The importance of cash flow
A business that appears successful can fail because of poor cash flow. And, even if poor cash flow doesn’t put your business at risk, it might hurt your potential to grow.
For example, you might run a small business that makes toys. A large retail chain wants to place an order for 5,000 toys. You will make a lot of money, but the retail chain won’t pay you for the order until 90 days after you deliver the toys.
You know that you’ll need to buy the parts for the toys, pay your employees to assemble the toys and pay to ship the toys to the retailer. The entire process could take 30 days.
It would be a great opportunity to make money and get your toy in front of new customers. However, you realize you can’t afford to pay for the parts, employees, shipping and all your usual business expenses while you wait for the payment. Unfortunately, you have to say no to this great opportunity because you aren’t making enough money to cover all the expenses.
Or, given the same situation, a different business owner might say yes without thinking through the full process. After paying for parts, assembly and shipping, the order arrives at the retail chain, and the 90-day payment countdown begins. But at this point, the business is out of money.
It can’t afford to pay employees so they start to leave, and it can’t afford rent payments and the landlord threatens to kick the business owner out of the building. While the business is owed a lot of money, it doesn’t have enough savings to pay for day-to-day operations. The business is forced to close before the payment arrives.
According to SCORE, a nonprofit small business mentoring network, poor cash flow is the number one reason small business fail. With careful planning and management, you can help ensure your business is one that succeeds.
Managing your cash flow
As a business owner, you can use different tools and resources to manage your business’s cash flow and make sure you’ll have enough money to pay your expenses.
Creating a budget is an important first step because you can use your budget to determine your monthly income and expenses, and figure out how much you may earn or spend in the future.
You could also create and use a cash flow statement — there are free templates online — to better understand whether you have a positive or negative cash flow.
- Positive cash flow is when you have more money coming into your business then you’re spending.
- Negative cash flow is when more cash leaves your business than comes into your business. Having negative cash flow could be a sign that you’ll have trouble paying for future expenses.
Managing cash flow can be especially hard if you run a seasonal business. You make most of your money during a short period, but have to figure out how to pay your basic expenses all year, and any extra expenses leading up to and during your busy season. But even with a year-round business, making everything add up can be a challenge.
Finding ways to get paid more quickly and delay when you have to pay others can help with cash flow management. Additionally, having access to cash via savings or a loan could help you get through difficult times.
Here are several resources and tactics you can use to help manage your business’s cash flow.
Build your savings
While many new business owners have to use all their available money to pay for and grow their business, you may want to try and put aside a little bit of your business income to build your savings. You can then use the money you’ve saved if you need to pay for expenses or invest in an opportunity.
Increase revenue and lower expenses
One of the most straightforward ways to improve your cash flow is to make more money and spend less money. You could do this by:
- Increasing your prices.
- Using promotions to increase your sales.
- Trying to find an additional way to make money. Perhaps you could offer a new product or service. Or, you might be able to sell a membership or subscription service, which could increase your monthly revenue.
- Lowering utility costs by using less electricity or water, and trying your heating or cooling system less often.
- Investing in environmentally friendly equipment that uses less electricity.
- Comparing options before agreeing to an ongoing expense, such as a software subscription or equipment rental.
Open a credit line
You may be able to open a business credit line with a bank, credit union or other financial institution. Your credit line will have a credit limit, which is the most money you can borrow at one time. However, you don’t have to borrow money immediately when you open a credit line.
Some accounts have an annual fee, but aside from that, you’ll generally only have to pay fees or interest if you borrow money. For a low (or no) cost option, you can keep your credit line open and available in case you need additional cash.
Ask to pay suppliers over time
If you buy supplies from other businesses, you may be able to pay your suppliers or vendors with “terms.” A terms agreement means you can pay the supplier a certain number of days after they send you an invoice (i.e., a bill). Negotiating terms with your suppliers can be a very effective way to manage your cash flow without any additional expenses.
For example, with net-30 terms, you have to pay the invoice within 30 days of receiving it. Or, you may be able to ask for net-45 terms and pay after 45 days, net-60 terms and pay after 60 days, or an even longer terms agreement.
