs and
lost sales. More risk!
Working Capital Issues
Optimal Amount (Level) of Current Assets
Risk Analysis
Policy
Risk
A
Low
B
Average
C
High
Risk increases as the level of current assets are
reduced.
Summary of the Optimal Amount of
Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy
A
B
C
Liquidity
High
Average
Low
Profitability
Low
Average
High
Risk
Low
Average
High
1. Profitability varies inversely with liquidity.
2. Profitability moves together with risk.
(risk and return are a dancing partners in an eternal
dance)
Conservative vs Aggressive strategy of WCM
• Conservative policy focuses on allocating large
funds in Current Assets financed by more long
term debt.
• Aggressive policy allocates small funds in
Current Assets, which are financed by a large
volume of short-term financing or current
liabilities (Altaf &Ahmad, 2019).
• Each policy has its own benefits and costs.
Conservative vs Aggressive strategy of WCM
•
•
•
•
Risks vs. Costs Trade-Off (Conservative
Approach:
This is a low risk/return policy
Suitable for companies operating in a volatile
market with uncertain demand curve (Awopetu,
2012)
The firm invests heavily in current assets with
minimal use of short-term credit or current
liabilities (Temtime, 2016)
The more Long Term Debt the firm uses, the
more conservative is the policy
Conservative vs Aggressive strategy of WCM
Risks vs. Costs Trade-Off (Conservative
Approach:
• Long-Term Financing Benefits
– Less worry in refinancing short-term obligations
– Less uncertainty regarding future interest costs
• Long-Term Financing Risks
– Borrowing more than what is necessary
– Borrowing at a higher overall cost (usually)
• Result
– Manager accepts less expected profits in exchange for
taking less risk (Baños, Garcia, & Martinez, 2016).
Conservative vs Aggressive strategy of WCM
Risks vs. Costs Trade-Off (Aggressive
Approach):
• This is a high risk/return policy
• suitable for firms that operate in relatively
stable markets and generate a steady revenue
(Awopetu, 2012)
• The firm invests a little amount in current
assets with heavy dependence on short-term
credit or current liabilities (Temtime, 2016)
Conservative vs Aggressive strategy of WCM
• Risks vs. Costs Trade-Off (Aggressive Approach):
•
Short-Term Financing Benefits
–
–
•
Short-Term Financing Risks
–
–
•
Financing long-term needs with a lower interest cost than
long-term debt
Borrowing only what is necessary
Refinancing short-term obligations in the future
Uncertain future interest costs
Result
–
Manager accepts greater expected profits in exchange for
taking greater risk (Baños et al., 2016)
Conservative vs Aggressive strategy of
WCM
Final Thoughts:
• Risk return trade off and the management‘s attitude
toward risk will determine the appropriate level of
current assets and the use of Short term credit.
• If futures sales demand, production, and receivables
collections are certain, then there is no need for the
firm to hold excessive level of current assets and not
to have more long term financing than it actually
needs.
• The greater the ability of a firm to borrow in times of
emergency, the less it needs to provide for a margin
of safety.
Liquidity measured using Financial
ratios
• A Financial Ratio is an index that relates two
accounting numbers and is obtained by
dividing one number by the other
• Liquidity ratios measure the ability of a
company to meet its current obligations.
• A comparison of CA with CL gives an indication
of the short term debt paying ability of a
company (Cunog, 2016).
Liquidity measured using Financial
ratios
• Current ratio: Shows a firm’s ability to cover its
current liabilities with its current assets.
• Traditional benchmark: 2
* Decreased current ratio indicates lower
liquidity
* Industry averages provide contextual
benchmark (Gibson, 2016).
Liquidity measured using Financial
ratios
• Quick ratio: Shows a firm’s ability to meet
current liabilities with its most liquid assets.
• Measures the immediate liquidity of the firm.
• Relates the most liquid assets to current
liabilities by excluding inventories.
• Traditional benchmark: 1
• Industry averages provide contextual
benchmark (Gibson, 2016).
Liquidity measured using Financial
ratios
• Cash ratio: Shows a firm’s ability to meet current
liabilities using cash and Marketable securities.
• Extremely conservative.
• A cash ratio that is too low could indicate a problem
with paying bills.
• A high ratio could also indicate that the company is not
using its cash to it best advantage (Gibson, 2016).
• liquidity ratios are limited in that they only consider
the firm’s current assets.
• If the firm is able to generate significant cash quickly
from its ongoing activities, it might be highly liquid
even if these ratios are poor (Gibson, 2016).
