Cash Flow — What is it, and How Should You be Managing it for Your Business?
Cash flow is the fuel for any growing business and the lifeblood for those in distress. Monitoring cash flow and related balances is an absolute necessity for any company that doesn’t just want to stay in business – but wants to turnaround, revitalize and thrive.
Without liquid funds, a business can’t afford even the essentials like payroll, utilities, or rent. At a higher level, liquid funds are vital for capital investments, software, travel expenses, marketing, replenishing office supplies, and any number of other resources a company needs to operate effectively. These may seem like obvious statements for anyone familiar with how businesses and corporate enterprises operate.
And yet, if we all have this core understanding – that cash flow is so critical to the life of business – why is it that so many business owners and leaders, from family-owned businesses to startups and large corporations, struggle to understand and manage it?
A recent study from Intuit found that 61 percent of businesses worldwide struggle with cash flow. The study also found that almost one-third of business owners struggle to the point that they cannot meet their financial obligations – meaning they can’t pay vendors, employees, or themselves because they don’t have enough cash in the business.
This doesn’t have to be the case.
By dedicating reasonable time and effort toward understanding (a) why cash flow is essential, (b) what’s driving it or causing friction, and (c) how to manage it, a company can go from constantly struggling to being liquid and prepared for the next round of hiring and capital expenditures.
What Does Cash Flow Mean for a Business?
Cash flow refers to the amounts and timing of cash coming into and going out of a business during a specific period. This may be over days, weeks, months, or longer.
At the most basic level, there are two forms of cash flow for a business — positive and negative. Positive cash flow is cash in; negative cash flow is cash out. But we need to take this one step further. While every company has cash coming in and going out, what matters most is net cash flow.
Positive net cash flow means more cash is coming into a business than leaving it. So, a company still has ample funds left over after paying cash for payroll, materials, loan obligations, rent, utilities, and much more. This is where a business wants to be at the end of a given period.
Negative net cash flow means the opposite — more funds are leaving a business than is coming into it. For companies that don’t have cash reserves, or enough receivables collections, there aren’t enough funds to cover necessary expenses (i.e., payroll, bills, loan payments, etc.) either in the current period or future periods. While negative net cash flow isn’t necessarily a problem at a moment in time, perpetually negative net cash flow can be catastrophic.
Cash flow vs. revenue
Many non-financial professionals get confused and think cash flow is the same as revenue. It’s not.
Revenue measures the proceeds recognized by a business from the sales of the company’s products or services. But most sales occur on credit, meaning that the company has earned the right to declare revenue, even though the customer has not yet paid the cash. This results in accounts receivable.
Cash flow measures the tangible funds coming into and going out of your business. So, that includes collections on accounts receivable, payments on accounts payable, funds spent on or received from investment activities and financing (i.e., lenders), among a multitude of other activities.
Here are some basic examples:
If a company receives cash on $50,000 in accounts receivable, that’s positive cash flow.
If a company pays $75,000 in cash on accounts payable, that’s negative cash flow.
If a company pulls $100,000 from a line of credit into the business, that’s positive cash flow. If the company pays it back, that’s negative cash flow.
If a company buys a $125,000 piece of equipment and pays for it in cash, that’s negative cash flow. If the company sells that equipment in cash, that’s positive cash flow.
All of this is relatively straight forward when considering the underlying accounting transaction. Right?
What leads to negative cash flow?
When business owners and leaders don’t have a good grasp on their finances and what drives them, they risk making major mistakes. I’ve worked with more than two dozen companies experiencing serious liquidity challenges because of these mistakes.
Some practices that can lead to negative net cash flow include:
Hiring too rapidly or at unsustainable rates
Agreeing to inferior vendor terms
Not understanding the impact of meeting demands of cash-on-delivery
Purchasing product that is too costly
Paying suppliers too quickly
Keeping too much inventory in stock or failing to liquidate stagnant inventory
Maintaining an inefficient manufacturing or production process
Not charging enough for product
Failing to collect on past-due invoices
Taking on projects that are too capital-intensive without sufficient returns
Overextending on a revolving line of credit
A poor understanding of business activity timing
And much more
When a company makes one or more of these poor decisions, it needs to determine the seriousness of the problem, isolate the problem by doing what I call “stopping the bleeding”, and explore remedies through restructuring the business, refinancing, or by finding innovative ways to bring more money into the business.
How to Manage Cash Flow in 5 Steps
Many small businesses struggle with cash flow at some point. But that doesn’t have to be the case.
Here are five cash flow management strategies that can help businesses avoid the sudden panic of wondering how to make payroll and rent this month.
