Running a successful business always comes down to planning. Yet, a large percentage of new companies entering a market, don’t make it past the first year.
Why is that?
A lot of it comes down to one simple mistake: poor cash flow management.
What is Cash Flow Management?
In the simplest terms, cash flow management is the process of tracking how much money comes in and out of your business.
The definition can be summarized as the process of monitoring, analyzing, and optimizing the net amount of cash receipts minus expenses. It’s all about managing your business finances responsibly.
Cash management helps to predict how much money will be available in the future to cover things like debt, payroll, and vendor invoices. Net cash flow is a critical measure of financial health for any organization.
Understanding Cash Flow
A business’s cash flow can involve a variety of financial actions. A company takes money in from sales as revenue and spends money on expenses. It also receives income from things like:
- Interest
- Investments
- Royalties
- Licensing agreements
- Sell products on credit
One of the most important objectives in financial reporting is assessing the amount, timing, and uncertainty of cash flows.
This includes where they originate from and exactly where they go. This is essential for gauging a company’s operational efficiency, liquidity, business needs, profit margins, and overall performance.
A positive cash flow indicates that a company’s liquid assets are increasing. This enables a business to reinvest, cover obligations, make repayments to shareholders, fund expenses, and provide a buffer against future financial obstacles.
Companies with strong financial flexibility have more leverage when it comes to profitable investments. Organizations with a lot of working capital also fare better in downturns, avoiding the risks of financial distress.
All cash flows can be analyzed using a cash flow statement. This is a standard financial document that reports on a company’s sources and usage of cash over a certain period of time. It’s essential for effective cash flow management.
Cash Flow Categories
Cash can flow from and through several parts of an organization. This means, there are many types and categories of cash flow. Consider some of these to start:
Cash Flows from Operations (CFO)
Operating cash flow describes money flows from ordinary operations, like production and the sale of goods. This is the figure that determines whether or not a company has enough funds coming in to pay bills and operating expenses. There must be more operating cash inflows (CFO) than outflows for a business to have long-term viability.
CFO is calculated by subtracting operating expenses (paid in cash) for the period from cash received from sales. The cash position is recorded on a company’s cash flow statement, which is typically reported on a quarterly or annual basis.
Ultimately, operating cash flow will indicate whether a business is capable of generating enough cash flow to maintain and expand operations. Cash flow projections can also indicate when an organization might need extra financing for capital expansion.
CFO is useful when it comes time to segregate sales from cash received. For example, if a business generates a large sale, it should boost earnings and drive revenue. But, what if you have difficulty collecting payment?
In this case, the sale has yet to improve the cash flow because nothing has been paid. The longer this goes on, the more it can negatively affect cash flow and lead to a poor balance sheet.
Cash Flows from Investing (CFI)
Investing cash flow (CFI) is a figure that represents how much cash has been generated or spent from investment-related activities in a specific time period. Investing activities can include:
- Purchases of speculative assets
- Investments in securities
- Sale of securities and assets
Negative CFI may be a result of long-term investments, like research and development (R&D). In this case, low metrics are not necessarily a warning sign of poor financial health.
Cash Flows from Financing (CFF)
Financing cash flow (CFF) demonstrates the net flows of cash that are used to fund the business and its capital.
Financing activities can include transactions that involve issuing debt or equity and paying dividends. CFF provides investors with insight into an organization’s financial health and how well the capital structure is managed.
Why is Cash Flow Management Important in Business?
Cash management is critical for a company’s success. According to a study by U.S. Bank, 82% of businesses fail because of poor cash flow management. If the business constantly spends more than it earns, there are going to be issues with cash flow.
At a basic level, a company’s ability to create value for investors is determined by its ability to maximize long-term free cash flow (FCF) and generate positive cash flows.
Free cash flow is the cash a business generates from normal operations after subtracting money spent on capital expenditures (CapEx).
For a small business, avoiding extended cash shortages (large gaps between cash inflows and cash outflows) is important. The longer you go without positive cash flow, the harder it will be to stay in business for an extended period of time.
How Do You Manage Cash Flow?
As a business owner, you should always be looking to improve the cash flow management process. Some tasks are simple while others may require extensive planning. To head off cash flow problems, here are a few tips to get you started:
1. Reporting and Forecasts
The first step is to perform a cash flow analysis and start looking at the numbers. This should be done on a regular basis, along with cash flow forecasting.
This starts with a series of “what-ifs” such as a large client moving on or unexpected expenses. If you have a short client list, this step is even more critical to long-term sustainability.
By analyzing as many scenarios as possible, an organization can identify and spotlight the highest areas of risk in operations. This gives managers the data needed to plan accordingly.
There are also a variety of software accounting programs with built-in reporting to make cash flow analysis a tad easier.
2. Delay Outflows
Cash flow management is about developing strategies to keep an adequate flow for your business. One of the most common moves is to shorten the cash flow conversion period, so you bring in money faster.
3. Cut Expenses
Run a fine-tooth comb through expenses whenever possible. To leverage cash flow, put off spending unnecessary money. All of this should be done while avoiding any late payment fees or penalties.
Your working relationship with vendors should never suffer. It’s important to always maintain a good credit rating to negotiate the best possible payment terms and pricing.
A business should also examine capital expenditures. For example, repairing equipment instead of replacing it can ease outflow pressure. Delaying upgrades and replacements until absolutely necessary is one way of keeping more cash in hand.
4. Finance Large Orders
Rather than paying for large purchases outright, a business can also rely on a line of credit. Financing large orders, especially with a low-interest rate, can help leverage cash flow.
This also helps to slim down inventories without interfering with business needs. It’s a smarter means of financial management.
