As a small business owner, there are many metrics you may use to measure the financial health of your company. Perhaps the most important is cash flow, which measures how much money is moving in and out of your business at a given time.
This article will outline everything owners need to know about small business cash flows. Specifically, you’ll learn what cash flow is, why a strong cash flow is important, and things you can do to improve your cash flow.
Cash Flow — The Basics
According to Harvard Business School, cash flow “refers to the net balance of cash moving into and out of a business at a specific point in time.” If your company has more money moving in than moving out, that’s a positive cash flow. Conversely, if your cash outflows exceed your cash inflows, you have a negative cash flow.
Within this spectrum are different types of cash flows, including:
- Operating cash flow
- Financing cash flow
- Investing cash flow
Operating cash flow tracks your operating expenses and income, typically derived from normal day-to-day business operations. This can include things like the sale of goods and the costs associated with making that product.
Financing cash flow relates to the amount of cash you garner from investors and creditors. This can include debt and equity, such as a small business loan or line of credit taken out to finance a large capital expenditure.
Investing cash flow relates to investment-related activities, such as the sale of a security or the purchase of a piece of equipment with cash.
Why a Strong Cash Flow Is Critical for Business
If you’re not focusing on cash flow management, you may want to shift your strategy. Having strong cash flows are important to the health of a business for a few reasons.
For one, a positive cash flow allows you to reinvest in your company. Ways in which you could possibly do so include:
- Focusing on boosting employee benefits, perhaps via a 401(k) match or a better health insurance plan
- Investing in research and development and potentially creating new products/service lines
- Expanding your business by opening up another location or hiring more employees
Strong cash flows can also help ensure that you, as the owner, have enough money to retire after you sell your company. Too often, business owners fall victim to valuation gaps. This is when the asking price of the business in a sale scenario falls short of the owner’s post-sale financial needs (often a retirement nest egg). If you have a strong cash balance, you can diversify your portfolio by increasing the amount of money you invest outside of the business.
Essentially, a strong cash flow provides flexibility. It ensures you have enough cash on hand to grow your business or your personal nest egg as you see fit. Similarly, a positive cash flow can make the company more enjoyable to run, knowing that you can meet business needs as they arise.
Lastly, a positive cash flow can make your business more valuable. Many valuations are based on a business’s cash flows. If the saying in real estate is “location, location, location,” then the equivalent statement in valuations would be “cash flow, cash flow, cash flow.”
Cash flow issues can raise red flags for investors or buyers. They may limit the types of business buyers who acquire companies in the lower middle market (annual revenues between $5 million and $25 million), or even render the business unsellable.
Even if you don’t think you are ready to sell, it’s never too early to start preparing. Conducting annual valuations can give you a better idea of where your company stands compared to its competitors, as well as your market value.
Valuations can also help you identify cash flow problems so that you can focus on proper financial management in the future. Taking the time to optimize your business finances now will help both in the short-term and long-term.
How to Improve Small Business Cash Flow
Now that you have a better understanding of why positive cash flow should be a vital component of your business model, let’s take a closer look at some of the things you can do to improve your cash flow.
Understand Your Current Cash Flow And Run Cash Flow Projections
If you’re looking to improve your cash flow, you first need to understand its current state. Consider using a cash flow statement template to get started. Here, you’ll sift through your business expenses, accounts receivables, accounts payables, and other similar categories to help determine both your current cash flows and future cash flows. If you use accounting software, you may have a built-in cash flow component that you could also use.
Alter Your Payment Terms
Another way to boost your cash flow is by adjusting your pricing and payment terms with your customers. For instance, let’s say that you are Net 60 at the moment with a customer. You could offer a customer a 2.5% discount if they pay Net 30. The sooner you can get money into your bank account, the more flexibility you have as a business.
Use Credit Wisely
By sitting on cash, you can potentially earn money thanks to interest rates. The longer you can hold onto cash, the more you can make. Consider putting operational expenses on something like a business credit card. Pay off the full balance each month, otherwise your lender will end up charging interest. But if you pay off your balance in full, you’ll have cash for a longer period of time.
As an example, let’s say that you spend $1,000 per week. You have $5,000 in your account at the beginning of the month. If you pay these expenses upfront, your account will be down to $2,000 going into the last week of the month, assuming you have no cash inflows. But if you pay with a credit card, your account will be $5,000 going into the last week of the month, assuming no cash inflows or interest earned.
Evaluate Your Supply Chain Management
If you offer goods to customers, you’ll want to take a close look at your inventory and supply chain management. If you have a backlog of inventory, your cash flow will suffer. Your profit margin will also suffer, as you may find yourself paying for unnecessary storage space.
Streamlining your supply chain management so that you only have enough inventory on hand can potentially help with cash flows. (Although, as an aside, you may also want to think about any discounts you’re getting from suppliers for buying raw goods in bulk.)
Strong Cash Flows Improve the Prospects of a Future Sale
When it comes to growing a company, one thing owners need to be mindful of is small business cash flow. A positive cash flow is essential for a few reasons. For one, it offers flexibility to do things like reinvest in the company or fund your personal nest egg.
A healthy cash flow will also assist with business valuations. Cash flow is one of the most critical components of a business valuation. Even if you don’t think you’re ready to sell your company, having a trusted advisor analyze your cash flow during an annual valuation can offer guidance so that you can further improve your company’s standing relative to the market.
If you’re looking for a trusted team of advisors to help with your business valuations, contact the team at Allan Taylor & Company. The advisors at Allan Taylor & Co. have been in your shoes and can guide you through the entire process, from preparation and planning to finding the right buyer and closing the deal.