Step 1: Stay on top of recordkeeping
The first step to managing cash flow is active reporting – knowing what funds are coming in and going out of a business. This involves documenting key line-items within the P&L and balance sheet and drilling down to a level of detail necessary for reasonable precision. In the absence of accurate and timely reporting and forecasting, it’s almost impossible to determine a company’s cash flow status.
Because most small businesses have a limited number of human resources dedicated to accounting and finance, it’s not uncommon for these individuals to fall behind given the other pressing needs on their time. Once this happens once or twice with minimal consequences, a poor forecasting process may become routine, and it can feel daunting to catch up.
If a company finds itself in this position, action should be taken to free up time for the person responsible for cash planning, offload it to another person or new-hire with capacity, or outsource it to a firm that does cash flow planning as a service. While these may be additional expenses in the near-term, it may be well worth it to avoid more costly mistakes later.
Step 2: Determine what can be maintained, grown, or cut
Once the cash flow forecast is created, knowing where a company’s funds are coming and where they’re going, department heads can better determine whether expenses are reasonable, should be increased, or may be cut.
For instance, perhaps the company is paying for software that is antiquated and difficult to integrate with other platforms. While there may be limited maintenance costs, the costs of inefficiency may be enough to justify the expenditure on a replacement. Similarly, the company may identify that certain equipment is underutilized and would be better in liquidation than as a lease expense.
Ironically, the same assessment may be done on revenue. Companies should routinely perform due diligence to ensure the company is selling the right product to the right customers at the right rates. Over time, it may become clearer that certain products and customer are high-maintenance, capital intensive, have high return rates, or are slower to pay. As a result, department heads should conduct assessments to ascertain whether the current product and portfolio and customer base is appropriate, should be expanded, or should be trimmed.
Step 3: Restructure payment terms
After the company has been “right-sized”, new investments and opportunity explored, and excess costs eliminated, it’s prudent to look at payment terms for the company’s vendors. There may be an opportunity to revisit the relationships and strategically restructure terms to keep more cash in the business without damaging vendor relationships. Additionally, it’s worthwhile to explore alternate suppliers who may be able to offer better rates or terms. Recognize that any renegotiation or restructuring does not need to be permanent. But to make “the ask” and know exactly what leniency must be asked for, the forecast in Step 1 must be high quality.
Step 4: Encourage faster payments from customers
Getting customers to pay faster means having more cash on hand for operating expenses. But, of course, customers are also managing their own cash flow, so they may try to hold off on making payments for as long as possible if they’re struggling.
With that in mind, here are a few ways to encourage faster payments:
Set up automatic payment reminders
Make it easy for customers to pay using online payment options (ACH, wire, direct debit)
Offer discounts to customers who pay quickly
Require a down payment for first-time customers and periodic payment options
Avoid taking on customers with substandard credit and cut those who do
Provide strategic deals to move out-of-date inventory
Punctually follow up with a phone call when a customer is late with their payment
Have legal enforcement protocols in place for if the relationship goes sour
Step 5: Look 13 weeks ahead (instead of one week at a time)
Too often, business owners realize they’re out of cash when it’s too late – there isn’t enough of a runway to turn the business around and take substantive measures that may take weeks, months, or longer. This leads to rash decisions and a scrambling to get some money. This can further lead to poor decision-making, such as taking out a high-interest loan, severing critical staff, jeopardizing relationships with key vendors, liquidating vital fixed assets, and more.
In contrast, professionals working in FP&A and restructuring environments often use a 13-week cash flow tool. This allows them to look at activity three months out at a granular level. This allows them to recognize when they will likely be short on cash based on predictable events (i.e., renewing a software license, making other anticipated capital investments, amortizing debt principal, paying bonuses, and more).
With a 13-week runway and window, it is significantly easier and less stressful to predict and manage cash flow crunches and reserved. This allows businesses to be proactive rather than reactive to changes in their business, leading to more informed decision-making.
Some companies might think 13 weeks is too far of an outlook, while others may see it as being too short. Rather than be tied to the standards of 13 weeks, companies can effectively get started running a 6-week or 8-week outlook. The idea is to look further into the future rather than the immediate present to stay on top of cash flow and make sure there’s enough money in the business to meet expenses. Those companies with longer business cycles may consider 26-week or longer windows.
Effective Planning Leads to Better Outcomes
Planning is the best way to stay on top of cash flow. But those who are not financial experts may struggle to determine where to start.
That’s why I offer FP&A advisory services for businesses that recognize the importance of strategic financial planning and need some support to get started. Book a call to learn more.