Cash flow is one of the most important indicators of how a business is performing. A positive cash flow means that a company is able to meet its obligations promptly, without needing to borrow money. Naturally, a business aims for a positive cash flow to keep its day-to-day operations running smoothly.
Managing cash flow is difficult, especially for small- and medium-sized businesses. However, cash management is necessary to make sure financial difficulties won't plague a business. Cash flow problems arise when a company does not have enough money to cover its debts as they become due. While this is normal to happen on occasion, a cash flow that is consistently negative is a red flag and should immediately alarm management to take action.
Cash flow problems can cause major interruptions for small and medium-sized businesses. For this reason, it is best to understand, identify and manage the top causes of cash flow problems.
1. Low Profits or Slow Business Performance
Having low profits is perhaps one of the biggest causes behind cash flow problems. While cash flow and profit are two different things, a company’s net profit has a direct impact on its cash flow. High income simply means more cash flow for the business, and low income means less cash coming in.
However, over a certain period of time, a company may be profitable but still have cash flow difficulties. This is mainly due to the accrual basis of accounting, where revenues and expenses are recorded as they are incurred, not received. For example, when a company makes an insurance prepayment, it decreases its cash but the profit is not affected at the time the payment is made. On the other hand, a company may be unprofitable but still have excess cash, like when it receives a payment that increases its cash flow, such as a deposit from one of the shareholders.
Strong profits not only ensure that a company is making enough cash to cover its expenses; they also allow a company to reinvest its cash, expand its products and services, and even take on new credit or loans. All of this translates to more cash inflow, as opposed to a company with lower profits and that is struggling to just make ends meet.
2. Allowing Too Many Sales on Credit
Another thing that negatively affects cash flow is having too many sales on credit. This may not be a big issue for strong and established businesses, but it is best for small- and medium-sized companies to get paid in cash. An increase in credit sales can hurt cash flow, while a decrease boosts cash flow.
When a company performs its services on credit, it gives its clients a one- or two-month window to make the payment. However, the company has already paid for their expenses upfront, negatively impacting cash flow. This is especially true if the company gives too much credit, has relaxed credit terms or policies, and manages its cash poorly, which takes us to the following point.
3. Inefficient Cash Management
It is crucial for small- and medium-sized business owners to implement solid cash management strategies in order to maximize cash flow.
One way to do this is to carefully manage assets and liabilities. For example, not following up on tardy payments in accounts receivables will delay and decrease the amount of cash coming in. Not filing the necessary documents like preliminary notices to protect your lien rights can also wreak havoc on your liquidity. Likewise, keeping the right level of inventory is important, as a company does not want to tie up too much of its cash in inventories, and at the same time must be able to secure what’s required for the immediate needs of the business. Payments made to suppliers, which means cash going out of the company, need to be accurate and on time to avoid any extra fees or penalties.
4. Not Utilizing the Cash Flow Statement
There are tools and reports available that help business owners understand and manage their financial positions. In addition to the balance sheet and income statement, the cash flow statement helps managers make informed decisions to maximize business cash.
The cash flow statement is used to map and plan when, and how much, cash will come in and out of a business. This financial statement evaluates the business’ current cash position and also helps forecast upcoming cash transactions. For example, if an owner knows that they will be receiving a payment of $10,000 in two weeks, they can start planning which payments they will make against that amount in a way that will not exceed the $10,000.
The statement of cash flow also helps owners know their main sources of cash. Since the cash flow statement classifies cash as operating, financing or investing activities, an owner may decide to focus on certain activities to help increase cash flow.
5. Insufficient Cash Reserves
Companies should always keep at least a minimum balance of cash aside for use in emergency situations that may arise. Maintaining cash on hand helps companies gain quick access to it when they need it. The amount of money that is reserved should depend on the needs of the company.
Most small businesses do not have enough of a cash buffer. This leaves them unprepared for emergencies and unexpected circumstances that are sure to arise. Therefore, it is vital that there is always cash for urgent funding to ensure liquidity and avoid any negative cash flow.
6. Receiving Partial Payments
In some businesses, it is typical that consumers make partial payments for the services they receive. A portion of the payment is deliberately withheld to ensure the customers that all the obligations and services agreed upon will be performed satisfactorily. This is especially common in construction and other industries where there are long, complex projects to be executed.
In these fields, partial payments greatly affect cash flow. For instance, using construction as the example, the amount of work performed is fully paid for by the contractor; however, a part of the money is withheld.
Partial payments negatively affect a business’ cash flow as most of the expenses and costs need to be paid upfront. Receiving only part of the payment may lead managers to pursue expensive debt to make up for the amounts spent. This disrupts and strains a project’s cash flow, especially at the beginning of the project. In fact, most construction businesses only see their cash flow positive toward the end of their projects or when the retainer is released.
Cash Flow Is Essential
Cash flow is an important parameter of a company’s financial health. A business must have total control over the cash flowing in and out of it by implementing strict policies and practicing good financial management. Effective cash flow management allows a business room for growth and expansion, which will lead to more revenue and sales.
A company with poor cash flow practices, on the other hand, will struggle to perform normal day-to-day operations and may jeopardize its existence. Although businesses of all sizes need good cash management skills, it is most critical for small- and medium-sized companies that have little room for financial error.
About the Author: Patrick Hogan is the CEO of Handle.com, which builds software that helps contractors, subcontractors, and material suppliers with late payments. Handle.com also provides funding for construction businesses in the form of invoice factoring, material supply trade credit and mechanics lien purchasing.