An especially powerful tool in the array of financial resources for an entrepreneur is the cash flow statement. This financial report exposes crucial elements necessary for small business cash flow management.
Why Cash Flow is Important for Small Businesses?
Devotion to cash flow is vital to assuring that business results align with expectations. Cash flow is not the same thing as profit. Understanding the difference is necessary for small business survival. Among the distinctions is that uncollected revenue and unpaid expenses are yet to entail any cash. Of course, some enterprises only count revenue when collected and expenses when paid, which is the cash basis of accounting.
Nevertheless, the following additional factors that don’t affect profit are also important to discover with cash flow analysis.
- Loan payments reduce cash flow
- Depreciable asset purchases lower cash flow
- Depreciation expense increases cash flow, but not profit
- Borrowing and owner capital contributions raise cash flow
Common Small Business Cash Flow Problems
The key to averting operational trouble and surviving harsh economic circumstances is monitoring cash flow details. Punishing headwinds of market forces are weathered by scrutinizing all cash flow elements. Short-term dips in cash flow are not bad if they are a consequence of business expansion. After all, a sales increase is generally preceded by rising expenditures. But excessive growth can create difficulty from running out of cash to further expand.
The causes of money shortages can become a dense thicket unless the essential features of cash flow are examined in an easily understood reporting format. The cash flow statement performs this function. The aim of small business cash flow management is to target upcoming steps by first peering into the past to obtain a grip on reality. Future acts depend on the assessment of current trends before they manifest into these painful problems.
- Customer invoices not promptly collected
- Vendor bills not paid on time
- Inventory accumulation that excessively uses cash
- Borrowing too much for needed cash
- Equipment needs ignored to replace old items or buy ones
Examples of Cash Flow Management Problems in Business
A cash flow statement conveys the steps that change cash from the beginning of a period to the end of that period. The Cash Flow Statement below for XYZ Company maps the changes in cash for the business during the recent six months. XYZ did almost everything during the period that can impact cash flow. Several key insights may be diagnosed for identifying the company’s next moves in small business cash flow management.
Annual Cash Flow Statement of XYZ Company
|XYZ Company||Jan.- June, 20xx|
|Net Profit from Operations||30,000|
|Additions to Cash|
|Increase in Accounts Payable||10,000|
|Subtractions from Cash|
|Increase in Accounts Receivable||-15,000|
|Increase in Inventory||-10,000|
|TOTAL CASH FROM OPERATIONS||20,000|
|Cash from Investing Activities|
|TOTAL CASH FROM INVESTING ACTIVITIES||-7,000|
|Cash from Financing Activities|
|Borrowing increase (decrease)||6,000|
|Cash from (to) owners||-24,000|
|TOTAL CASH FROM FINANCING ACTIVITIES||
|NET INCREASE (DECREASE) IN CASH||-5,000|
An initial observation is that XYZ Company is profitable. But profitability is already ascertainable from examination of the Income Statement. The cash flow statement tells us more about the business and potential warning signs that lie ahead.
In addition to revenue that’s higher than operating expenses, XYZ has an expense for depreciation. This expense category is a deduction over time for assets acquired with cash in the past. Since no cash was used for this expense in the six-month period, this amount from the Income Statement adds to cash flow.
Changes in Accrued Income and Expenses
Because XYZ uses accrual accounting, revenue is earned when jobs are complete and invoiced to customers. Cash flow increases from collecting amounts invoiced, including sales earlier than the past six months that are excluded from revenue for this period. Cash flow decreases by the amount of revenue invoiced in the past six months but not yet collected.
Consequently, a higher accounts receivable balance at the end of the recent six months is a reduction in cash flow; lower accounts receivable would be a rise in cash flow. Although XYZ Company has more revenue than expenses, much of the sales are merely increasing accounts receivable. The profit is not leading to cash flow.
In addition, the accrual method of accounting records expenses that are billed although not yet paid. Cash flow for XYZ decreases from paying amounts billed for expenses earlier than the past six months. Cash flow increases by the amount of billed expenses in the past six months that are not yet paid.
A larger accounts payable balance at the end of the recent six months is an increase in cash flow; a lower accounts payable balance would be a cash flow decline. XYZ has rising accounts payable in the period. Cash flow is increased because the company is not paying all the bills for its expenses.
Differences in Assets and Liabilities
Changes in the cost for inventory have a similar impact on cash flow. Declining cash flow is triggered from acquiring more inventory than was sold. Cash flow increases if inventory falls. XYZ Company had a higher inventory cost balance at the end of the recent six months. Cash flow is decreased by this greater cost.
Purchases of depreciable assets decrease cash flow. However, selling a fixed asset will increase cash flow. XYZ replaced equipment in the recent six months, which decreased cash flow.
Cash flow increases from borrowing. Reducing loans balances decreases cash flow. XYZ Company had a borrowing increase, which added to cash flow.
Effective Cash Flow Management Tips for Small Business
- Focus on revenue trends - When sales are rising, management of cash receipts is of paramount importance. Reduced or negative cash flow in an environment of higher revenue calls for procedural efficiency. Invoice customers immediately upon completion of projects. Submit invoices by email to shorten collection times.
- Simplifying payment methods - Acceptance of credit and debit cards is only a small step in this direction. A secure online payment system further hastens the collection process. Systems are available that can link on a company’s website. Keeping customer credit card information on file allows automatic processing of invoice remittance on the due date.
- A temporary decline in revenue calls for attention to inventory - Selling excess inventory at reduced prices is commonly a prudent response. Make sure customers understand these are limited time offers rather than permanent pricing changes. The message is that these discounts are rewards to customers, not evidence of cash flow difficulties.
- Offering early pay discounts to customers is worthwhile when cash flow is tight - A discount of 2% to 5% will hasten collection of many accounts receivable. A similar approach is borrowing by invoice financing. Lenders advance funds at a discount to the face amount of invoices. Third party invoice financing avoids having customers expect future discounting.
- Pay vendors on the last possible day - Most vendors allow 30 or even 60 days for payment. Remitting cash immediately denies cash availability for more urgent expenditures. Online bill payment systems permit scheduling payments precisely on the due dates. Asking vendors to extend payment terms is often successful when explaining that cash flow constraints are a consequence of spending more in an environment of rising sales.
- Establishing lines of credit to avoid a crisis when cash is running low - These loans are in place to draw upon when needed. Paying for expenses with a business credit card is another easy way of obtaining financing. Moreover, a cash rewards card earns money for the business. If cash is still tight when the credit card bill arrives, it can be paid with funds drawn on a line of credit.
Most small business struggles are related to cash flow rather than profit. In fact, cash flow challenges are particularly frustrating when revenue and profit are rising. A permanent decline in revenue is, of course, a systemic problem requiring more drastic action, such as relocation and payroll reduction. But a business can survive temporarily slower revenue by holding sufficient cash. Judicious small business cash flow management, regardless of the direction for sales revenue, is therefore essential to sustainable operations.