As long as you have cash, you can keep the lights on.
And yet for many small business owners, cash management doesn't get the attention it deserves.
A business that has good cash flow management practices not only creates peace of mind for the owners. It also is more likely to get loans from a bank, get more attractive rates on debt, is able to negotiate better terms with suppliers or customers, and more.
What is cash flow management?
Cash flow is basically how money moves in and out of your business. If you have more money coming in than going out, you're in good shape. If you have more going out than coming in, even if your business is profitable, you can find yourself in a sticky situation and risk insolvency.
The cash flow cycle
The cash flow cycle for a given period consist of three elements:
- Starting cash position - how much cash you have at the beginning of a period.
- Net cash flow for that period - cash receipts (inflows) minus cash disbursements (outflows).
- Ending cash position - if you have a positive net cash flow, your ending cash position will be higher than your starting cash position. If you have negative net cash flow, your ending cash position will be lower.
It seems simple, but it can be difficult for business owners to get a handle on for a couple of reasons.
Cash Flow vs. Profits
Many owners confuse cash flow with profits. But your profits (as reported on your financial statements) show you your income after expenses - not necessarily the inflows and outflows of cash in a given time frame.
While you could have a very profitable business, it's possible to get into a cash crunch because the money flowing out of the business in a given month exceeds the money coming in in that same month.
While cash-based accounting minimizes this somewhat, it's not perfect. And most businesses of any complexity use accrual accounting, which while painting a more accurate picture of profitability can be deceiving from a cash flow perspective. This is because you will often recognize revenue from your customers on your income statements, but not necessarily receive the money until later. Ditto expenses you pay for on credit - they're recognized as expenses immediately, even if you don't actually pay for them until later.
In a sense, cash flow is actually more important than profit. It's not uncommon for a business to operate at a loss, at least for a while. Most startups that raise venture funding do this, optimizing for rapid expansion at the expense of profitability. Seasonal businesses will often experience this as well, running at a loss until the busy season at which point they make it all up.
But cash is another matter. Run out of cash, and your business stops immediately. It's like a car running out of fuel.
Cash Flow vs. Cash in the Bank
Many business owners don't even look at their financial statements, much less use them to effectively manage the business. Rather, they simply consult the company checking account to make sure there's money in there.
This can be problematic because that money in the account is simply a snapshot in time. It doesn't tell you what expenses are coming up, or what inflows you might expect. And while a small business owner might think they have an intuitive understanding of both, as the business grows keeping those guide rails in one's head becomes impractical.
Unless you're extremely frugal with spending and have a constant surplus of cash, this can be a recipe for disaster. But being that frugal out of an abundance of caution means you have cash sitting idle that could be reinvested in the business. By having a more accurate handle on inflows and outflows you can make more informed decisions for the business.
If you have healthy surpluses, access to lines of credit and other short term debt facilities, a monthly period for your cash cycle probably makes sense. If you are red-lining the business and have little recourse if things get tight, you want to manage cash flow much more closely - a weekly or even daily cadence is appropriate.
What contributes to cash flow?
Revenue and expenses obviously play a huge role in your cash flow. But there are subsets of each that important to consider. A couple examples include:
- Accounts receivable - how much money is owed to you, and how long has it been owed?
- Accounts payable - how much do you owe vendors, and when is it due?
- Inventory - how much do you need to have to serve customers effectively without carrying too much overhead?
- Capital expenditures - how and when should you make investments in the business that will eventually have a positive ROI, and when can you expect that ROI to be achieved?
- Debt service - how much debt do you have, when does it need to be paid, and when should you pay down principal vs. simply paying interest?
Your cash flow management tools - the cash flow statement and the cash plan
There are two primary tools businesses use for managing cash, and they work closely together.
The first is the cash flow statement. This is a report that is created retroactively, to show you how cash flowed in and out of the business in a preceding period.
The cash plan is a forward-looking tool, and is effectively a forecast of future cash needs. A cash plan can look a couple months in advance all the way up to a year in advance.
A healthy cash flow management cadence starts with these two tools. You create your cash plan into the future. At the end of each month (or more frequently if necessary) you create your cash flow statement. And you compare the two documents to identify the degree and source of variance, updating your cash plan if necessary.
While most business owners use financial accounting software like Quickbooks and therefore have cash statements built into their financial management sytem (whether or not they look at them is another question), in our experience cash plans are much less common. And yet they are essential to a healthy cash management process.
A good cash plan helps you prevent cash shortages that cath you off guard. When compared to your actual cash flow statements, they help you understand trends in the business and find opportunities for optimization. Like an operating budget, they help you anticipate future cash needs to facilitate growth and accomplish your business strategy. And they can give you additional color to your financial picture, which can not only help you sleep at night but also inform lending decisions with banks or establishing credit with suppliers.