Liquidity measured using Financial
ratios
Working capital ratios
* We use the firm’s income statement and
balance sheet to gauge how efficiently the
firm is utilizing its net working capital.
accounts receivable days: To evaluate the speed
at which a company turns sales into cash.
Accounts Receivable Days = Accounts Receivable
Average Daily Sales
Liquidity measured using Financial
ratios
accounts receivable days
• This ratio can fluctuate seasonally
• It should be compared to the credit terms of the
company and the average indutsry.
• Unexplained siginificant increase could be a cause
of concern:
* The firm is doing a poor job collecting money
from its customers.
* The firm is trying to boost sales by offering
generous credit terms
Liquidity measured using Financial
ratios
Aging Accounts Receivables:
• The process of classifying accounts receivables
by their age outstanding as of a given date.
• It is a mean to obtain insights into the liquidity
of receivables and the management ability to
enforce its credit policy.
• The company can focus its efforts on collecting
old accounts.
Liquidity measured using Financial
ratios
Accounts Payable Days
Indicates the promptness of payment to
suppliers by the firm.
Accounts Payable Days = Accounts payables*365
Purchases
Liquidity measured using Financial
ratios
Inventory Turnover in days:
• To help determine how effectively the firm is managing
inventory
• To gain an indication of the liquidity of inventory
• It tells how many days, on average, before inventory is
turned into accounts receivables through sales
• LIFO and FIFO considerations
Inventory Turnover in days = Inventory * Days in the year
Cost of goods sold
Liquidity measured using Financial
ratios
Operating cycle vs Cash cycle
• Operating cycle is defined as the length of
time from the commitment of cash for
purchases until the collection of receivebales
resulting from the sale of goods and services.
• Cash conversion cycle is the length of time
from the actual outlay of cash purchases until
the collection of receivables resulting from the
sale of goods and services.
Liquidity measured using Financial
ratios
Operating cycle vs Cash cycle
Operating cycle = Inventory turnover in days +
Receivable turnover in days
Cash conversion cycle = Operating cycle –
Payable turnover in days
Liquidity measured using Financial
ratios
Operating cycle vs cash cycle. Brigham, Houston
(2010, p. 496) with some adjustments.
Liquidity measured using Financial
ratios
Operating cycle vs Cash cycle
• The length of operating cycle is an important factor in
determining a firm’s current assets needs
• A very short operating cycle indicate that the firm is operating
effectively with a small amount of current assets and a low
current and acid test ratios.
• The firm is liquid in a dynamic way and does not have to rely
on high level of liquidity as measured by the current asset or
the acid test.
• A relatively long operating cycle could be a warning sign of
excessive accounts receivables and/or inventory.
• A relatively short cash cycle is not necessary a sign of good
management. A company could have a short cash cycle by
simply not paying its bills on time.
Accounting statement of cash flows
• The statement of cash flows provides
information about the changes
in cash and cash equivalents of an entity for a
reporting period, showing separately
changes from operating activities, investing
activities and financing activities (IFRS, 2009).
Accounting statement of cash flows
Cash Flow from Opearting Activities:
These cash flows are generally the cash effects of transactions
that enter into the determination of net income.
Cash Flow from Investing Activities
Shows impact of buying and selling fixed assets and debt or
equity securities of other entities
Cash Flow from Financing Activities
Shows impact of all cash transactions with shareholders and
the borrowing and repaying transactions with lenders.
Accounting statement of cash flows
Statement of Cash Flow (IFRS, 2009)
Accounting statement of cash flows
Accounting statement of cash flows
When used with Financial ratios, the SCF should
help the manager assess and identify the
following:
* The ability to generate future net cash inflows
from operations to pay debts, interest and
dividends.
* The need for external financing
* The resaons for the differences between net
income and net cash flow from operating
activities
Cash Flow management: Best practices
for SMEs
Four important guiding principles:
1. Accelerate cash receipts
2. Slow down cash outlays
3. Optimize inventory management
4. Maintain an optimal cash balance
Cash Flow management: Best practices
for SMEs
1.Accelerate cash receipts
• Cash Sales
• Establishing Credit Terms using industry standards
• Establish a collection policy
• Send invoices early (electronic invoices with link to online
payments)
• Offer small discounts for quick payments
• Monitor accounts receivables using the following two tools:
* Accounts Receivable Days should be compared to policy
specified in the firm credit terms to judge the effectiveness
of its credit policy
* Aging Schedule: Management can compare the normal
payments pattern to the current payments pattern.
