There are myriad ways a business can fail: Maybe an entrepreneur didn’t understand his or her customers well enough, there was a breakdown in leadership or there was no set plan for the future.
And while all these setbacks are viable threats to a startup, the most fatal blow to any small business is, simply put, a lack of cash.
A healthy cashflow is the lifeblood of a business. After all, creditors and employees both like to see paychecks. Measuring cash flow boils down to liquidity — or, the company’s ability to pay its short-term expenses or face selling off assets for quick cash — and solvency, which has more to do with an enterprise’s ability to meet its long-term financial obligations.
A company’s ability to pay its bills this month gives us no real insight into the long-term financial health of the business.
Startups should focus on increasing or speeding up the inflow of cash to their business while decreasing or delaying the outflow of cash to improve the debt-to-asset ratio. Primary sources of cash inflows include operational income, investment gains, and financing. In personal finance, gifts and donations would be included in the inflow section. Outflows for businesses are most commonly seen in the form of operational expenses and investments.
Cash flow can be increased by:
- Selling more goods and services
- Selling an asset
- Reducing costs
- Increasing the selling price
- Collecting faster
- Paying slower
- Bringing in more equity
- Taking a loan
Monitoring this flow is often overlooked by business owners who assume that positive monthly profits indicate healthy cash flow.
There are several scenarios in which profits are inversely related to cash flow but the most common example can be seen in a company that primarily makes sales using credit.
A kitchen appliance retailer may purchase a toaster for $10 that it intends to sell for $5 cash up front and an additional $10 in 2 months, so $15 total. While the retailer could account for a $15 sale from the $5 cash revenue and $10 accounts receivable boost, the cash flow for the month is actually -$5 since in this period, the retailer only made back half of the $10 that it spent on the toaster in the first place.
Deferring collection in this fashion is risky. Creditors will not have the patience to wait two months for the appliance retailer to collect the money he needs to pay his bills this month.
Take the following steps to reduce your receivables-payables gap:
- Monitor every cash inflow and outflow using a cash budget separate from the income statement. Knowing where the dollars are coming from and going each month gives business owners a higher level of familiarity with their business’s finances. The results? More accurate forecasting and fewer surprises.
- Understand the importance of timeliness in cash flow. Mobile accounting apps can dramatically improve the ease and speed of a startup’s collection process. The ability to align instant invoices with debtors’ monthly payment schedules creates a flow that benefits both the buyer and seller.
- Segment suppliers, inventory, and customers. By segmenting these elements of your business, you may find that some products, for example, only sell sporadically and are tying up a lot of cash. Understanding which segments have the best flow will help you to prioritize and reallocate cash.
As the business world dives deeper in the digital world, we must remember that hard cash is king. As your business grows, taking on new clients, product lines, service offerings, and suppliers, always remember that the bills need to be paid with real money, not IOU’s. By understanding this concept and taking the proper steps to keep cash flowing, you drastically improve your business’s odds of surviving and expanding.