Cash Is King: Cash Management Is The Most Important Factor To The Financial Strength Of Startups And Small Businesses
Launching a startup or running a small business requires determination, ingenuity, and a strong work ethic. But even if you have these traits, your venture will not succeed unless you can also manage its cash flow.
Cashflow management is important for both day-to-day operations and for reaching long-term business goals. It helps your business remain adaptable to changing market conditions, helps you seize new opportunities, makes growth easier and ensures you have funds available for unexpected emergencies.
To help you appreciate the value of cash management, this guide will explain:
- Why businesses should have cash on hand
- Why managing cash flow is particularly important for small businesses
- How profitability is different to positive cash flow
- How to fix cash flow problems within a business
- What is the best way to create healthy cash flow?
- What is cash accessibility?
- How you can forecast and understand cash planning
Why Should Businesses Have Cash On Hand?
Before we jump in, let us define what cash is on hand. This term refers to cash that is immediately accessible by the business, which can be spent on day-to-day operations or saved for future use. It is money in your bank account, cash register, PayPal account, or investments which you can quickly convert to cash. Having cash on hand is useful for several reasons:
Funds for day-to-day expenses
Startups and small businesses tend to have many a wide variety of expenses including manufacturing costs, wages, raw materials, overheads, advertising and so on. Many of these expenses need to be paid for upfront. If your business does not have cash available to pay for these expenses, it can significantly interfere with its ongoing operations.
Having cash on hand keeps businesses agile
Cash on hand makes it easier to adapt to changing market conditions, take advantage of opportunities, and deal with unexpected problems. Having cash available is particularly useful when you need to:
- Purchase new equipment
- Re-stock your business after an unexpected increase in sales
- Acquire other businesses or intellectual property when the opportunity arises
- Take advantage of cheap advertising options or other discount opportunities
- Deal with unexpected costs
- Hire additional employees whenever needed, and so on
Cash makes it easier to survive an economic downturn
The global financial crisis and COVID-19 pandemic have both shown us how quickly an economy can enter a recession. Businesses that have cash on hand are much more likely to survive these kinds of downturns, as they can continue paying employees, servicing debt, paying bills, and stocking their shelves. Cash on hand creates a bridge to better times.
Cash also gives you the ability to rebuild once tough times are over. As soon as economic conditions begin to improve, you can use cash to run aggressive advertising campaigns, launch new products into the market, or expand to new locations.
Reducing transaction costs
When running a startup or small business, it is important to avoid unnecessary costs as much as possible. Having cash on hand can help you do so, because you can avoid fees associated with low bank balance limits, overdrafts, late payments to vendors, and other such transactional costs. A healthy cash balance also helps you avoid high-interest credit cards and personal loans.
Why Is Managing Cash Flow Important For Small Businesses?
Cash flow management is the act of monitoring the cash that comes into and out of the business. There are several advantages obtained by managing your cash flow:
- Cash on hand
Managing your cash flow makes it easier to have cash on hand when needed. This cash can be used to pay for wages, bills, raw materials, stock, and the other items mentioned earlier.
- Identify unnecessary costs
Monitoring your enterprise’s cash flow means you will know precisely where each dollar is going. It can help you identify expenditure that is not necessary, or which is delivering a poor return on investment. It helps you avoid the most common question asked by most entrepreneurs and small business owners at the end of the month: “Where did all my money go?”
- Get credit before you need it
Having good knowledge of your businesses cash flow will help you understand when the money might run out. You can prepare for this event well in advance, obtaining credit to ensure your business can continue operation.
- Make good use of assets
Learning how cash is being used within your business will help you understand how assets are being used. For example, you can learn how much money a specific machine costs to run each month or how much money it makes. This makes it easier to allocate resources in the best way possible.
- The ability to see into the future
Good cash flow management will help you understand your business’s cash position in the future. You will know how much cash will be needed to continue operation and how much you will have if you continue operating in the same way. This allows you to make changes to your business to address any cash flow issues well before they occur.
What Is The Difference Between Profitability And Cash Flow?
Knowing the difference between profitability and cash flow will help you understand your businesses financial position. Here is a short summary of the two terms.
Cash flow refers to the amount of cash moving into and out of a business over a specific period. It can be negative or positive. Positive cash flow means the business has more money coming in than going out, which is usually a good thing. Negative cash flow means there is more money moving out of the business than is coming in.
Accountants will also differentiate cash flow into two categories: Operating Cash Flow and Non-operating Cash Flow:
- Operating Cash Flow
This is cash flow generated by a company’s normal business operations. This can include the cash that is received from customers, cash spent to purchase the raw materials used in the manufacturing process, and so on.
- Non-operational Cash Flow
This is cash flow that has come from sources other than the businesses day-to-day operations. It could be a loan from a bank, funds obtained by issuing stock, money from an angel investor and so on.
Profit refers to the balance that remains after your business’s operating expenses have been subtracted from its revenues. In other words, what is left after your bills are subtracted from the proceeds of doing business.
It is important to note that there are two different types of profit used in the accounting world: Gross Profit and Net Profit.
- Gross profit is the profit you make after deducting costs directly associated with making the product or service you offer. It is calculated by subtracting revenue from the cost of goods sold (COGS). COGS is all the expenses you can directly attribute to the production of your product or service, like materials and labor.
- Net Profit is a more accurate way to assess profitability as it includes all the costs associated with your business. It is calculated by subtracting COGS, interest, taxes, and other operating expenses from total revenue. This calculation includes expenses like rent, loan repayments, salaries, advertising costs, energy bills and so on.
