For many ambitious entrepreneurs, owning and operating their own business is the realization of the American dream. The opportunity to be your own boss, see your vision become a reality, and reap the rewards of your hard work is one that is very appealing. However, owning a small or medium-sized business (SMB) is also not for the faint of heart. In addition to the countless hours spent growing your business, you also need to wear many hats and be knowledgeable in a variety of areas – one of which is cash flow.
In the U.S., thousands of new businesses are started every day, but unfortunately, not all of them will be successful. In fact, according to the Small Business Administration (SBA), only about fifty percent of all small businesses will make it past their fifth year in operation. While there are many factors that contribute to business failure, one of the most common is poor cash flow management. In fact, a study by U.S. Bank concluded that 82% of small businesses fail due to issues related to cash flow.
So how can SMBs effectively manage their cash flow so that they can set themselves up for success? In the following, we’ll explore what cash flow is, why it’s important, and offer some tips on how to successfully manage cash flow.
- One of the most common factors that contribute to business failure is poor cash flow management. One study shows that 82% of small businesses fail due to issues related to cash flow.
- Understanding your businesses’ cash flow can help you plan for and manage any potential financial challenges.
- There are many things you can do to help you effectively manage your cash flow including maintaining accurate financial records, understanding your cash flow cycle, and creating a budget.
- Ineffective management of cash flow can have negative impact on your business, while good cash flow management can help you to secure financing.
What is cash flow?
In its simplest form, cash flow is the incoming and outgoing cash that is generated by a business. This can include money from things like sales, investments, loans, and credit lines. It also includes expenses like bills, payroll, and other operating costs. Managing cash flow effectively is critical for businesses of all sizes, but it can be especially challenging for SMBs.
This is because small businesses often have limited resources and are less able to absorb unexpected costs or slow periods. They also may not have the same access to capital as larger businesses, making it more difficult to cover short-term expenses. As a result, it’s important for SMBs to have a good handle on their cash flow so that they can plan for and manage any potential challenges.
Why is cash flow important?
There are several reasons why cash flow is so important for businesses, but perhaps the most important is that it helps to ensure the survival of your business. This is because, as mentioned earlier, cash flow problems are one of the most common reasons that businesses fail.
In addition to helping avoid business failure, managing cash flow effectively can also help you to:
- Make sound financial decisions: When you have a good understanding of your cash flow, you’re in a better position to make informed decisions about things like pricing, investments, and expansions.
- Achieve business goals: Effective cash flow management can help you to free up cash that can be used to invest in growth or other areas of your business.
- Improve relationships with vendors and suppliers: If you’re able to pay your bills on time, you’re likely to develop better relationships with the people and businesses you work with. This, in turn, can lead to more favorable terms and conditions.
How to manage cash flow effectively
Finding the right balance between incoming and outgoing cash can be a challenge, but there are a number of things that SMBs can do to effectively manage their cash flow.
Maintain accurate financial records
This may seem like a no-brainer, but it’s important to have accurate and up-to-date financial records. This will give you a clear picture of your cash flow so that you can make informed decisions about your business.
Understand your cash flow cycle
Every business has a unique cash flow cycle, which is the time it takes to generate and receive cash from sales. Understanding your organization’s distinct cash flow cycle can help you to better manage your cash flow.
Create a budget
Every SMB should have a budget in place. This is crucial to helping business owners make strategic decisions such as how to allocate resources, where to cut costs, and where there are opportunities for expansion. A budget can be a helpful tool for forecasting your cash flow and managing your expenses. When creating a budget, be sure to include a buffer for unexpected costs.
Manage your invoices
Make sure that you’re billing your customers promptly and keeping track of outstanding invoices. This will help you to ensure that you’re getting paid in a timely manner. There are great web-based invoicing platforms that can automate this process for you, including features such as sending payment reminders, that will save you time.
Stay disciplined with expenses
It’s important to keep a close eye on your expenses and only spend money on things that are necessary. Related to this, it’s equally important to spread expenses out over time rather than paying every bill all at once. This will help you to avoid cash flow crunches each month.
Consider using accounting software
Technology should be used to your advantage when it comes to managing cash flow. Accounting software can automate many of the tasks associated with cash flow management, such as invoicing, budgeting, and tracking expenses, as well as being very useful for tax purposes.
Make smart payroll decisions
Streamlining payroll functions should be a priority for SMBs. One way to do this is to offer employees the option to be paid via direct deposit rather than paper checks. This can help to improve cash flow by reducing the time it takes for employees to receive their pay. Also, carefully consider when you’re paying employees. For example, if your business has a slow season, you may want to consider paying employees bi-weekly rather than weekly. This can help to improve cash flow during slower times.
What are the impacts of poor cash flow management?
The margin for error for SMBs is often much smaller than for larger enterprise-level businesses, so proper cash flow management is essential. Poor cash flow management can lead to a number of problems for small to medium-sized businesses, including:
Inability to pay bills on time: This can damage relationships with vendors and suppliers, damage credit, and difficulty accessing financing in the future.
Inability to make payroll: This can result in employee dissatisfaction and turnover, as well as legal trouble.
Difficulty growing or expanding the business: Poor cash flow management can limit a business’s ability to invest in growth opportunities, such as new products or services, marketing campaigns, or hiring new employees.
From a macro perspective, poor cash flow management makes it difficult for SMBs to maintain an accurate understanding of their own cash and financial assets. This lack of transparency can have ripple effects throughout the business, including hampering decision-making and long-term planning. And of course, as aforementioned, the reason over 80% of SMBs fail is directly related to cash flow problems.
How does good cash flow management help to secure financing?
One of the first things that lenders will look at when considering financing for a small business is the business’s cash flow statement. The cash flow statement provides insight into whether a business can generate enough cash to repay a loan. It can also be used to predict future cash flow, which is important for lenders to consider when making lending decisions.
Although guidelines differ from lender to lender, generally speaking, lenders will usually require a debt service coverage ratio (DSCR) of 1.25, according to the Small Business Finance Institute. What this means is that for every $1 of debt, the business must generate $1.25 in cash flow. If a business can’t meet this requirement, it may have difficulty securing financing.
Often, if a business is growing rapidly, it will require an influx of capital for things like inventory, new equipment, or hiring new employees. In cases like this, a business that is growing quickly may have negative cash flow, meaning they are burning through cash more quickly than they are generating it. This is a perfect example of why it’s so critical to have a buttoned-up cash flow statement that clearly shows the business’s ability to repay any new debt. Lenders may require a higher debt coverage ratio, but if the business can demonstrate that it can successfully manage cash flow, they will be more likely to approve financing.
Building and running a small to medium-sized business is no easy feat. Setting strategic goals, planning for future growth, and investing in the right technology and business tools are all important pieces of the puzzle. Probably the most critical, however, is proper cash flow management. By understanding what cash flow is, why it’s important, and following the suggestions outlined above, business owners can put themselves in a much better position to succeed.