The concept of cash flow is often one of the most difficult concepts for small-business owners and entrepreneurs to grasp. Frequently, they focus only on revenue and profits, and while both of these are important, overlooking the amount of cash available is a bit like trying to balance a tripod that has only two legs. All three “legs” of the business are needed to ensure that the company can continue to operate.
To understand why cash is so important, it might be helpful to define critical terms.
- Revenue is the income that the business generates. Most of it comes from sales of the company’s products or services, but some may be derived from passive sources such as royalties or interest earned. However, income is not always equivalent to cash. If you have accounts receivables, you must wait until customers pay before you will have cash available.
- Profit is the amount left over after you subtract all of your expenses from your revenue. Your gross profit is the amount left after you subtract the cost of finished goods purchased for resale or the cost of raw materials to produce goods for sale. Your net profit is derived by also subtracting your other operating expenses, including payroll, utilities, rent, postage, office supplies and taxes.
- Cash flow is an analysis of how much cash is coming in compared to how much cash is going out. It measures the amount of cash you will have available to pay utility bills, salaries and other operating expenses.
Why “Cash Is King”
A company can have outstanding sales that will generate excellent profits, but without sufficient cash, it could still be forced to close its doors. The following example illustrates how this can happen.
- XYZ Contractors signs a contract with John Doe to remodel his home. The extensive project will require 90 days to complete.
- The total of the contract is $150,000.
- Mr. Doe is to make a down payment of $15,000 on the first day of work, followed by payments of $25,000 on day 30, $50,000 on day 60 and the balance of $60,000 on the day that all work is completed.
- XYZ estimates that the total cost of materials will be $20,000. The company orders the materials on credit, agreeing to make monthly payments of $2,000. The first payment will be due 30 days after the vendor ships the materials.
- The company expects to pay its workers $80,000 during the three months that the project takes to complete.
- After subtracting all labor and materials, XYZ should make a profit of $50,000 on the job.
If you only look at sales and profit, it appears that XYZ is in sound financial shape. However, the company will need cash to meet weekly payrolls for its employees, make payments on the materials purchased, keep the utilities on, make payments on any vehicles or equipment already purchased on credit, pay rent and make the payments on liability, workers’ compensation and vehicle insurance. Without sufficient cash, the company might be forced to default on its contract or even declare bankruptcy.
Money Management Is Critical
All companies must have an effective plan for managing all of their assets, including their cash. However, money management is especially critical for small businesses. The following tips can help you ensure that you will have the cash you need to keep your business going.
- Prepare frequent forecasts to determine how much cash the business will need to meet all obligations.
- Prepare frequent cash flow statements to determine whether your business will have the cash needed.
- Control inventories. Although inventory is an asset, it is not easily converted to cash, so you do not want to have too much of your money tied up in inventory.
- Always maintain a “cash cushion” to cover unexpected expenses.
- Consider offering a discount for earlier payment of invoices. For example, if a customer has terms of net 30, consider offering a discount of 2 percent if payment is received within 10 days of the invoice date.
- Be proactive about collecting on past-due invoices. The number of days that you wait before calling customers depends on your business, your history with the customer and other factors.
You might also consider hiring a chief financial officer to help you manage your cash as well as provide you with the financial insights that can help you take advantage of opportunities and expand your business. If you would like to explore the various ways that a CFO can contribute to your success, please call (901) 277-6165 or complete the contact form on my website.