Every business needs cash. One of the most common business failures is the lack of cash a business has and also because of poor cash management. Cash problems can kill business that would have survived otherwise.
Here we will discuss the best rules for managing cash flow so you do not go out of business.
Do not confuse profits with cash
Profit and cash are not the same thing. Profits are an accounting concept, not money in the bank. Profits are what is leftover after you subtract costs and expenses from sales. However, you can be profitable but have money tied up in inventory, or in your accounts receivable, waiting for your customers to pay their invoices.
Cash flow is not intuitive
Do not try to calculate cash flow in your head. Cash flow takes a hit as soon as you have inventory, or sales on credit. Inventory is bought and paid for and stored until it becomes sold. Making the sale does not mean you have the money. Incurring the expense does not mean you paid for it already.
Cash-based accounting sounds good but it is not. it takes accrual accounting to reflect unpaid bills, and prepaid expenses and other factors that can kill cash flow. You or somebody you trust must be able to do and understand a cash flow statement and do regular cash flow analysis.
Growth can absorb cash
Sudden growth requires extra cash. Be careful because growth costs cash. It is a matter of working capital. The faster you grow, the more financing you need.
Business to business sales suck up your cash
When you are a business selling to another business, that sales mean money. You deliver the goods or services along with an invoice and the customer pays the invoice later. This means months later. When you sell something to a distributor that sells it to a retailer, you typically get the money four or five months later if you are lucky. Yes, there are ways to speed up getting paid, but also, in many businesses, you must wait.
Inventory sucks up cash
You have to buy your product or make it before you can sell it. Your suppliers expect to get paid even if you put the product on your shelves and wait to sell it.
Working capital is your peace of mind
Working capital is what is leftover when you subtract current liabilities from current assets. It is money in the bank that you use to pay your running costs and expenses and buy inventory while waiting to get paid by your customers.
Working capital is the result of good cash flow. Sometimes you can adjust business practices to improve the cash impact, and sometimes it is just a cost of doing business. You must be aware of it and plan for it ahead of time.
Best practices are not enough
There are some ways to mitigate underlying cash flow weaknesses. Some businesses get prepayments, discounts for paying on time, on-time inventory delivery and more. Still the solution in planning for cash and having enough working capital, rather than changing the way business is done.
Vital metrics to watch
The following are vital metrics you need to pay close attention to.
- Collection days measures how long you wait to get paid
- Inventory turnover measures how long your inventory sits on your working capital and clogs your cash flow
- Payment days is how long you wait to pay your vendors
Always monitor these three vital signs of cash flow. Create a cash flow forecast and project them 12 months ahead and compare your plan to what actually happens. Look for unexpected changes and figure out what happened, and why. Take action where you can.