Be conservative with your cash plan.
As a rule of thumb, whenever you are in doubt about a potential number in your cash plan it's wise to err on the side of caution. Estimate low on cash inflows, estimate high on cash outflows. The worst case scenario is you are too conservative, and have too much cash sitting idle. A problem, but not nearly as bad as the reverse.
It's also a good idea to maintain some amount of cushion in your cash plan, as plans never turn out exactly as one draws them up. How much of a cushion depends on the volatility of your business, but can range anywhere from 5% of average monthly disbursements up to 25% or more.
How to improve cash flow
With those two documents created, you can now start to examine the variance between your plan and the cash flow statements. In doing so, you can find ideas for ways to improve cash flow over time. A couple of suggestions for things to look for:
Raising your prices is one of the fastest ways to improve cash flow. More revenue in means more more cash to pay bills. And yet raising prices is usually one of the last things owners think of.
Raising prices has a ton of benefits in a addition to improving cash flow. It's the fastest way to improve profitability (assuming you can deliver the same service for the same cost as before.) Over time it tends to attract higher caliber customers. And it can actually elevate your brand.
Be aggressive with receivables.
Revenue is like oxygen for your business. You want to get it as quickly as you possibly can. Optimizing your receivables is one of the best ways to improve your cash position. High receivables can put a big strain on your cash flow - and long-term receivables often turn into defaults, which can really mess with your projections.
Start measuring receivables.
You manage what you measure. Add "Number of days receivables" to your key accounting metrics, or ask your bookkeeper or accountant to provide this number with your monthly accounting reports.
The number will certainly vary by type of business you're in. As a general rule of thumb if you can keep this number under 35 days you're doing well.
Implement more aggressive collections processes.
Stress the importance of this number to your finance or account team. Consider making it an OKR if relevant. Often simply being good about follow up is sufficient to get results and improve receivables.
One way to speed up receivables is to get a lockbox service. Your customers will send checks directly to the bank, which are then processed according to your instructions. This can cut down on the time between when a check is mailed and when cash hits your bank account. Most major banks offer this service for an added fee to business accounts - depending on the number of deposits you are making this fee can be more than worth it.
Explore ways to incentivize better receivables.
There are a number of strategies you can use to improve the rate at which you collect cash. They won't all be right for your business, but it's worth asking yourself whether some of these options are viable.
- Can you offer an incentive for paying early? Consider raising your pricing by 10% and then offer a 10% discount for early payment.
- Can you collect payment up front? Again, this can be a useful way to maximize return on ad spend, allowing you to manage cash much more easily and potentially reinvest in acquiring new customers.
Move to a monthly recurring revenue model.
We're huge fans of monthly recurring revenue (MRR) models. One of the primary reasons is they make receivables problems largely go away. They allow you to start collecting money from clients automatically on a monthly basis, eliminating the need for most follow up. The only major exception is when there are credit card billing issues, which you want a process for handing. But for the most part you'll be able to collect receivables automatically without having to think about it.
MRR models have many other benefits (making it easier to raise prices since you can spread the increase out over time, etc). We go into much more detail on monthly recurring revenue models here.
Along the same lines, you want to delay having to spend money as long as you can.
When you're negotiating contracts that have Net-X terms, negogiate as best you're able to draw them out. To the degree they try to push back hard on payment terms, negotiate them down on price.
With software or other tools, ask to spread payments out over time. Pay monthly vs. annually unless the annual discount is meaningful.
Just like you monitor your receivables, have your financial reporting monitor payables. Set goals or OKRs on increasing average payables.
Examine fixed assets
Look at your fixed assets on your balance sheet, and ask yourself if any of them are being under-utilized. Assets that aren't productive is similar to cash that is sitting idle. You might either want to find ways to make those assets more productive, or consider selling them to release the cash sitting latent.
Get a source of short term cash for emergencies
A line of credit or equity loan from a bank can be a godsend when things get tight. It can sometimes be difficult to get a line of credit without a solid track record, and many banks will ask for a personal guarantee. But the peace of mind that you can cover payroll or other short term expenses if necessary might be worth it.
How to get started
The first step is to get on the same page with your accountant or bookkeeper on the need for a cash flow management process. Assess your current state by reviewing the last few months of your cash flow statements. Look for patterns. Make some immediate course corrections if necessary. Then put together your first cash flow plan.
Don't worry if it isn't perfect. You'll continue to refine it as you get more comfortable with the process. The key is to get started.