One of the most important topics for any business owner to fully understand is how, when, and to what extent money moves in and out of their company, and what it all means in terms of their ability to continue operating. Along with understanding breakeven points, the topic of cash flow is absolutely critical to successful financial management, and is heavily intertwined with all aspects of a business’ operating model. In this article, we will attempt to address the following questions:
- What is cash flow (definition, use, importance, etc.)?
- How does it compare to profit?
- What are the typical challenges related to cash flow?
- How can I improve cash flow management?
Cash flow entails all of the cash and cash equivalents coming into and out of your business on a periodic basis. It is either positive or negative. Positive cash flow is when your cash inflows exceed the cash outflows. Negative cash flow is when your cash inflows are less than your cash outflows. Very basically, an inflow occurs when you receive your customers’ payments, and an outflow occurs when you pay a bill or other obligation. Simple.
Cash flow is important to a business because it’s how obligations like employee wages, insurance, rent, debt payments, and purchases are made. Profit on the other hand, is an accounting construct. A business can be cash flow positive, but not necessarily profitable. A business can be cash flow negative, yet still profitable. The main thing to keep in mind is that you can’t pay your bills (nor your employees’ wages, nor rent for that matter) with profit. We pay these things with cash. While profitability is indeed important, focusing solely on whether your revenue exceeds your expenses, while neglecting whether your cash inflows exceed your cash outflows, can drive a company out of business if it is not able to pay its bills on time.
While all this is quite intuitive, we start to have a meaningful problem when we stop paying attention. As the term implies, it is a flow – a constant back and forth between paying your bills (outflows) and getting paid by your customers (inflows). The timing of all of these variables will determine what your cash flow situation is like at any given moment and it is very easy to lose track, get painted into a corner, then make a rash decision as to how to remedy the problem, propagating a downward spiral that leads to a going out of business sale.
Typical scenarios where we stop paying attention, or when negative cash flow starts to become the norm and thus problematic, are:
- We’ve extended payment terms (like Net 30) to our customers and they’re simply falling behind or are having issues making payments on time.
- We are spending cash faster than we are collecting cash. We are making purchases for our business in order to meet demand, and are actually generating quite a bit of sales; however, we’ve lost sight of collecting the cash on these sales, while continuing to spend cash on our bills and other costs associated with the sales.
- We are in growth mode, and we do not want to lose out on the sales opportunities. So, we spend money to expand. Well, just as in example two, above, if we start building our products two or three months in advance (in order to meet demand), but are collecting payments five or six months later, we could end up broke.
- Our suppliers have tighter payment terms than we do for our own customers and this has put us in a position where we are spending cash faster than we are collecting it.
- We are paying our suppliers too quickly rather than waiting to pay them at the last possible moment, just before there is any real risk of harming the relationship.
- We spent way too much on inventory because we forecasted sales incorrectly and are struggling to liquidate (e.g., get the cash that’s locked up in our inventory).
- We tend to sell to other businesses, which is good for us because they are a valuable customer segment; however, this also means they pay us months after invoicing. We don’t want to push them too hard and run the risk of losing their business.
- We have a banker, but we don’t proactively communicate to them when we are expecting a pick up in sales. As a result, the possible solutions they could provide, via financing, aren’t being leveraged and we end up spending more cash than we are collecting.
To avoid scenarios like these, one could consider the following steps.
- Require cash only payments or cash on delivery (COD)
- Reduce payment terms to get paid faster, while being careful not to jeopardize revenue, as flexible payment terms are known to help increase sales
- Provide incentives or discounts to customers who pay early or upfront with cash
- Proactively contact customers who are historically delinquent and urge them to make payments
- Optimize the payment terms your suppliers have allowed by paying at the last acceptable moment
- Negotiate with your suppliers to get more flexible payment terms and make efforts to establish and maintain a strong relationship with them should you be late on payments in the future and require flexibility
- Establish a line of credit and be disciplined about using it (using it only for very specific situations where your bills are at risk of not getting paid due to cash flow issues)
- If you accept checks as payment, deposit them immediately
- Perhaps most obviously, if one is not already doing so and if possible, build up a cash reserve that covers a reasonable amount of time’s worth of operating expenses (say 3-6 months) while timing the savings against necessary investments and lower demand periods.
- Have a plan in place to handle any increases in demand that you are expecting, like working with your banker to tap into amenable financing options to grow your business
While growth and profitability are very important objectives of any business, cash flow is equally if not more important. Hopefully, some of the points we have made in this article will be of use to you as you navigate all of the flows in your business. Thanks for reading, and let us know if you have any questions or thoughts.