A study conducted by Staples explored the concerns of 500 small business owners in August of 2013. It found that while an overwhelming majority of small business owners claim to be confident in managing their finances, less than half are familiar with basic accounting terms like “accounts receivable,” and 23 percent have bounced a check in the past year.
More than a quarter of small business owners surveyed admit to losing sleep over cash flow problems, and for good reason: Improper cash flow maintenance can cause even profitable businesses to crumble before they get off the ground. Understanding cash flow and learning some basic accounting strategies can reduce stress and help business owners succeed.
What is Cash Flow?
Cash flow is a simple concept to learn but difficult to master. Essentially, it refers to the ebb and flow of money as it leaves and enters a business. Every business has expenses (outflow) and profits (inflow); the challenge of cash flow maintenance is ensuring that the two are balanced. If a company’s outflow becomes greater than its inflow, even temporarily, this can cause a cash flow gap. These gaps can cause serious financial trouble even if a company is generally profitable.
For example, imagine that you are in the business of making custom furniture. You take an order for an oak dining room set and obtain a down payment of 10 percent. The final price of the finished set is $3,000, leaving you with $300 to get started. However, you must order materials, pay your employees and maintain the business for several weeks until the product is finished, and these expenses greatly outstrip the $300 you have for the project. Even though the finished product will generate a profit, you are faced with short-term financial insecurity until it’s done. This represents a cash flow gap, and it can be a devastating scenario for a start-up business.
Cash Flow: An Alternative to Credit
Although cash flow gaps can be frustrating for business owners, there is a positive side to cash flow: When managed properly, it can serve to reduce a company’s reliance on credit. This is good news for business owners who may have trouble qualifying for credit or have a small line of credit to draw from. It’s especially helpful for small businesses that have little starting capital. It’s possible to get a business off the ground with minimal startup money if you are careful with your cash flow.
The key to using cash flow as an alternative to credit is to monitor it very closely and spend only when you know you can replace that money immediately. This usually means starting with a solid customer base or otherwise guaranteed buyers and minimal stock. If you do this, it’s vital that your distributors are fast and reliable; otherwise, you run the risk of running out of product or materials in the face of heavy demand.
Balancing cash flow is always a challenge, and a line of credit can undoubtedly help to smooth over the peaks and valleys any company might experience. Credit is never an alternative to proper cash flow maintenance, however, and implementing a cash flow system from day one will help you avoid damaging your credit to avoid financial insecurity.
Establishing a Cash Flow System
The first and most important step to cash flow management is good record keeping. Begin by writing down every expense, including start-up costs, fixed monthly expenses and variable expenses. Then complete sales projections to identify whether the business is financially viable.
You can utilize a bookkeeping program to track your real expenses and profits and compare them against your projections. This is crucial to ensuring that your projections are accurate and helps keep you on track financially. By seeing where money is going as it comes in, you can make adjustments to your expenses. Otherwise, you’re acting blindly.
Many free bookkeeping and accounting programs are available online, and paid versions with more features are also available; experiment until you find a system that fits your needs. It may also pay to hire a bookkeeper and accountant to keep track of your finances. Not only will this free you of the task, a good CPA can identify further opportunities to save money and grow wealth.
Once it’s clear that the business is in fact both feasible and profitable, the key to maintaining positive cash flow is to ensure that you can maintain a steady inflow to compensate for your outflow. This becomes easier when you are able to ensure timely payments and maintain appropriate profit margins. By charging as much as the market can bear for your goods, you maximize profitability, and ensuring swift payments allows you to to maintain constant inflow.
It’s also important to keep your business accounts separate from your personal account. This allows you to see how much money you actually have available and helps to curb the urge to overspend funds that are needed later. Set up a regular payroll for yourself. Meanwhile, focus on stockpiling “emergency” money in your business account to cover the lean times.
Tips for Collecting Payments
The greatest challenge faced by most businesses in cash flow maintenance is ensuring timely payments. In businesses where payment is always rendered at the time of service, this becomes simple: You must only manage your stock so that you have only as much product as you can reasonably move in a brief period. For businesses that provide services and bill later, however, here are some tips for getting customers to pay on time:
Require a portion of the payment up front, and ensure that this down payment is enough to cover your necessary expenses.
Use professional, easy-to-read invoices that make it clear what services are being billed.
Provide an incentive to customers who pay early or on time, and penalize customers who pay late.
Follow up on unpaid invoices regularly. Be polite but firm.
Avoid a collections agency when possible as it will charge a hefty fee and damage customer relations.
Trim customers who routinely cause cash flow problems by paying late.
Understanding how cash flow works and monitoring it carefully will save you a lot of headaches as a small business owner. Practicing smart invoicing strategies and cutting loose customers who routinely cause cash flow problems will also help to ensure that the peaks and valleys of your business do not cause financial insecurity.