Many a new business owner has asked, “Why is cash flow so important?”. Think of it as a water tank: water comes in at the top (cash coming in) and drains out the bottom (cash going out). To ensure there is enough water, a business needs more coming in than going out!
This conversation is a regular occurrence:
- Month 1: Company A made a net profit of $XXX for last year, the business is doing well”
- Month 12: Company A had to close the business. They could not pay my loans, suppliers, and ran out of cash”
The community is so engrossed in profit but really the lack of cash is the biggest reason businesses fail. Profit is a great indicator of how a business is going, but in the end its just a term use to represent a virtual number. Cash is real cash currency, one that is physical and tangible.
Why is cash important?
Cash flow is the money coming in and out of the business. Money coming in from sales and customers, and money going out from wages, purchases and suppliers. In simple terms, if more money is coming in and is going out, cash flow is ‘positive’ and there is enough to pay bills. If it is the other way, then expect calls from debt collectors.
Here is a great example of why cash is represents such importance to measuring a business
Business A paid $3,000 for the shoes. This has been paid to the supplier.
Business A sold $5,000 worth of shoes. Customer has not paid yet.
$2,000 profit! Business is a success.
Wrong, the business has used up $3,000 of cash, but received nothing yet from the sales. It is in negative cash flow. Let us hope the customer ends up paying or there will be any money to pay the next bills! This can be referred to as the cash conversion cycle which is an important metric.
Cash when starting a business
When starting a business, dealing with cash is the most difficult. There are multiple expenses flying out, with minimal or no sales or customers coming in. The business may have borrowed money in the form a loan, which adds to the cash going out. The first 6 months are crucial, if there is not enough cash to carry through this time, the chances for success are not good. Suppliers often want Cash on delivery, and customers tend be slow to part their monies. All these factors combined to make this a ‘make or break’ time.
How to avoid cash flow problems
There are some simple things to mitigate your cash flow risk and to buy some much needed time until the business reaches positive cash flow on a month to month basis.
- Monitor cash frequently. This is so important; it also allows tracking of unwanted expenses
- Review stock. Are there slow moving and obsolete stock? It might be better to order lower quantities at the start.
- Pay on time / early discounts. Ask the supplier, there are many that offer this.
- Have a cash cushion. ALWAYS. Typically, a sound cushion is to maintain cash equal to 3-6 months of operating expenses. Expenses are usually more predictable as many are relatively fixed. If a business spends $10,000 a month, then they should keep between $30,000 – $60,000 at all times.
- Consider an overdraft which enables the business to access short-term funding to fill a temporary cash shortfall. Bear in mind interest will be payable.
It all narrows down to the important saying of ‘cash is king’.
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