Small business owners contend with a host of problems every day. They strive to produce products or services cost-effectively, increase sales, satisfy unhappy customers, and motivate disgruntled employees. They quickly learn that most of these problems can be solved with cash.
What is Cash Flow?
Cash flow is a snapshot of your business finances taken during a specific time period. It provides a picture of money flowing into and out of your business, letting you know how liquid and flexible your enterprise is, while gauging its relative long-term health. You generally want to track and analyze your small business cash flow on a monthly basis, but it’s often helpful to look at it on a weekly, quarterly, or annual basis as well.
Why is Cash Flow Important?
Cash flow is the lifeblood of an organization. It pays salaries, buys supplies, and makes investments in infrastructure. Owners who cannot efficiently manage their business cash flow are almost certain to fail. Those who can are able to improve nearly every aspect of their business.
Many small businesses make mistakes when it comes to their cash flow accounting. They over forecast sales, fail to track bills, incorrectly allocate resources correctly during startup, or don't plan ahead.
What Does it Mean to be Cash Flow Positive?
The goal of any business should be to make more money than it spends. If you’re doing so, you’re on your way to profitability. Where you can run into trouble, though, is when your spending (accounts paid) outpaces your income (accounts received) over a short period of time, stressing your cash flow.
Let’s say, for example, that you have $100,000 of cash on hand in a given month. You spend $150,000 on rent, utilities, employee salaries, taxes, loans, supplies, and raw materials. And you sell $200,000 in products or services. You’ve made $50,000 in profit, right?
But what if that $200,000 doesn’t come in right away? What if the invoice payment process of your top customer is slow, perhaps taking an extra month or two to pay you? Suddenly, your business is experiencing a negative cash flow. You may have a problem meeting your current financial obligations.
Being cash flow positive means understanding the flow of money in and out of your business and making adjustments to compensate for short- or long-term disruptions that may occur. Your goal should be to always stay on the positive side of your accounting ledger.
How Do I Analyze Cash Flow?
If you’ve never analyzed your business cash flow before, you might begin by using a simple spreadsheet. First figure how much cash you have on hand at the beginning of the time period - a particular month, let’s say. If you have multiple business bank accounts, add them all together. Put this number at the top of the sheet.
Next, list all your payments and income for that month. This includes all your operating, investment, and financing activities. Subtract the payments from your cash on hand and add the income to your cash on hand. Make sure that you use actual income and not invoiced income that you haven’t yet received.
That should leave you with a number that’s either larger than the cash on hand you began with (positive cash flow) or smaller than that (negative cash flow). While you might have a negative cash flow for a temporary period of time, especially if you have some big, one-time expenses, you generally want to see a positive cash flow each month.
Tips to Improve Cash Flow
Converting sales into cash as quickly as possible, while reducing and extending your payments to build a cash cushion, is the basis for long-term, sustained growth, whether your company is large or small. Implementing some or all of the following suggestions can help boost your cash flow.
Anticipate Future Needs. Avoid surprises. There is nothing more difficult or disheartening than searching for cash when you're desperate. To start, keep accurate, timely accounting records as they are essential to understanding your business's financial standing. Use your past monthly income and cash flow statements as well as your balance sheet to calculate available cash and project likely results for the next three to six months. These pro forma statements can help alert you in advance of any shortfalls, giving you time to prepare for them. Some business owners, anticipating a future need, open a relationship with a bank for payroll and general company accounts and regularly supply the bank officers with operating statements in order to build trust. Depending upon the authority of the bank officer, however, these efforts are not always successful. To improve your chances, notify your banker that you are eventually going to seek a loan, making it clear that the intent of the relationship is to have access to financing if needed.
