You’ve heard the mantra “Cash is King” when it comes to business. We wholeheartedly agree with this statement. However, when it comes to your growing small business or startup, a more realistic analogy is “Cash is Oxygen”. The faster you move, the more you need. Many business owners fail to understand this until it’s too late. Cash flow issues kill many businesses that might otherwise have survived. According to an oft-cited U.S. Bank study, 82 percent of business failures are due to bad cash management.
Here are 9 rules to keep in mind when running your small business so that you improve cash flow and avoid any liquidity issues.
1. Growth needs cash to sustain. It may seem unusual for a business when sales orders are flooding in that cash flow could be an issue. But it’s a serious problem faced by many growing companies. Higher sales typically mean higher costs to deliver the orders. In addition, the other parts of the business need to expand to support the new business volume. The faster you grow, the more financing you’ll need.
2. Margins aren’t cash; they’re accounting. Accounting can get pretty creative. Your board and shareholders love hearing about the industry-leading margins you’re earning. However they’re not the ones paying your employees and landlord. In fact, you can’t pay your employees with margins. You may book sales when you deliver the order to your customer, but how long before the cash payment reaches you? 60 days, 90 days, longer? If you pay your expenses and your customers don’t, it’s suddenly an exercise in business survival. You can show fat accounting margins while having an empty bank account.
3. B2B sales vacuum up cash. The simple view is that more sales equals more money, but when you’re a business selling to other businesses, it’s not that simple. You deliver the goods or services along with an invoice, and your customers pay the invoice later. Typically that’s months later. You’ll often find the larger the customer, the longer the payment terms. And businesses are great customers that buy with high volume, so you can’t just pass them to collections because they’ll never work with you again. So you’re stuck waiting. We’ve seen small businesses selling a good to a distributor that then sells it to a retailer, getting paid well after 120 days later. And if you’re a B2B distributor, you’re often stuck between the manufacturer who demands payment immediately and your customer who will stretch you as long as they can.
4. Cash flow isn’t intuitive. Cash flow management can get complex very quickly. Model out your cash flow carefully. Figure out how much working capital is locked up in inventory, receivables, raw materials, etc. Understand how much you need to meet sales targets and fixed operating expenses. Just because you made the sale doesn’t mean you have the cash. And just because you’ve paid for the inventory doesn’t mean it’s a cost of goods sold yet.
We’d probably recommend using Excel, but whatever gets the job done.
5. Inventory locks up cash. You have to buy your good or build it before you can sell it. Even if you sell the good, your vendors expect to get paid. Every dollar locked up in inventory is a dollar you don’t have in cash. You may make 2x or 3x your money on the inventory eventually but margins ≠ cash.
6. Understanding working capital is a survival skill and a necessary one. Any accounting major can tell you that working capital is when you subtract current liabilities from current assets. From a practical perspective, it’s the money in your bank account that you use to pay operating costs, buy inventory, and pay vendors while waiting to get paid by your business customers. Maintaining enough cash to do this while dealing with the fluctuations of seasonality and growth is a highly valuable skill.
7. Receivables is cash in your customer’s bank account that belongs to you. The money your customers owe you is called accounts receivable. Similar to inventory, every dollar in accounts receivable is a dollar less cash you have. The deal may be done and the invoice sent, but until the cash is in your bank account, you need to remain vigilant. We released a detailed guide with 11 advanced tips on collecting that can help you collect faster.
8. Monitor these three business vital signs: You’re the doctor and your business is the patient. You need to watch certain metrics to make sure it’s healthy. Inventory Turnover is a measure of how long your inventory sits on your balance sheet and is not being converted into cash. Collection Days measures how long you’re waiting for payment for goods sold or services rendered. Payment Days is how long you take to pay your suppliers. Monitor these three vital signs of cash flow. Project them out 12 to 18 months ahead and compare your plan to what actually happens. You may be surprised at the insights you learn about your business.
9. Line up financing before you need it: Reach out to companies that provide financing before you need it. Particularly with credit line type products, where you don’t pay interest on what you don’t use, it makes sense to set them up before your business has cash flow issues. If you wait until you’re in a jam to set up a facility or take out a loan, you will pay higher rates and be subject to more onerous terms. Starting the search while your business is healthy also allows you to negotiate from a position of strength. Be proactive and find a financing partner early that’s ready to grow with you.
These rules are a good start to mitigating cash flow issues before they become serious problems for your business. If you’d like to learn more about cash flow management and the financing options available, schedule a complimentary consultation with Harper today and find out why so many small businesses choose to work with us. Fill out your contact information here or call (310) 817-0376 to speak to a member of our team.