Running a healthy business is about more than turning a decent profit; just because a company is making sales, it doesn’t mean it has enough cash on hand to meet its obligations.
High overheads, over-expanding, and failing to collect on accounts receivable are just some of the ways profitable businesses can run into financial shortfalls. In fact, a lack of cash is frequently cited as one of the top reasons new businesses fail.
In short, cashflow is the lifeblood of your business, and managing it is one of the most important skills you can learn as a business owner.
Here’s a rundown on the basics of cashflow.
#1 A brief definition of terms
Cashflow comprises all of the money that flows in and out of a business. Cash inflow is the money coming into your business in the form of revenue from the products or services your business provides, while cash outflow is all the money moving out of your business in the form of overheads, loan repayments, accounts payable, and so forth.
Positive cashflow is when your business is bringing in more money than is going out. Negative cashflow, as you may have guessed, is the opposite. It’s obviously desirable to be in a state of positive cashflow, but negative cashflow isn’t necessarily the end of the world, as long as it’s been planned for and there’s an overdraft or similar facility to cover the shortfall.
Liquidity refers to the proportion of a business’s assets that are cash or cash-equivalent (the latter includes short-term, easily retrievable investments such as term deposits). A business is said to be ‘highly liquid’ when it has a high proportion of these assets.
#2 The cashflow statement
This is a common financial statement that summarises a business’s cash position, taking into account revenue, debt obligations, and operating costs, among other things. Learning to read a cashflow statement and performing regular analyses will help you to keep apprised of your business’s liquidity.
#3 Accounting and planning
Strong bookkeeping is one of the cornerstones of a viable business, and it’s certainly a necessity for managing cashflow. Poor financial records another common reason SMEs fail.
Talk to your accountant and develop a robust financial plan for your business. Being able to anticipate and compensate for periods of low cash inflow is vital, especially for business that’s still in its infancy.
#4 Cashflow and invoicing
If you don’t invoice promptly, or your invoice terms are too generous, you risk simply running out of money. It’s essential to have a clear invoicing process and well-defined payment terms to ensure you get paid on time.
Consider investing in a professional invoicing system to keep things running smoothly.
#5 Cashflow and the sales-marketing cycle
It’s common for SMEs – especially those who provide commissioned services – to prioritise marketing when business is slow, and production when business is good. But this often means that the business isn’t earning when it’s marketing, and isn’t marketing when it’s earning. The result is a boom-bust cycle of high and low liquidity, sometimes called a ‘double-helix trap’.
The result of a mismatch of cash outflows and inflows, the double-helix trap is not a good financial position, as it risks frequent cash shortfalls. This common problem demonstrates how important it is to have comprehensive financial plan in place before you even think about opening shop, and to align your inflows and outflows in a way that results in a positive cash position.