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Cash flow is a fundamental metric that’s used as an indicator of the financial health of a business. In essence it’s the net amount of cash flowing into and out of a business within a set period of time. If within that time there’s more than enough cash on hand to pay all bills and expenses, then there’s a positive cash flow; if however, cash flowing out of the business exceeds what’s coming in, this may signal cash flow problems are imminent.
Cash flow is typically a more realistic view of a company’s financial health than profit as although a business may be profitable, it can still be in a negative cash flow situation which, left unchecked, can cause more serious financial challenges for business owners. Having said that, negative cash flow can be a good sign for many newer businesses and rapidly growing organizations as it can signal that more investment is needed to keep pace with growth.
There are three main types of cash flow that a business might consider at different stages and these will commonly appear on the cash flow statement…
Operating cash flow – the daily expenses incurred in the running of the business including salaries, payments to suppliers and cash coming in from customers;
Investing cash flow – these are the less frequent, more ad-hoc expenses incurred in growing the business. This cash may be put towards purchasing new equipment, real estate or even the acquisition of another business;
Financing cash flow – this is an uncommon feature on a cash flow statement as it occurs infrequently and might include such things as cash gained from selling equity and dividends, borrowing on debt finance and issuing stock options or an example of negative financing cash flow could be a loan settlement payment.
Whatever the income or expenditure, it’s vital to have a hold on the business’ cash flow position, particularly as the costs of doing business are rising rapidly. A regular audit of cash flow will enable you to spot some of the common cash flow problems and address them before the situation deteriorates.
Finance is necessary in almost every business and is usually extremely beneficial but any new debt finance must be weighed up carefully. Interest rates are rising and you will need to have the free cash flow to make the repayments plus the interest, if not, cash flow could be impacted and you may be under pressure to take on more debt to pay regular monthly outgoings. Many companies that have taken out multiple cash advances (Merchant Cash Advances) can find themselves in this position and have to borrow more just to pay back expensive debt finance products. Refinancing to lower-interest debt could be a way to mitigate cash flow problems stemming from high debt ratios.
The growth of a business is undoubtedly a good thing, rushing that process however, may not be in the business’ best interests. Payroll is the biggest cost for any business and taking on too many employees at one time might not be feasible while still maintaining positive cash flow. Likewise, in a product-based business, inventory is expensive and so is the cost of storing it, in the eventuality that it doesn’t sell through as quickly as expected or a big customer fails to materialize. Growing at a steady pace usually allows for more controlled spending and it’s good to explore all options before investing in fixed assets.
Just as over-investment can cause a cash flow blip if not done at the right time, under-investment can strangle a business’ ability to improve their cash flow position and generate more income. Not investing into the latest equipment or technology to stay relevant in the market can lead to a lack of ability in competing, losing customers and entering a downward spiral financially. It’s important to invest in the future of the business, however be mindful of the timing and always ensure any cash going into new product ranges or assets is well thought out and backed up by a business plan.
The work of a small business owner is never done and it’s fair to say that not many relish the prospect of keeping their bookkeeping in order. Although it can be viewed as an unproductive task, bad or non-existent bookkeeping means losing track of deposits and payments and operating this way consistently means visibility of cash flow is diminished and ultimately it can result in missed payments, poor credit rating and inability to secure low cost finance. If there is no in-house resource to help with this, consider working with someone to bring it -up-to-date and then put processes in place to manage it properly going forward, perhaps utilizing automated software; bookkeeping may not be exciting but it’s a necessity in controlling cash flow.
COVID being a prime example, many businesses will fall foul to external economic, social and political situations that they simply could not have prepared for. Whilst it’s easier to stay on top of what competitors and the broader market are doing, being prepared for a more significant, global event or threat is best with a cash reserve which can support the business through difficult and unforeseen circumstances which they’re rarely able to control.
It’s easy to get caught up in the excitement of a business’ success and underestimate how much it might cost to grow and expand, particularly when the business is growing rapidly. Without a precise plan for expansion, expenses may be omitted and net profit exaggerated, presenting a cash flow problem for entrepreneurs and business owners. Some of the items that can often be overlooked are legal fees, permits and licenses within the state and country that you’re operating, advertising and marketing costs, product development and of course, the costs of labor, which are on the rise in most industries. A detailed business plan for expansion will ensure nothing is excluded and it’s better that you overestimate than underestimate to avoid cash flow problems at an exciting time in the business’ growth.
In any business, it goes without saying that if you’re settling your accounts payable before your customers pay you, there could be a 30 or 60-day gap between money going out and coming back in. Your monthly expenses such as salaries, taxes and insurance must still be paid in this ‘in-between’ period but where does that come from if you’re only being paid on extended terms or not paid at all in some cases? The best way to address this problem is having a clear policy on who to extend credit to, when and what the terms are and also ensuring you’re on top of collecting your own receivables.
One of the more frequent mistakes businesses make is mistaking profitability for positive cash flow. While profit is what’s left each month once all expenses have been paid, cash flow is the net flow of cash into and out of the business at a specific point in time; cash flow can still be negative even if the business is profitable and it’s easy to ignore cash flow metrics, falling into a trap where you’re unable to pay expenses or invest into the business. Converse to this are businesses that have positive cash flow but are failing to turn a profit which is often the case for startups and other rapidly growing companies. There is no one ‘best’ way to measure the financial health of a business, both profitability and cash flow are key metrics for different reasons and maintaining clarity on both will prevent small challenges becoming bigger issues.
Sales numbers should ideally be based on a 90-95% probability of closing but if sales forecasting is consistently inaccurate, this can be detrimental to cash flow as you’re overestimating what’s coming in and eventually this will catch up if there’s not enough to cover outgoings. Conversely, underestimating what business is in the pipeline might prevent a business from investing as necessary and then impact cash flow projections. Accurate sales forecasts will also enable careful inventory planning and ensure that the business doesn’t have more on hand than required. Be conservative in sales forecasting and in relevant industries, always build in something for seasonality.
Not having some cash set aside for the unexpected can make all the other cash flow problems mentioned even worse. Many cash flow issues could be easily remedied with a small pot of funds set aside to cover unforeseen economic scenarios, a lull in sales or the need to purchase a large amount of inventory. For most businesses, a buffer fund that covers three to six months of operating expenses should be enough, however, every business is different and this will depend on expenses, growth ambitions, the industry and current access to finance.
Ignoring or not understanding a business’ cash flow position can easily result in falling into one of the common pitfalls we’ve discussed and at worst, even threaten your ability to continue operating. If any of these cash flow problems feel familiar and you’re concerned about pushing through a really tough time, it’s vital to act early, particularly in the current economic climate.
We’re always happy to speak to entrepreneurs and business owners about how best to identify any issues and optimize liquidity while still having a clear route to grow and thrive – reach out to our team to discuss your options and set a path for future success.
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