4 Ways to Improve Your Small Business’ Cash Flow
Cash flow can be a struggle for many small businesses, especially those in a growth phase or just starting out.
In fact, cash flow is the number one reason new companies fail. When you think about either product- or service-based businesses, there’s always a considerable outlay of cash before you can begin collecting revenue. If you’re starting a lawn mowing business, for example, you’ll have to buy a lawn mower, pay for advertising, book clients, and perform the work before you can even issue your first bill. This means cash flow is really important, not only to bring in operating capital while a new business is trying to build up initial revenue, but also to cover those short-term borrowing needs.
Cash flow can make or break a small business. At times, negative cash flow can and likely will happen, but there are measures you can take to make sure you’re accurately tracking and managing it so that it’s working for you and your business. But, before we dive into those measures, let’s start with the basics.
So, what is Cash Flow?
The concept of Cash Flow is a simple one – it’s the money that flows into and out of your business. Generally, without a sufficient flow of cash, your business can’t continue to operate, so it’s an important balance to strike. Not only do you need to make sure you have sufficient funds available, but you also have to be able to anticipate when you’re going to be cash-flow negative before you actually get there. Most banks don’t do short-term lending very quickly, so you need to make sure you’re forecasting your cash flow appropriately to plan for your borrowing needs in advance.
Most organizations have “operating cash flow” and “free cash flow.” Operating cash flow (OCF) is essentially how much cash is generated by an organization’s normal business operations. Free cash flow (FCF) is your operating cash flow less capital expenditures, which includes fixed assets. If you think about all of your expenses that you have in your business, but you don’t include the fixed assets that you’re going to capitalize, then that is your free cash flow.
The cash flow for service-based and product-based companies is impacted by expenses that are due in advance, and any income that is collected in arrears. Let’s look at an example. Say you’re a service-based business, charging clients based on the number of hours your employees work for them. This usually means you’re paying out your own payroll before sending an invoice to the client. So, your payroll expenses go out first, and then your invoice, but if you give your clients 30 days to pay you and you pay your employees weekly, you’re going to have to cover four payroll periods before you receive any income to cover those expenses.
How does Cash Flow Differ from Profits?
Occasionally we get asked about the difference between cash flow and profits, and which is more important. Simply put, where cash flow is the movement of money into and out of a business, profits are what you have left over to keep. Cash flow depends on the timing of when your expenses are paid and when your money is received. When you invoice a client, for example, you’re going to record the revenue on the day that you invoice them, but the day that you collect the money is when your cash flow actually increases. Profit is the revenue remaining after you’ve paid all of your expenses.
All of this said, it is actually possible to be profitable without having a positive cash flow and vice versa. If you’re a product-based business for example, and you’re manufacturing a tangible item, you have to pay for all the materials, manufacture the product, package it, and then deliver it to your consumer. You need to cover all of those expenses before you ever receive any revenue for it. So even though your profit and loss statement may show that you’re making a profit, your cash flow could be negative because you’ve had to incur so many expenses before you collect.
It is important to monitor and forecast both profits and cash flow in order to sustainably grow your business. If you find your business in a negative cash flow situation, or perhaps approaching one, here are 4 ways to improve it.
4 Ways to Improve your Small Business’ Cash Flow
1. Bill In Advance
One of the easiest ways for you to control and improve your cash flow is to have your customers pay in advance. This is especially easy to do on retainer- or in subscription-based businesses where customers are generally more accustomed to these billing terms. It is important to note, however, that once you have established your billing procedure, it is difficult to make the switch to asking your clients to pay sooner. If this is something you’d like to implement in your business, it’s best to plan ahead and implement as new clients come onboard.
2. Encourage your customers to pay more quickly
Another way to improve your cash flow is to incentivize your customers to pay more frequently. Oftentimes payment terms are 30 days; you could offer an incentive discount, like 2% off any outstanding balance when it is paid ahead of that term. Often this discount is incentive enough for customers to pay early.
3. Reduce Borrowing with Accurate Forecasting
One of the things that businesses don’t really consider when they are looking at forecasting their cash flow is the cost to borrow capital when they’re already experiencing a negative cash flow. Borrowing needs to be planned and right-sized for your company to ensure you are not over-borrowing or over-paying on interest. Cash flow forecasting will enable you to see if and when you’re coming up on a cash flow shortage so you can plan appropriately. By accurately forecasting, you can ensure you borrow enough to cover your cash flow negative period, but not more than you absolutely need.
4. Negotiate Terms with Vendors
When you’re focused on developing and manufacturing a product, one of the best ways to improve your cash flow is to negotiate the payment terms with your vendors. In the case of a product-based business, you could have hundreds or thousands of dollars in product ready to be sold that you’ve already paid for, which means you’ve got a large expenditure that you need to recoup. For this reason, having a bank you can work with to negotiate the terms of your lending, and factoring those terms into your expenses when you’re forecasting, is crucial.
Or, if you’re in a situation where you’re buying a lot of materials needed to manufacture your product, it’s wise to buy in bulk and buy in advance whenever possible. For some businesses, a product has to sit for some time while it goes through testing before it is able to be sold. If this case applies to your business, knowing how long you might have to carry that inventory will help you to anticipate your cash flow needs. It’s also important to have a plan in place for what happens if your product doesn’t sell. Knowing how low you can go with your pricing but still cover your cash flow needs is important, especially when you’ve got loans from the bank waiting to be paid.
Cash flow can be a deceivingly simple concept, but it can have significant business impacts – both positive and negative – if not monitored and managed correctly. By looking at your overall cash flow situation, anticipating your lending needs, and considering where and when you’ll need to be paying out for materials or services rendered, you can start to develop a strategy for forecasting and managing your cash flow effectively.