In this third article on cash flow management within small firms I take a look at the role of learning within the small firm as owner-managers and their teams confront the reality of maintaining sufficient liquidity in the business. In preparing this series I have selected research papers published within the academic literature in the past five years.
The research paper reviewed here is by Ignatius Ekanem from the University of Middlesex. It was published in the Journal of Small Business and Enterprise Development in 2010 and focuses on the management of cash flow and liquidity in the small firm and the role of organisational learning in dealing with this.
The study involved a longitudinal analysis of eight small firms undertaken as case studies with the owners interviewed at three separate intervals over a 12 month period during the financial year 1998-1999. Four of the firms were engaged in the printing industry and the remainder within the clothing manufacturing sector. All were incorporated businesses with between 6 and 50 employees.
Cash flow management varies from industry to industry
Key findings from these cases were that the approach taken to cash flow management differed across the two industry sectors. In the printing industry there was a sense of cash flow management emerging from having to face crises in liquidity within the firm. By comparison the clothing manufacturers were more likely to follow similar conventions and practices.
The following quotes are drawn from the paper and reflect the crisis management facing the printers:
“From hindsight, it is a bit silly, but I used to stock a lot of materials to avoid running out. I mean we were basically buying stuff in large quantities. I didn’t realise that I was tying down cash by so doing until my production manager suggested that I should reduce my order size when buying. Initially, I ignored him. I didn’t want to lose my discounts [from bulk buying], but when the liquidity problem became critical, I decided to do as he suggested and it worked. Now, I don’t ignore him anymore" (interview with owner-manager printing company, 5 October, 1998; page 130).
“Again, I used to be attracted by cash discounts for early payments to my creditors. I did not actually think through whether these discounts were really worth it. My accountant had advised me many times to change my system [of payment] and hold onto my credit until the last moment, but I thought I knew better. However, when the problem persisted, I decided to give it a go. At that stage, I was prepared to do anything to avoid disaster. On the whole, he has been very supportive” (interview with owner-manager printing company, 5 October, 1998; page 130)
“Oh! This was a nightmare for us before I approached my accountant for help. We basically didn’t know what to do in this regard. Initially, the accountant was doing this for us, but over the years Lynda [the credit controller] has acquired a lot of confidence from the support we have received from him. Now, she can do it herself” (interview with owner-manager printing company, 7 October, 1998; page 130).
By contrast the clothing manufacturers were more inclined to work via cash flow forecasts even though they were not easily constructed as the following quote reveals:
“It’s not an easy thing to do, you know. It’s like looking into a crystal ball. We do examine the last few years book to forecast future cash flows” (interview with owner-manager clothing business, 13 October 1998 page 132).
Discounting and collection of accounts receivable
Each of these comments reflects the challenges that many small business owners face in learning how to manage cash flow. Customers seek discounts and longer payment terms while suppliers are keen to secure bulk purchases offering discounts. Yet discounting, particularly for good customers only serves to reduce profit margins and longer credit terms reduces the flow of cash into the business. Further, even though the attraction of discounts for bulk purchases seems appealing, there is a cost of carrying too much inventory and it risks reducing the available cash for short term operating costs.
What these comments also reveal are the difficulties that many small business owners have in making reliable cash flow forecasts and their reliance on accountants to help them. This often occurs once a problem has arisen and liquidity is tight. Developing systems that can prevent such crises taking place and teaching staff to implement them is the desirable approach. According to Ekanem many of the small business owners he interviewed used intuition and personal judgement when deciding whether or not to offer credit to customers.
Over time they developed active systems of following up payments owed to them by debtors. As one credit controller within a small printing company explained:
“I phone up creditors a few days after the expiration of the credit period. This is followed by several other calls until either payment is made or we seek solicitor’s advice“ (credit controller, third interview, 1 April 1999; page 131).
Closed and open-loop learning
According to Ekanem the findings from these case studies suggests a process of closed and open-loop learning by the owner-managers in relation to cash flow management. The clothing firms tended to follow a closed-loop approach characterised by following well-established industry norms and procedures. By comparison the printers were more likely to employ an open-loop learning approach. Here they relied on advice from accountants and their own experience to modify their policies on credit and their practices for debt collection.
For example, even when the industry average collection period for accounts receivable was 30 to 90 days, most owners in the printing industry sought to collect payments within 14 days and were persistent in phoning customers if they did not pay up on time. The use of solicitors or other debt collection agencies when debts became considerably overdue was not something that all owners resorted to. This was due to the expense and time involved.
Lessons to be noted
One of Ekanem’s conclusions is that the financial management practices of large firms should not be used as a benchmark for small firms. Owner-managers learn more from experience and the interaction with professionals such as accountants in developing appropriate strategies for the operation of their businesses.
The study also highlights the differences that exist between different industries in relation to the time taken to collect debtors and make payments to creditors. Some industries have long payment cycles with several weeks or even months between the commencement of a job, its completion and the time taken before final payments are made. Businesses with average debtor payment cycles of 30 days will need to have sufficient cash on hand to provide working capital for about a month. However, if this debtor collection period were to push out to 60 or even 90 days the working capital requirement will rise and the amount of cash on hand needed will increase.
It is therefore important for small business owners to examine their cash flow requirements and prepare cash flow forecasts. These should consider the amount of cash that the business will need on hand to fill the gaps between the time it takes to collect payments from customers and the dates when creditor payments fall due. If this gap cannot be filled by normal cash flow, the owner may need to adjust their terms of credit with customers, seek up-front payments, or negotiate better repayment terms with creditors. However, if these measures cannot be made to work the owner may need to talk to their bank about an overdraught.
Note: Tim Mazzarol is President of the Small Enterprise Association of Australia and New Zealand (SEAANZ).
SEAANZ is a not-for-profit organisation founded in 1987. It is dedicated to the aim of bringing together small business professionals in practice, education and training, and to promote small business development, communication and dissemination of research, ideas and information.