We’ve all heard the saying “Cash is King,” and the term was thrown around a ton during the financial crisis starting in the fall of 2008. But what is it about having cash on hand that makes it so important to a small business?
The truth is there have been more than a few entrepreneurs over the last several years that were forced to shut down despite their brilliant business plans and innovative products. And it all comes back to cash flow. The lesson these entrepreneurs are taking away is that when cash outflow exceeds cash inflow the countdown clock is already running. If that financial runway is getting short, there better be a solid plan in place to either lengthen the runway, or ensure a successful takeoff.
So lets start with what cash flow is and what it is not.
Cash inflow is any sort of actual cash payment you receive from your customer, receipt of a loan payment, cash infusion from an investor, or essentially any transaction that builds your cash available balance. Note that a promise from a customer to pay a certain amount to you in the future is not a cash inflow since you do not have the cash yet. The most important cash inflow is payments from your customers.
Cash outflow is any financial transaction that reduces your available cash balance such as purchasing inventory, paying employees, paying operational expenses, making loan payments, etc.
Operationally, positive cash flow occurs when your cash inflows from operations (payments from customers) exceeds your cash outflows from operations (payments to vendors/operating expenses).
I know all of this might sound rudimentary or simple, however more than a few small business’ have ceased to exist simply because they did not manage their cash flow responsibly. When considering poor cash management in small business there is often a snowball effect.
Lets look at an example;
John starts a small business that manufacturers medical device parts. John sells these medical devices to a distributor who has NET 60 terms with him meaning they are required to pay him 60 days from the date of the invoice. John orders the materials he uses to create the medical devices from a company that requires him to pay them on NET 10 terms. Due to Johns innovative product his customer wants an initial order of $100,000, which is great considering his raw materials and production costs are only $70,000. However, within 10 days John will need to come up with $50,000 to pay for the materials, but he won’t see his $100,000 payment until 60 days after he ships the order. John decides he will go out and get a working capital loan to cover the shortfall for 60 days. Unfortunately John finds out that due to his credit score and time in business he will need to pay the lender 22% interest on the money and the first payment is due within 30 days of funding. You can see that John is already in a really bad cash flow situation that can instantaneously be made 10 times worse if his machinery breaks, an employee wants a raise, or any other number of sudden business needs arise. And John can forget about trying to grow his business because whatever cash inflow he does receive will be needed to just keep current operations afloat.
Through some careful planning and cash flow management John could have easily avoided this situation, some of those ways are discussed below.
- Cash Flow Budgeting
In the above example John had a profitable business on paper, but not cash flow wise. It’s crucial to plan for cash flow, not just Revenue and Expenses. Through careful planning any small business can easily forecast future cash flow crunches that may arise and either proactively plan for those through outside funding, or better yet, build up a cash reserve for those unforeseen cash flow crunches.
- Credit Terms
Credit terms with both customers and suppliers/vendors is often one of the most overlooked ways to improve cash flow. If we can ensure that our customers terms are shorter than those we agree to repay our vendors we can have a much safer platform from which to make business decisions. It’s important to take care of both our vendors as well as our customers, since we often spend years developing these relationships, but with some solid negotiating we may be able to greatly improve our cash situation on a daily basis through advantageous credit terms.
- Collection Practices
Rapid collections of outstanding receivables and timely payments lead to sound cash flow management. If someone owes you money it’s important to stay on top of those receivables. With the day to day management of your small business it’s easy to let those little details slide, but that can lead to disaster when an unexpected expense pops up and you are scrambling for cash. Develop a consistent method for collections that includes a pre-emptive notice of an invoice due
- Invoice Customers Quickly
Corresponding to collection practices, it is equally important to invoice your customers quickly because that starts the receivables cycle. By waiting a few days, or worse a week or two, you are essentially saying I’d rather let my customer keep their money for another week rather than pay for the goods or services I provided.
- Cash Reserve
Another practice to develop solid cash flow management is building up your cash reserves. This can be accomplished through item 1 above in creating a budget that you stick to. Also, watch your company expenditures. Sure it would be nice to buy new computers every year, however unnecessary spending will always start to pinch your cash flow.
- Capital Budgeting
There is only so much cash to go around. Maybe there is a piece of equipment that could reduce your production cost, but you still need the cash to do it right? Take a close look at what your expected cost savings or increased sales might be on a capital purchase like equipment, machinery, transportation, etc. It might make sense to lease the equipment in order to have a small monthly payment that is manageable rather than an outright purchase that may pinch your cash flow and prohibit future growth.
In any small business cash really is king, and through employing some of the strategies above you can greatly enhance the cash position of your small business which opens up so many doors that are closed to competitors that have poor cash management skills.