5. Keep Inflows Predictable
For optimal cash management, cash inflows must be timely and predictable. Collect as soon as possible.
Offering early payment discounts and incentives to customers is one way of upping your cash flow game. You bring money in the door quicker when you reward people financially. Even 2% is enough incentive for clients to pay their bills sooner.
Accounts receivable and accounts payable must also follow up swiftly on late payments and reassess any deals that aren’t performing. Selling or leasing out idle equipment is a great way of bringing in extra cash. This helps to keep reliable lines of cash inflow that a business can count on.
6. Escrow Services
For additional security, many companies will turn to escrow services. In this manner, a business can ensure payments aren’t delayed, especially with expensive or time-consuming projects.
Escrow services are quickly becoming a popular method for organizations to avoid cash flow issues down the road. It’s especially prevalent with businesses that conduct shows, events, or gatherings that can be canceled at the last minute.
Common Cash Flow Management Issues
When it comes to cash flow challenges, there are some key issues every business must face. Here are a few of them:
Cycling Industries
If you have a business in a highly cyclical industry, you can be prone to cash flow problems. This is seen a lot in the real estate industry where the market can change at the drop of a dime.
For example, property development requires a large amount of initial capital, as well as ongoing streams of cash flow. Unless some of the development is sold early, there will be cash flow issues, particularly if the market softens during construction.
Paired with poor planning, negative cash flow for extended periods of time can force even the richest of developers into bankruptcy.
Variable Patterns of Revenue
Just like a cycling industry, if a business is seasonal, cash flow can really deteriorate during the off-season. In this case, cash flow can only be managed properly with concise planning and budgeting.
Performing a spend analysis and projecting fixed expenses is one way to keep a consistent flow of cash, year-round. This is the repetitive process of grouping procurement data, vendors, and purchases by cost to find opportunities for expense reduction and operational improvement.
Think about all the fixed and variable expenses that could occur in a year. Figure out the potential shortfall during the slow periods and then open a separate account to save and budget for that amount of money. This will cover any cash flow shortages and ensure the business keeps moving all year, while keeping your hands out of the cookie jar.
Rapid Expansion
Any company experiencing rapid growth can run into cash flow problems. Business growth typically involves higher labor costs, additional space, more capital investment for equipment, and so on.
Maintaining increasing levels of inventory can also eat into your cash flow. If a business doesn’t plan properly, its growth can kill its cash.
Lack of Accounts Receivable System
One of the most common cash flow problems a small business will see is the lack of an organized accounts receivable system. So many companies are eager to obtain new customers that they forget about collecting on invoices.
There are no structures in place to ensure the bills going out are getting paid on time. Red flags that a client may pay late (or not at all) are often ignored for new ventures.
All companies should develop and record rules for managing AR. This includes tasks like:
- Obtaining a deposit
- Keeping payment info on file
- Setting up automated bill pay
- Specifying a 30-day payment window in the terms
A company’s AR policy should also define how to address customers who fail to pay, such as obtaining pre-payment or sending them to collections.
Extending Credit
Extending credit to other businesses is another way a company can run into cash flow problems. Invoicing is typically done on 30 to 60-day windows. It’s not unusual for customers to delay payment to pad their own cash flows. This can leave a business in a financial crunch.
To address this problem, make sure the invoice and contract clearly state the payment terms and don’t go beyond 30-days unless your cash flow can handle it.
Projecting Expenses
A large struggle many small business owners face is learning how to properly project expenses and calculate future debts. Deciding what is important and what is not can be a huge challenge. A company must look at immediate needs and assess accordingly.
Basic accounting software can help pull reports on past income and expense data to make more specific projections. Cash flow and sales projection reports show whether a business has enough money to cover operating expenses based on forecasted revenue.
Debt Financing vs. Equity Financing
To avoid common cash flow issues, a little financing may be in order. There are generally two types of credit a business can use to ensure financial health throughout the year. This is debt financing and equity financing.
Equity Financing
Small businesses and startups often look to equity financing to grow. This involves raising money from angel investors or venture capitalists who essentially provide an additional form of cash flow.
It’s less risky than any other form of financing because the loan doesn’t have to be repaid if the business doesn’t succeed.
However, in exchange for the cash, the investor becomes a part-owner in the business. This means they take a share of profits and have a say in how the business is run.
Debt Financing
When an organization is expanding, it requires consistent injections of cash. This can take on the form of a business loan from a financial institution known as debt financing.
Just remember! It’s common when using these loans for assets (like buildings, land, or machinery), that these assets are used as collateral for the loan. So, like a car, when things go unpaid, assets can be repossessed.
The main advantage of debt financing over equity financing is that the business owner retains full control and ownership of the company.
However, for short-term cash flow problems, many smaller companies still stick to using credit cards to make up the difference.
Whatever form of financing is required, it’s important to always have an updated business plan in place that can be presented to investors and financial institutions. It should clearly demonstrate the need (and subsequent effect) of financing for the future of the company.
Cashing In
All of this boils down to one fact: cash control is essential for business success.
One of the main reasons small businesses fail is poor cash flow management. It doesn’t matter how many sales you have in a quarter if none of that money is coming through the door.
Focus on total cash control, which is internal control of cash, cash-related policies, and cash flow management. Cash disbursements and cash controlling receipts help to reduce erroneous payments, fraud, and theft.
Business growth requires strong corporate governance and segregation of duties. Instill a policy with authorized approvals, signature authority with limits, and bank account reconciliation.
AP automation is the first step in modern cash flow management. Consider implementing a platform that mechanizes daily tasks, reduces errors, and projects future revenue. This is a good start to getting a handle on cash flow management and ensuring your business is never in the red!
