The Value of Cash Flow for Small Businesses
You’re excited to start your small business. You’re confident that your product or service offering will blow the market away. Sure, that’s definitely an excellent foundation for a new business. But new business owners must also master some basic financial principles, especially if you have no prior finance backgrounds.
Do you know that insufficient funds or negative cash flow is the second leading reason for a business to fail in the United States, according to the U.S. Small Business Administration? Don’t be part of that statistic!
In this article, we will discuss the great importance of cash flow for small businesses and how to manage it.
The Basics of Cash Flow
Cash flow, in a nutshell, is the amount of money that goes out of a business versus those that go in.
Cash inflow, just like food is to the body, pumps life into the business coming from the following sources:
- Payments from customers
- Interest earned on savings and investments
- Influx of loan proceeds
- Funds from investors
Conversely, cash outflow, just like how energy from food is expended on bodily activities, pays for the different expenses of the business operations. Some examples are:
- Rent on the office or branch locations
- Payment for raw materials of products
- Salary of employees
Positive cash flow happens when there is more cash going in compared to that going out. This state, especially a highly positive cash flow, is ideal for any business. A highly positive cash flow will give room to hiring additional employees and exploring new ventures, to name a few.
Inversely, negative cash flow happens when there is more cash going out than there is going in. This state makes for unstable grounds for the business. A business that is continuously under a negative cash flow is at a high risk of folding up due to the inability to pay for operations expenses.
The Four Gold Standards of Cash Flow
Here are the fundamental laws of good cash flow management:
- Business growth needs cash – the faster you want to grow your business, the more funding allowance you need to have.
- Have a cash flow forecast – this guide is essential in benchmarking the financial health of your business.
- Closely monitor receivables – every dollar not yet collected from customers is a dollar taken away from the business operations.
- Cash is king – No cash translates to no business.
How to Plan for Attaining a Positive Cash Flow
Now that we have established how a positive cash flow makes for stable and smoothly running business operations, let us dive deeper into how this much-coveted state can be achieved.
Upon starting your business, take the time to tabulate the amount of money you and your business partners have initially invested in the business plus the proceeds from the loans you may have taken. This is your baseline amount.
Next, list down all opening expenses you have incurred or about to pay as you commence your business. Some examples are fees for licenses and permits, signages, and initial inventory. If the resulting net figure is immediately breakeven or worse, negative, it merely means that you need to raise more funds to start this business successfully. You may also want to review if your listed expenses are really all essential at the very beginning of the company.
The third column on your table is the expected or forecasted inflow of money into the business per month. This covers projected sales, inputs from new investors, or additional loans that may be coming in. Whether the company is brand new (no past sales) or just purchased from a previous owner (with a basis for historical sales), it is advised to project future sales on the conservative side. It is always better to outperform targets and end up with a highly positive cash flow than to over project and end up short on cash.
Lastly, make a forecast of your monthly operations expenses. This would include continuing rent, salary of employees, advertising fees, and of course, your payment to yourself. A company that is not able to factor in adequate funds for salaries will lose valuable human resources and ruin its reputation in attracting future strong workforce.
Another useful tip for this exercise is to be objective and as accurate as you possibly can. Get detailed cost estimates from suppliers, so you don’t get unpleasant surprises. If you see that expenses are too high and that the margin for a positive cash flow may be slim, it is best to find ways on how to cut down on spending rather than inflating your projected sales. The same principle of erring on the conservative side here still applies.
The more or the earlier that a business maintains or achieves positive cash flow, the sooner you can regain your investment.
Tips on Increasing Cash Inflow
Do you know that 58.2% of businesses cited slow-paying customers as their most significant hurdle in keeping a positive cash flow?
Let’s say that after you’ve done your homework on mapping your inflows and outflows and really scoured all possible means to lower spending, you still end up with a slim positive cash flow. What do you do now? Let’s look at the ways you can pump up your inflow.
- Issue invoices as quickly as possible after the product or service has been rendered. The sooner customers are billed, the sooner you could get paid and have a fresh influx of funds for the next cycle of business.
- Assign a conscientious staff to monitor and follow-up on invoice payments closely. The simple act of following up increases the chances of customers paying earlier.
- Avoid offering too long leeways in the payment of your invoices. You could research industry standards or offer terms for partial or staggered payments to ensure a steady influx of income.
- Offer discounts for early settlement of dues to incentivize customers to pay early and in full.
- Require upfront deposits for big projects. In this way, not all materials that will be used for that project will be coming out of your own funds, thus ensuring a more positive cash flow state.
High inflows would allow for a business to purchase more raw materials or inventory, thus enabling it to take on more new customers.
Smartly Managing Cash Outflows
Now that you have identified the necessary expenses that you simply cannot do away with in running the business and have already lowered them down to as low as you possibly can, here are some smart tips on how paying for them will be a little easier on your cash flow:
- Maximize the payment terms on your bills. This way, you can allow for more cash inflow before you part with chunks of your funds.
- Check if your suppliers offer discounts for prompt payment and determine the optimal benefits for your business. Will the discount improve cash flow more, or will delaying payment to maximum term prove more beneficial?
- Ask if flexible payment term options are available. Longer terms are very useful in managing cash flow for lean months or when your business is still starting out. A caveat, though, is to try asking for this once a certain level of trust has been established with that particular supplier. You wouldn’t want to outright ask for this at the very start and risk appearing unable to pay bills.
- Form real relationships with your most important suppliers. Never underestimate how this can help when you find yourself in a pinch and would badly need an extension for payments. A simple extension on your due date could spell the difference between a month’s or cycle’s positive or negative cash flow.
Maintaining healthy ties with crucial vendors through prompt and full payment of dues would spell the difference between a smoothly flowing business and a very stressful and disorganized one.
The Value of Cash Reserves
As in life and in business, we should always be prepared for a rainy day. Companies need to build momentum before they start having a steady flow of customers. Furthermore, all businesses go through lean seasons. However, bills and expenses will not wait for you to gain your footing.
It is for this reason that just as we rely on savings during times of illnesses or unemployment, we must also have cash reserves for the tough times in our business if we want it to have stability and longevity. A safe allowance is to have three months to a year’s worth of funds to cover expenses. Without cash reserves, a business that encountered a single season of drought will immediately go bankrupt.
A smart tip in setting up your cash reserve is to factor it in during the initial investment stage. You could also build this nest egg coming from additional investors’ funds. Lastly, it is also wise to set up a ready credit line with a bank while the business is doing well just in case, utilizing it as the need arises.
While it is a fantastic business proposition and a stellar team that sparks a business idea into life, remember that cash flow is one of the critical factors that will keep it afloat. All new entrepreneurs must take due diligence to carefully study cash flow before diving into a business.
We hope that the learnings you have gleaned from this article will help you launch a successful business venture. Good luck and cheers to a prosperous journey!