Cash flow is the lifeblood of any business. Simply put, a business cannot survive long without positive cash flow. Cash is even more important in a growing business which requires investments in staff, equipment and inventory. Yet it is one of the most challenging aspects to manage for many business owners.
CASHFLOW AND PROFIT ARE NOT THE SAME
A primary reason cash flow can be difficult to manage is a misunderstanding that cashflow and profit are synonymous. Profit is the difference between revenue and expenses. This is often reflected on your income statement, otherwise known as a profit and loss (P&L) statement.
However, profit includes several items that are not related to the movement of cash. For example, depreciation is recorded as an expense but does not impact the amount of money in your bank account. Conversely, income excludes critical cash flow items like owner distributions, loan payments and capital expenditures. Cash flow is truly the movement of cash in or out of your business.
Therefore, relying on income as a proxy for cash flow can be a mistake with devastating consequences.
GETTING A HANDLE ON CASHFLOW
To get a view into your actual cash flow, you need to begin reviewing a cash flow statement in addition to your income statement and balance sheet. Any good accountant or bookkeeping software can produce a cash flow statement. In reviewing a cash flow statement, cash flow will be broken down into three main sections:
- Operating –cash inflows and outflows related to regular business operations
- Investing –cash flows associated with areas of investment including investments in equipment and property. A purchase of equipment will reflect as a cash outflow and a sale of equipment or property will reflect as a cash inflow
- Financing – cash flows associated with debt payments or owner distributions (outflows) and capital raises or owner contributions (inflows)
Consider a cash flow statement as a summary of the past. While it contains valuable information, it does not help much when it comes to managing cash flow timely. If there is one thing a business owner can attest to, it is that business is dynamic. Changes in the market do not wait for you to review last month’s financial statements.
Therefore, we suggest developing a cash flow forecast. The forecast should look out at least 13 weeks, but a higher-level outlook of 90 days or more is ideal. By determining how much cash you will have in the future, you will be able to make more educated decisions around hiring, investing, etc. You will also have time to adjust and avoid the need for an emergency injection of cash.
INCORPORATING CASH MANAGEMENT INTO YOUR STRATEGY
If you find that your cash flow is break-even or forecast a shortfall, here are some tips to strengthen your cash position and ensure you operate a positive cash flow business.
1. Review your expenses regularly
It is important to keep a regular rhythm in place to review your operating expenses and contracts to ensure you are still spending money in the right places and at the best rates. Begin by zeroing in on any expense line items from your financial statements that are growing faster than other expenses, or outpacing revenue growth. Consider eliminating unnecessary expenses or renegotiating contracts.
2. Manage your accounts payable
Review vendor payment terms and ensure they are at least as long as the terms you have with your customers. If your customers are on a net-30 payment cycle, negotiate terms with your suppliers at net-45 if possible. Pay careful attention to late fees. Any late fees or penalties should be evaluated for root cause and remedied immediately.
3. Manage your accounts receivable
Carefully manage receipt of payment from your customers. Build a contract structure that allows you to collect the maximum amount of cash up front in a sale or engagement and has terms favorable to your company. Build down payments into every contract if possible and consider offering small discounts for early payments or prepayments.
4. Establish a cash reserve account
Every business should have at least three bank accounts to help allocate funds for the appropriate purposes. An operating account should be kept with an amount of cash necessary to fund the ongoing operations of the business. A separate account should be established for tax obligations. Finally, a savings account should be established in the event the business needs to self-fund a cash shortfall in an unexpected situation. Like an emergency fund for your household finances, a cash reserve account will help your business avoid costly debt or the need to make an emergency owner contribution.
5. Pay attention to timing
Timing is everything. If your business is seasonal, make sure you are accounting for this in your cash management strategy. When most of a business’ cash inflow is in one part of the year, it is even more critical to establish a forecast and a reserve account. It also helps to review expenses to see if your vendor payments are timed to hit in one part of the year. If so, renegotiate contracts to help spread out expenses or ask for installment or subscription-based payments for annual contracts rather than one-time payments.
Cash is important when operating or scaling a business but it is also a major part of the value equation when determining what your company is worth. A negative cashflow business will be hard to market when the time comes to sell or transition your company.
If you could use a hand managing or forecasting your cashflow, contact us for a free strategy call.