Build Connections With Lenders. The odds of being able to borrow cash or entice investors to put more money in your company when you absolutely need it are low. Bankers are least interested in lending to a company in desperate straits since their first objective is to be paid back. Build connections in the financial community before you need its help, not when you need it, and you may be able to secure a commitment of future loans. Bankers generally make secured loans on such assets as the following:
Accounts Receivable. Typically established as a revolving line of credit based upon a percentage (60% to 80%) of total accounts receivable (AR) due within a 60- to 90-day period, accounts receivable financing is one of the most common corporate loans. The balance due moves up and down as AR varies: When sales and AR increase, the bank advances more cash on the line; when sales and AR decrease, you're expected to make a payment to bring the loan in line with the negotiated loan-to-AR ratio.
Inventory. Lenders generally like inventory as it's expected to be sold and turned into cash. Bankers generally prefer finished or raw inventory since it's most marketable in the event of default. Many bankers don't lend on in-process inventory as additional investment is required before it can be sold. Like an accounts receivable loan, an inventory loan moves up and down as inventory levels change. A typical ratio of loan to inventory is 50%.
Equipment. While technically not a short-term loan, owned equipment in good condition can secure a fixed-term loan for a single shot of cash in an emergency. Remember, however, that the more specialized the equipment, the lower loan-to-value ratio you may receive. For example, a 2012 Ford 150 is likely to have a higher loan ratio than a variable drill press or a customized trailer. If you have old or excess equipment that's marketable, sell it for cash. Having extra cash is more valuable than an idle asset.
Some business owners elect to sell their accounts receivable to a third party rather than borrow on them, a process called factoring. Specific terms are negotiated between the third party, or "factor," and the company. These terms include the ratio of value paid for each invoice, whether the sale is "recourse" or "non-recourse," and any fees that might be paid to establish and maintain the relationship between the company and the factor. The advantage for a company, especially if it's newly established or has damaged credit, is that the factor looks first to the credit worthiness of the customer who owes the money, rather than to the company that sells the AR.
Keep Your Cash Working. Keep your cash balances in interest-earning accounts, which are available at most banks. In some cases, you might encounter a minimum balance requirement. However, since interest rates on these accounts are often lower than those of savings accounts, certificates of deposit (CDs), or money market accounts, consider keeping the bulk of your funds in higher-paying accounts. Transfer funds as needed to meet the minimum balance requirement in your interest-bearing checking account (plus the total payments due that week or month). Avoid long-term CDs, which lock you in for a specific period of time, as redeeming them early may cost you interest. Either invest in penalty-free CDs or commit that portion of funds you aren't likely to need during the life of the CD. Set up a separate payroll account and establish a bi-monthly cycle. Bi-weekly payroll systems require 26 pay cycles a year, bi-monthly only 24, which means you save the extra administrative costs of collecting, verifying, and tabulating payroll information. Require your employees to take direct deposits to reduce the costs of writing and delivering checks. Finally, transfer payroll funds immediately before payment to keep your cash earning interest as long as possible.
Train Your Customers. As a small business owner, your goal is to collect payment for your services or products before or shortly after incurring the expense of producing or delivering them. The optimal outcome is to receive payment on delivery (COD), but that is not always possible. Invoice your customers the day you deliver your product with the notation that "payment is expected on invoice receipt." Don't suggest that waiting until the end of the month is an option. Include a notification that interest is charged for all payments later than 30 days and collection procedures may be initiated if payment isn't made. Also, stay on top of your accounts receivable aging - a report categorizing accounts receivable according to the length of time invoices have been outstanding - with an established process for following up with late or delinquent payers. Send:
An initial form letter 10 days following receipt asking for payment.
A second follow-up letter - more aggressive - in 20 days demanding payment.
A third letter in 30 days and a phone call from your collections clerk seeking payment.
It's important to have early contact with potential delinquent payers and to offer a variety of options for payment if they have difficulties. These options might include a credit card charge or a payment plan. Be careful about instituting a policy of discounts for early payment since big customers are likely to delay and take the discount at the same time. Remember, a customer who doesn't pay isn't really a customer, but an expense. Determine how you want to handle late or non-pays before they arise, document your decision into policy, and stick with your policy.
