When I started my current business more than 15 years ago, I quickly learned that cash flow is more important than profitability for a small business.
Several months after launching the company, I won a six-figure contract with a healthy profit margin. I thought it was a great start, but my enthusiasm quickly subsided when I saw the terms. I couldn't submit an invoice until the final deliverable was approved, and their accounts payable department needed 60 days to process my invoice. This meant that I had to wait a total of six months from the time I started the project until I would see any cash. In the meantime, I would need to cover tens of thousands of dollars in expenses to complete the work. I was able to finance the project through short-term loans from friends and family; otherwise, I probably wouldn’t be operating today.
After that trial by fire on the importance of cash, I become very methodical about planning my cash flow to ensure I wouldn’t be caught by surprise with a cash crunch that could end the business.
In my experience, most business owners struggle with managing their cash flow properly, which can lead to a cycle of poor decisions. A last-minute cash crunch may mean taking out short-term loans with exorbitant fees and interest rates, selling assets at deeply discounted prices or missing out on opportunities for growth.
Understanding Your Cash Flow
Cash coming in and going out of your business can typically be organized into three categories:
- Operating cash flow: Cash related to the day-to-day operations of your business, such as collecting from customers and paying expenses
- Investing cash flow: Cash related to the purchase or sale of plant, property and equipment or other long assets
- Financing cash flow: Cash coming from or going to investors. This includes loans, revolving lines of credit and equity (stock)
All three sources and uses of cash can be combined to provide an overall picture of how your cash balances change over time. The change in cash plus the cash you have on hand can give you an accurate measure of how much cash your business really has. The information isn’t just for understanding the past; it’s the starting point for projecting your future cash needs.
Projecting Your Cash Flow
The driver of your cash-flow projection is typically your operating cash flow. A sale may take place in January, but the client won’t actually pay you until March or April. Similarly, a vendor may ship inventory now but not require payment for a month. In the meantime, you may or may not sell that inventory for cash.
Operating cash flow is ideally projected monthly (or even weekly in some businesses) to determine if you will need support from financing activities.
Investing activities are ideally modeled as well, although for most businesses, this will be the cash flow area with the least amount of activity. Unless you're in an aggressive growth phase that requires the purchase of assets, you likely won’t have much investing activities. But given that these tend to be large transactions, they can have a significant impact on your cash flow.
Financing activities usually serve as the “plug” in your cash-flow model. Any deficits in operating or investing cash flow may be covered with cash from financing activities. For large cash shortfalls—such as those from the purchase of large assets—this could come in the form of selling shares to investors for cash. It could also come as cash from financing activities. Since it can take months to find potential investors or lenders and more months to actually receive their cash, it can be critical to know in advance what your financing cash flow will be.
Some Cash-Flow Tips
Cash flow is all about timing. Usually when a transaction occurs, you don't immediately feel the cash impact. When projecting your business cash flow, consider the following:
Be conservative. Customers pay late, and vendors want to get paid early. It usually isn’t the other way around. It can be important to build in assumptions that take into account negative cash months to ensure you have the access to credit necessary to cover the shortfall.
Include a minimum cash balance. When projecting cash flow, remember that you should never finish a month with negative cash. If your operating cash flow is negative, you might consider compensating through the sale of assets or more likely by borrowing money. But beyond that, it isn’t smart to model a cash balance to zero or almost zero. A margin of safety can be important. That’s why you should ideally maintain a minimum cash balance of at least 10 percent of your operating cash needs. If your operations consume $800,000 per month in cash, then your minimum cash balance should be at least $80,000.
Don’t count on more than 80 percent of your line of credit. When issuing a revolving line of credit, many financial institutions will not allow a small business to borrow against the entire line at one time. The most is usually 80 percent. If your line of credit is for $500,000, then the most you may be able to borrow is $400,000 at any given time. If your cash-flow projections require the use of a revolving line of credit, try not to count on more than 80 percent of the line’s limit.
Read more articles about cash flow.
A version of this article was originally published on December 11, 2015.