Cash flow is the lifeblood of a small business. Having adequate cash on hand is essential to ensure that key expenses are paid and business proceeds as usual. It also allows you to act on opportunities to invest in the growth of your business.
When cash flow is not working properly, however, it may disrupt business operations, hinder your ability to grow your business, and can even threaten the survival of your company.
In this article, you’ll discover the five most common cash flow problems faced by small businesses. You’ll also learn three key steps to help you manage cash flow and head off potential problems.
What Is Cash Flow?
Cash flow is the measurement of how much cash is flowing into your business via sales of products and services or via payments received from customers.
Most business owners define a cash flow “problem” to be when they don’t have adequate cash to pay their expenses. This may result in your business incurring penalties for late payments. You may be forced to take out additional loans to cover your expenses. You may even find that your company’s credit rating is negatively impacted because of late payments and higher amounts of debt.
5 Common Causes of Cash Flow Problems
Cash flow problems can be triggered by a variety of missteps. Here are five of the most common:
- Inadequate sales and/or profit margins. If you’re counting on generating a certain amount of revenue each month, seeing a dip in sales will naturally pinch off the flow of cash each month. Inadequate profit margins also cause problems, especially if you were counting on the profit to reinvest into your business or to create a cushion to draw on during lean months.
- Late payments from clients. If clients drag their feet on paying their bills, you won’t have the money you need from them to pay your own bills. In essence, you end up playing the bank for their businesses, drawing on your own reserves to pay bills that you should have cash to pay.
- Poor inventory management. If you are not able to properly manage inventory, your cash gets tied up in products that sit on shelves. Until you sell that inventory you won’t generate the cash you need.
- Seasonal variation. Most companies have slow periods. Some are more extreme than others, such as a Christmas tree farm or restaurants that cater to summer tourists. If you do not plan ahead properly and build a cash reserve to tide you through down times, you’ll experience a cash flow problem.
- Not having a financial plan. This may be the most important reason. Many business owners operate without having a firm grip on their financials. As long as there is cash in the bank account, some sales coming in, and accounts receivable on the books, they believe they are okay. But operating without a plan makes it too easy to overspend on expenses, overinvest in areas your business can’t support, take on too much debt, and not see the warning signs of a pending cash flow crisis until the storm hits.
3 Key Steps to Avoid Cash Flow Problems
Avoiding cash flow problems becomes easy when you take the following practical, powerful steps for managing your financials and cash.
- Create a financial strategic plan and cash flow forecast.
To know whether you are on track with your expenses and revenue, you need to have a financial strategic plan. This plan spells out how your company will achieve its goals and objectives – and confirms that they are achievable from a financial point of view.
You should create both a long-term plan covering two or three years, as well as a short-term plan that looks at your financial targets quarterly and monthly for one year. Developing a strategic plan involves forecasting your revenue and expenses, as well as managing the balance sheet.
Your cash flow forecast works hand in hand with your strategic plan by listing anticipated cash flow. The forecast helps you assess your company’s ability to meet the goals and objectives outlined in the strategic plan.
If cash flow is tight, your cash flow forecast should list out anticipated weekly cash flow for the next 13 weeks. If cash flow is comfortable, you can do a monthly cash flow that looks at the next 13 months.
- Understand, manage and fund your operating cycle.
To create an accurate cash flow forecast and to manage cash flow, you need to understand your operating cycle.
Your operating cycle is the length of time between expending funds for a product or service and the collection of funds for the sale of that product or service. As such, your operating cycle includes many areas of your business finances, including accounts receivable, inventory management, operating expenses, funding inventory and cost of goods sold, and seasonal variation.
For example, let’s say that your business manufactures and sells industrial fans. To create your products, you must purchase the components, manufacture the fans (including covering payroll), sell the items on accounts receivable, and then wait for the customer to pay. Your operating cycle starts on the date you spend cash to purchase fan components until the day the cash comes in from the customer to pay for the fan. This cycle may be 60 days, 90 days or even longer.
Once you know your operating cycle, you will know how much working capital you need on hand to cover that cycle. If your cash flow doesn’t provide an adequate amount of working capital, you will need to secure other forms of financing to tide you through lean times. One way to avoid cash flow issues, particularly if you have seasonal variations in your business, would be to have a line of credit or other funding sources available.
- Monitor and manage your gross profit.
When you are used to your business achieving a certain level of sales, a cash flow problem becomes apparent quickly when sales slump. But you can also experience a cash flow problem when your gross profits shrink, as well.
Gross profit is the amount of profit directly attributable to the product or service sold. It is the sale price less any direct expenses associated with the product or service. For example, if you run a coaching agency, your gross profit is the fee clients pay less the total cost of servicing the client, coach fees, all tools, software, etc. that are directly related to the coaching service.
The gross profit percentage is the amount of the gross profit divided by the fee. Let’s say that you charge $20,000 per client. The coach is paid $12,000, and the software and tools amount to $1,000. This leaves a gross profit of $7,000. The gross profit percentage is $7,000 divided by $20,000 or 35%.
By monitoring your gross profit and gross profit percentage, you’ll be able to more easily spot potential cash flow problems early on. When profits start to slip, you can then take corrective action to bring profit margins back up to where they need to be.
Address Cash Flow Issues Quickly
Cash flow issues may be common, but you do not have to accept them. Use the three steps outlined here to identify potential problems early on. If you see a potential cash flow problem looming, act quickly to minimize the impact on your company – and on your ability to achieve the goals and objectives outlined in your strategic plan.