Work With Your Vendors. Just as you want customers to pay you, your vendors want payment as soon as possible. However, early payment to vendors can hurt your cash flow and should be avoided if possible. Delay payment as long as you can while remaining consistent with the terms of the sale. If there is no penalty for late payments, set a pay cycle of 45 to 60 days from receipt of an invoice. While slowing the outflow of cash is important, it's equally important to maintain a good credit rating and cordial relations with critical vendors. Be aware that slowed payment might result in prickly contact from the affected vendor. In those cases, be vigilant that you make all future payments as promised. If you are forced to delay payments, contact the vendor as soon as possible with an explanation and a plan to become current on your debt.
Maximize Cash Inflows. There are a number of methods to increase cash flow, especially if you sell custom products or engage in extended contracts. Require security deposits equal to 50% of the order if the product or service is unusually large, complex, or one of a kind. If you work with contracts, set up payment schedules and amounts that parallel or exceed your sunk costs. If your customer demands modification of standard products or services that have not been identified in your contract, seek additional payment through fees or change orders. Small businesses that provide a regular service or product should consider subscription sales whereby customers prepay. Newspapers, magazines, cable television, landscaping, and pool maintenance are examples of products and services that lend themselves to a subscription model. In addition to receiving upfront cash to cover future costs, you have the advantages of securing future sales and easier resource scheduling. Layaway programs have come back in vogue as an alternative to sale and payment plans. A layaway program allows customers to select a specific product, which is then reserved for a future purchase and delivery when payment has been completed. This allows the seller to have use of the cash prior to incurring the product's cost. Special accounting treatment of the cash received is required, so be sure your accountant is aware of the program. Consider taking credit cards to ensure timely and probable payments, as well. If you elect to do so, raise your prices to compensate for the extra costs and give those customers who pay cash a discount equal to the fee that would be paid for a credit charge.
Shrink Cash Outflows. The combination of cutting or avoiding expenses overall and delaying payment as long as possible reduces demands on cash. Strategies to reduce cost include the following:
Repair Capital Equipment; Don't Replace It. Save money by having a regular maintenance program, using reconditioned replacement parts from third-party suppliers (rather than factory parts), and contracting with a local repair facility to handle jobs too big or complex for in-house personnel.
Buy Used Equipment. Used equipment in good condition is generally just as good as a new piece of machinery. Search local advertisements and auctions in your area, specifically looking for companies whose assets have been foreclosed and are being sold by a lender. You may be able to buy quality used equipment for savings up to 80% without a comparable degradation of capability.
Delay Product Upgrades Until Absolutely Necessary. Delay product upgrades and consider open-source software, which is generally free or available for a small donation. Any software you use should have a focus on safety and security, which should always come first for any business.
Barter Products for Supplies and Services. Suppliers who are also customers might be interested in a "trade" whereby each company receives all or a portion of its respective payments in the form of finished products. Since the exchange value is usually set at each company's respective retail price, a barter agreement effectively provides a "discount" equal to the net profit margin on your product and allows you to maintain cash that would otherwise be used. From an income tax perspective, be sure to report the products you receive from your suppliers as gross income in the year of receipt, while expensing the products or services you provide as a "cost of goods."
Maintain a positive cash flow by keeping a close eye on accounts receivable and accounts payable. We touched base on accounts receivable above (#2), but what about accounts payable?
Staying on top of the bills your business owes can really make or break your business. Moving your AP process to the cloud can solve most of the problems that business owners go through: lost bills, double data entry, and approval workflow.
Automated accounts payable helps businesses keep track of bills due with automatic notifications. Receive invoices on your phone and pay them with a click, which is similar to how Bill.com works!
Small business owners usually learn two principles early in the life of their companies. "Cash is king" refers to the importance of cash in any company, and the Golden Rule - "He who has the gold makes the rules" - the validity of which is apparent to anyone who's gone hat-in-hand to a lender. Building and keeping an adequate stockpile of cash provides maximum opportunity and flexibility to any business while enabling its owners to sleep soundly at night.