Cash Flow management: Best practices
for SMEs
Aging Schedule Brigham, Houston (2010, p. 598)
Cash Flow management: Best practices
for SMEs
2. Slow down cash outlays
• Borrow using accounts payable only if trade credit is the
cheapest source of funding
• Pay on the latest day allowed. For example, if the discount
period is 10 days and the firm is taking the discount,
payment should be made on day 10, not on day 2.
• Reputation is important; avoid developing bad relationship
with suppliers
• Monitor accounts payable to ensure that it is making its
payments at an optimal time:
* calculate the accounts payable days outstanding and
compare it to the credit terms.
* Compare the accounts payable days to Accounts
Receivable Days.
Cash Flow management: Best practices
for SMEs
3. Optimize inventory management
• The goal is to balance the costs and benefits associated
with inventory
• Excessive inventory uses cash and efficient
management of inventory increases firm value.
• In case of seasonality, the optimal level should take in
consideration the demand cycle and volatility
• Strong relationship with suppliers is important
• Inventory management software can help forecast
demand
Cash Flow management: Best practices
for SMEs
4. Maintain an optimal cash balance
* To meet its day-to-day needs
* To compensate for the uncertainty associated
with its cash flows
* To satisfy bank requirements
Cash Flow management: Best practices
for SMEs
4. Maintain an optimal cash balance
a. To meet its day-to-day needs
• Hold enough cash to be able to pay its bills
• The cash conversion cycle: the longer the cash
conversion cycle the higher should the cash balance be
• The quick ratio is a common measure of the ability of
the company to meet its short tem needs
• By increasing its cash balance, the firm can raise its
quick ratio to its desired level.
Cash Flow management: Best practices
for SMEs
4. Maintain an optimal cash balance
b. Precautionary Balance
• The size of this balance depends on the degree of
uncertainty surrounding a firm’s cash flows
• Uncertain future cash flows dictates a larger
precautionary balance
• A good measure is the volatility of operating cash flows
• Firm size could also determine the size of this balance
because it is costly for small firms to get access to
external funding
Cash Flow management: Best practices
for SMEs
4. Maintain an optimal cash balance
c. To satisfy bank requirements
• A compensating balance in an account at the
bank as compensation for services that the
bank performs
• The cash that a firm has tied up to meet a
compensating balance requirement is
unavailable for other uses
Cash Flow management: Best practices
for SMEs
• So how much cash to hold?
• Establish a target level of cash balances to
maintain
• The optimal strategy for a firm is to hold cash in
anticipation of seasonalities in its operating and
the compensating balance requirements.
• Include a cash reserve in case of emergencies.
Marketable securities could provide a return to
the firm and are easily converted to cash in case
of deficiencies.
Cash Flow management: Best practices
for SMEs
• Develop a strategic plan for the next 12 months
• A Cash Budget is a forecast of a firm’s future cash flows
arising from collections and disbursements, usually on a
monthly basis
* Determine the future cash needs of the firm
* Plan for the financing of these needs: line of credit
*Exercise control over cash and liquidity of the firm
• A projected income statement and a balance should also be
created
• Include various scenarios—optimistic, most likely and
pessimistic—in order to map out the impacts of each one
and reduce the risk of surprises
References
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Altaf, N. and Ahmad, F. (2019), “Working capital financing, firm performance and financial
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profitability”, doctoral dissertation, retrieved from ProQuest Digital Dissertations and Theses
database, UMI No. 3547808.
Baños-Caballero, S., García-Teruel, P.J. and Martínez-Solano, P. (2016), “Financing of working
capital requirement, financial flexibility and SME performance”, Journal of Business
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Mazzarol T (2014) Research review: A review of the latest research in the field of small business
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Miller, M. H. & Orr, D. (1966). A model of the demand for money by firms. The Quarterly Journal of
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References
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Smith, K. (1980). Profitability versus liquidity tradeoffs in working capital
management. Readings on the management of working capital, 549-562.
Sun, Z. & Wang, Y. (2015). Corporate precautionary savings: Evidence from the recent
financial crisis. The Quarterly Review of Economics and Finance, 56, 175–186
Song, K. & Lee, Y. (2012). Long-term effects of a financial crisis: Evidence from cash holdings
of East Asian firms. Journal of Financial and Quantitative Analysis, 47(3), 617– 641
Temtime, Z.T. (2016), “Relationship between working capital management, policies, and
profitability of small manufacturing firms”,available at:
http://scholarworks.waldenu.edu dissertations/2105/ (accessed January 21, 2017).
Whalen, E.L. (1966). A rationalization of the precautionary demand for cash. The Quarterly
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Thank You!
Questions