Many a new business owner has asked, "What is cash flow and why is it so important?" The short answer is cash flow is the amount of money coming in to a business and the amount of money going out. Think of it as a water tank: water comes in at the top and drains out the bottom. So to keep your tank nice and full, you want more coming in than going out. End of article, right? Well, not really...
Cash inflow is the lifeblood of your business and comes from sources like payments from customers, receipt of a loan, monetary infusion from an investor, or interest on savings or investments. Cash is also important because it later becomes payment for things that make your business run: expenses like stock or raw materials, employees, rent and other operating expenses. Naturally, positive cash flow is preferred. Positive cash flow means your business is running smoothly. High positive cash flow is even better and will allow you to make new investments (hire employees, open another location) and further grow your business. We love that, right!?! Conversely, there's negative cash flow: more money paying out out than being coming in.
Get Organized and Plan
Positive cash flow is driven by two things: organization and planning.
Let’s start with setting your baseline. Begin by looking at the cash you have in hand, this could be money you’ve invested in the business, cash in the business bank account, loans that you’ve received, or an investment from a partner.
If you're just starting your business, you're interest in cash flow is well-timed. Make a list of all the one-time start-up expenses that you have paid or expect to pay. Think incorporation fees, legal and accounting, licenses and permits, construction or remodeling, security deposit on a rental agreement or purchasing property, marketing materials and signage, initial inventory or supplies, fixtures like cash registers, office supplies, furniture, equipment, etc.
Next you want to determine your monthly expected cash sources. These can be projected sales, loans that you know are coming in at a certain date, investments from partners or investments. If you’re a new business you might want to project sales conservatively (better to outperform and have a better inflow of cash than you thought). If you’ve already started your business or are purchasing a business from someone else, you have a distinct advantage: sales history. History can’t predict the future, but it can paint a decent picture of what the future looks like and what business changes you might need to make.
Finally, you will need to assess your monthly expenses. This can be a bit tricky because it’s easy to overlook things and get a surprise you really don’t want. Monthly expenses to factor in can include rent or mortgage, insurance, advertising, marketing, website hosting, travel, utilities, payroll, inventory, taxes, loan payments, working capital, and last but not least paying yourself!
The most important thing about this process is being honest and objective. Do your homework and get accurate estimates of costs. If costs look high, simply projecting more sales when you don't have the capacity to close those sales won’t fill that proverbial water tank. So perhaps you tighten the outflow. What can you reduce or cut? For example, if you're launching a boutique, maybe you rent that 500 square foot space instead of the open, airy 1,000 square foot one. Or maybe you initially limit the amount of merchandise you buy. (Added bonus: if the merch is in high demand, you've not got scarcity on your side!)
Get Paid! How to Improve Incoming Cash Flow
If you invoice customers and they have a liberal time frame in which to pay you, that can make planning tricky. However, there are ways to encourage your customers to pay their bills more quickly:
- Issue invoices promptly and follow up on them regularly. This sounds simple, but many people put avoid paying others simply because they don’t like parting with their money.
- Offer a discount for early payment. If your standard contract has a thirty day term, give a small discount for payment within 10 days.
- Structure the payment with an upfront deposit or, if it’s a long project, schedule payment intervals throughout the project lifetime. This will ensure that you are getting some cash in the door along the way.
Paying Your Bills the Smart Way
You have to pay your bills, no two ways around it. It’s to your advantage to pay them in a timely fashion if you want to build trust with your creditors. (Plus some say it’s good karma.) But since we're talking about outflow, we need to consider good ol' cash flow. There are ways to pay your bills in a smart way to make sure that your cash flow remains positive:
- Use the payment term to its fullest. If you have a thirty day term on a bill, go ahead and use the thirty days to build up the cash. That way, you’ll have a better handle on what your cash flow looks like than if you simply write a check the day you receive the invoice.
- On the flip side, see if there are discounts for paying suppliers early. (Sounds familiar, no?)
- Ask about flexible payment terms when you make a deal with a vendor. You’ll never know if you don’t ask and it could help you out in a pinch. Be cautious with this though: asking for flexible payment terms before a deal is done can raise suspicion.
- Set up ETF payments. That way you can pay immediately when a payment is due, but won’t have to let go of the funds before you’re ready.
- Build a real relationship with your vendors. If they trust you and you’re honest with them it could go a long way to making your life easier if you need to ask for an extension or an accommodation.
Surviving Lean Months
We all know that there can be a lag between sales and receipt of payment. But the bills aren’t going to magically disappear or change their due dates because you haven’t collected payment. You’ve got to have enough cash to get you through lean months when the flow just isn’t there.
Build up some cash reserves to avoid this problem. Review your cash flow history and arrive at a reserves estimate that would cover your business for three months, six months, and a year. Just knowing those numbers can help you paint a better picture and, thus, make better business decisions.
You can also arrange a line of credit with your bank. When you’re flush it’s easier to get money than when you’re not, so you can talk to your banker about having the ability to borrow up to a preset limit any time you need it.
So, now you know what cash flow is, put that knowledge to work for you! Have more questions? Email us at email@example.com.