Cash Flow Vs Profit
So, in summary, Cash Flow is the amount of money going into and out of a business at a specific time. Profit is how much financial gain a business is making on its products or services.
Profit is an important indication of how successful your business is over the long term. Cash flow is more important for keeping a business operating on a day-to-day basis and will determine if your business can succeed in the short term.
Does Profit Equal Positive Cash Flow?
No, not always. Although most profitable businesses are cash flow positive most of the time, they can sometimes be cash flow negative. Here are a couple of scenarios where that might happen:
Scenario 1: A construction business is paid for completed projects several months after construction is finished. When they commence operations for the year, they may initially have negative cash flow as they incur expenses immediately (raw materials, wages) but don’t get paid for their work until a later date.
Despite being cash flow negative on several occasions throughout the year, they are still a profitable company. This type of business may need a source of finance which they can draw upon to continue operation until they are paid. Without this source of funding, they might have insufficient cash flow to purchase raw materials and pay wages.
Scenario 2: A startup business has had great success with its initial product line and is rapidly expanding its operations. Although their business operations may be profitable over the course of a financial year, their sudden expenditure may cause their cash flow to be negative in the short term.
What Is Cash Accessibility?
Cash accessibility, also referred to as the liquidity, is a measure of how readily usable your cash assets are. This is an important distinction to keep in mind when counting your cash, as it will help you understand how much cash is actually available when needed.
Cash that is held in a long-term deposit or invested in a separate venture may not always be easily accessible. Any cash that has been set aside for an important purpose like paying taxes or employee benefits may also be unavailable for use.
How To Fix Cash Flow Problems In The Business
There are several strategies you can implement to help a business struggling with cash flow, including:
- Shorten the duration of invoices
Long settlement periods on customer invoices can leave you struggling with cash flow. Consider shortening invoice collection periods to 30 day or less.
- Use software to automate invoices and payments
Some businesses struggle to invoice efficiently, which leads to slower payments for products or services. To overcome this, invest in software which streamlines the invoice process and makes it easier for customers to pay for their purchases.
- Identify unnecessary expenditure
Cash flow is a two-way street. If you are struggling to find enough cash, take a closer look at how you are spending it. Prioritize expenditures into categories such as already committed, necessary, and discretionary, and then manage them accordingly.
- Lengthen the duration of bills
Negotiate payment terms with vendors that extend payment dates to 30 days or more.
- Lease instead buy
Leasing equipment helps you avoid upfront cash payments for purchasing equipment outright (which impact cash flow). Note that there are finance charges to be rationalized when making lease verse buy decisions.
- Ask for deposits or partial payments
Instead of having one large lump sum payment at the end of project completion, ask for a deposit and several progress payments which occur as milestones are reached.
- Offer incentives for fast payment
Begin to offer customers exclusive deals or discounts if they pay more cash upfront for their purchases. The cost of such discounts should be evaluated against the availability and cost of other cash sources.
What Are The Best Practices For Managing A Healthy Cash Flow?
Monitor your cash flow regularly
The old adage knowledge is power really applies when it comes to cash flow. Keep concise analysis tools current to track cash movements in your business to help you identify opportunities which can be used to improve your cash position.
Get a line of credit before you need it
Having a line of credit available will help you deal with cash flow emergencies. It will ensure you can continue operation even when cash is extremely tight due to less sales, delayed invoice, unexpected expenses, or other factors.
Stay on top of invoicing and innovations to get paid faster
Too many businesses are lax when it comes to invoicing and collecting customer payments, which leads to cash flow problems. Take steps to make receiving payments as streamlined as possible. Email invoices directly to your customer’s accounts payable contact with payment links embedded in the invoice to allow for immediate payment. Offering customers a variety of payment solutions such as bank transfers, credit card processing, and various other easy payment applications, including PayPal, Stripe, Apple Pay, and Google Pay can speed up receipt of funds. Making it easier for customers to pay facilitates positive cash flow.
Speak to an accountant
Accountants specialize in monitoring and managing cash flows for startups and small businesses. They will track every cent being received or spent by your business and help you understand where changes need to be made.
What Is The Best Way To Forecast And Understand Cash Planning?
The best way to ensure strong cash flow is to use cash flow forecasting. It is a process for estimating a business’s future financial position. It can help a business:
- Always have enough cash on hand to deal with emergencies, unexpected changes in demand or strategic shifts
- Manage debt and interest payments
- Stay compliant with debt covenants
- Maintain short term liquidity
- Make more reliable budgets
There are two types of cash flow forecasting:
- Direct cash flow forecasting
This method looks at the cash flows and cash balances in the short term (often 90 days). It organizes upcoming payments and receipts into units of time. These units are then aggregated over the length of the forecast period. To put in simpler terms, it looks at recent real-world performance to estimate future performance.
- Indirect cash flow forecasting
This type of forecasting uses a variety of techniques which estimate how much cash a business will receive over a longer period. There are three methods often used to derive an indirect cash flow forecast: Adjusted Net Income (ANI), Proforma Balance Sheet, and the Accrual Reversal Method (ARM).
An accountant will be able to tell you which method is most suitable for your business. Once you have implemented some cash flow forecasting, you will have much more certainty about the liquidity of your business and how much cash you will have on hand going forward.
In Conclusion
As you can see, there are several advantages to managing cash flow. In addition to giving your business the resources necessary for day-to-day operations, it will help the business grow and adapt to changing market conditions.