But many small and midsize enterprises (SMEs) don’t pay enough attention to this process, thinking it’s too complicated. The following analysis breaks down the basics of cash flow management for SMEs.
The main goal of a strong cash flow management strategy is to convert net working capital (current assets minus current liabilities) into the most cash as quickly as possible, typically by doing three things: selling inventory quickly, collecting sales from customers quickly, and paying suppliers slowly.2
SMEs need cash mainly to finance inventory, meet the payroll, satisfy demand surges, and get through demand drop-offs. They also need incremental cash to mitigate the risks of slow-paying (or non-paying) customers and other disruptive events.
As such, SMEs should create a “cash culture,” whereby every employee—not just the finance people—focuses on cash management, recommends a study by the National Center for the Middle Market (NCMM).3 One important tool is a cash flow forecast, usually a one-year prediction of how cash will move in and out of the business, helping SMEs anticipate and prevent cash shortages.4 Daily cash reports are another tool.5
A popular cash flow management metric is the working capital ratio – current assets divided by current liabilities. Numbers vary by industry, but a working capital ratio between 1.2 and 2.0 is generally considered optimal. Lower ratios indicate potential solvency issues and higher ratios indicate potential underutilization of assets.6
SMEs also need to get a firm handle on their accounts payable (AP)—their obligations to pay suppliers/vendors for goods and services already provided. For many businesses, AP is a large number, presenting a significant opportunity to improve cash flow. Consider that for a company with $100 million in revenue, taking just one day longer to pay the bills can free up several hundred thousand dollars in cash annually, according to the NCMM study.7
Businesses should focus on two main AP areas to improve cash flow management: how their AP departments pay invoices, and how those departments are organized.
Altering the timing of invoice processing is a popular AP-based cash management strategy. Most SMEs—if they’re not just paying invoices as they are received or on set weekly or monthly schedules—simply delay payment as long as possible.
Even large corporations with sophisticated cash flow management approaches tend to stretch their days payable outstanding (DPO)—the average number of days it takes them to pay a supplier—to keep their hands on more cash.8 Another metric, accounts payable turnover (APT), shows how many times in a given period a company pays its AP.9 A decreasing APT ratio indicates that a company is taking longer to pay off its suppliers than in previous periods. However, only a quarter of firms consistently measure those key performance indicators as part of their cash flow management plans.10
It should be noted that those simple approaches can strain relationships with suppliers and/or weaken an SME’s credit rating. AP departments should consider stratifying their vendors and suppliers based on importance to the core business and their relative size, and adjust their payment approach accordingly, advises an analysis on CFO.com.11 Streamlining the number of vendors and suppliers has the added benefit of reducing procurement complexity—cutting costs, the likelihood of payment errors, and the need for additional resources for processing, managing, reconciling, and reviewing invoices.12
Another cash flow management strategy is to negotiate longer payment terms when buying untested or new products. The longer payment terms reduce the risk of locking up cash as unsold inventory.13
SMEs can also pay special attention to how they organize their AP departments. A centralized group—with standardized documentation, processing timeliness, payment methods, error-resolution practices, and exception reporting and handling—is the norm. A centralized AP department is also more likely to adopt modern technology to process payments.
When it comes to the procurement process, SMEs should also seek from their suppliers early-pay discounts, volume rebates, and other terms favorable to boosting their cash flows. In the NCMM study, 52 percent of the businesses surveyed said they work with suppliers that offer such discounts, typically reducing expenses by up to 5 percent.14
Building a “cash-centric” focus is key to managing cash flows more effectively. Understanding the issues and improving the processes that govern cash flow management, especially accounts payable, can free up cash that is otherwise locked inside a business.
Kristina Russo is a CPA and MBA with over 20 years of business experience in firms of all sizes and across several industries, including media and publishing, entertainment, retail and manufacturing.
1. “Dave Ramsey Quotes,” Goodread; https://www.goodreads.com/author/quotes/44526.Dave_Ramsey
2. “Role of Working Capital Management in Business Success,” Finextra; https://www.finextra.com/blogposting/15015/role-of-working-capital-management-in-business-success
3. Working Capital Management, National Center for the Middle Market; http://www.middlemarketcenter.org/Media/Documents/free-cash-flow-management-middle-market-companies_NCMM_Working_Capital_Flagship_FINAL_web.pdf
4. “5 Cash Management Tactics Small Businesses Use to Become Bigger Businesses,” Entrepreneur; https://www.entrepreneur.com/article/311867
5. Working Capital Management, National Center for the Middle Market; http://www.middlemarketcenter.org/Media/Documents/free-cash-flow-management-middle-market-companies_NCMM_Working_Capital_Flagship_FINAL_web.pdf
6. “Working Capital Management,” Investopedia; https://www.investopedia.com/terms/w/workingcapitalmanagement.asp
7. Working Capital Management, National Center for the Middle Market; http://www.middlemarketcenter.org/Media/Documents/free-cash-flow-management-middle-market-companies_NCMM_Working_Capital_Flagship_FINAL_web.pdf
8. Working Capital Report 2017/18: Pressure in the System, PwC; https://www.pwc.com/gx/en/services/advisory/deals/business-recovery-restructuring/working-capital-opportunity.html
9. “Accounts Payable Turnover Ratio,” Investopedia; https://www.investopedia.com/terms/a/accountspayableturnoverratio.asp
10. Working Capital Management, National Center for the Middle Market; http://www.middlemarketcenter.org/Media/Documents/free-cash-flow-management-middle-market-companies_NCMM_Working_Capital_Flagship_FINAL_web.pdf
11. “Six Ways to Stretch Your Payment Terms,” CFO; http://ww2.cfo.com/accounting-tax/2011/07/six-ways-to-stretch-your-payment-terms/
12. “How to Leverage Accounts Payable to Improve Working Capital,” Invensis; https://www.invensis.net/blog/finance-and-accounting/how-to-leverage-accounts-payable-to-improve-working-capital/
13. Make your working capital work for you: Strategies for optimizing your accounts payable,” Deloitte; https://www2.deloitte.com/content/dam/Deloitte/ca/Documents/finance/ca-en-FA-strategies-for-optimizing-your-accounts-payable.pdf
14. Working Capital Management, National Center for the Middle Market; http://www.middlemarketcenter.org/Media/Documents/free-cash-flow-management-middle-market-companies_NCMM_Working_Capital_Flagship_FINAL_web.pdf