Having a terms agreement will give you more time to pay your bills, letting you better plan for the future and worry less about how quickly a customer will pay you.
Net terms agreements are also called “trade credit.” By allowing you to pay over time, the company is extending you credit, which is like giving you a loan during that period. You generally don’t have to pay any interest, but some suppliers may offer you a discount if you agree to pay your invoice early.
Give customers a discount on early payments
Terms agreements work both ways, and if you sell products or services to other companies they might not pay your invoices right away. This can be especially true of large companies that have a lot of bargaining power — you either agree to their terms or they won’t buy from you. However, you may be able to entice customers to pay their invoices early with a discount. You might have a net-60 terms agreement with a customer, but give the customer a 5 percent discount if they pay within 30 days or a 10 percent discount if they pay the invoice immediately.
While you’ll receive less money overall, getting paid sooner could help you maintain positive cash flow.
If other companies owe you money, you may be able to use your unpaid invoices to take out a loan or open a line of credit.
The lender may consider how much money you’re owed, your business’s financial situation and your customer’s business credit (because your ability to repay the loan could depend on whether your customer pays their bill).
For example, you might send a customer an invoice for $1,000 with net-60 terms. Instead of waiting the 60 days to get paid, you decide to finance the invoice in order to cover immediate expenses. A lender loans you $800 right away, and you have to repay the loan plus interest in 60 days.
Invoice factoring is a type of invoice financing. In this case, instead of taking out a loan, you’re selling your invoice to the factoring company. Factoring companies will lend you money now, and charge you a fee, in return for being able to collect your customer’s invoice payment later.
When you factor an invoice, you receive a portion of the invoice amount upfront from the factoring company and the remainder of your invoice amount minus the factoring company’s fee when your customer pays the invoice. For example, with a $1,000 invoice that has net-60 terms, you might get $900 today and another $50 in 60 days, leaving $50 for the factoring company.
In practice, you may have to tell your customer to send payment to the factoring company. Some factoring companies will alternatively let you tell your customers to send payments to a bank account that the factoring company controls, but your customers won’t know you’re working with the factoring company.
Unlike with invoice financing, the customer is paying the factoring company rather than you. However, depending on your contract, you still might have to repay the money if your customer doesn’t pay their invoice.
With both invoice financing and factoring, compare your options carefully before signing a contract. The loan amount, fees and contract terms can change from one lender to another, and although invoice financing and factoring can help you manage your cash flow, it also costs money and you don’t want to get stuck paying unnecessary fees.
Merchant cash advances
You may be able to quickly borrow money with a merchant cash advance, but it can also be a costly option that leaves some small business owners stuck in debt for much longer than they anticipated.
With a merchant cash advance, you’ll generally receive an upfront amount of money in exchange for a percentage of your future credit card and debit card sales. Businesses that don’t accept cards might be able to get a merchant cash advance by agreeing to repay the money with fixed payments from a business bank account.
The total amount you’ll repay is determined when you receive your cash advance. For example, if you get a $10,000 advance, you might have to repay $14,000. As a result, early repayments won’t save you money because your total cost has already been determined.
Generally, you’ll have to make daily or weekly repayments.
Depending on the arrangement, your credit card processing company may split the money you earn between you and the merchant cash advance company. It may send all the money to the merchant cash advance company, which will then forward you your portion of the sales revenue. Or, you may have to give the merchant cash advance company authority to pull money from your bank account.
It can be easy to qualify for a merchant cash advance and quickly get money to help you pay for an emergency expense. However, repaying the money with a percentage of your sales can make it difficult to maintain positive cash flow. Merchant cash advances are also an expensive way to borrow money and should generally be a last resort.
Cash flow vs. profit
In business, profit and cash flow aren’t always the same. If your business uses the accrual method of accounting, you record the money you’re owed as revenue (incoming money) when you make a sale, not when you get paid.
For example, if a customer places a large order and agrees to pay you next month, you record the revenue when the customer places the order. By accounting standards, you may be profitable for this month because you have more revenue than expenses. However, you could still have negative cash flow because you won’t receive the actual payment until next month.
You want to have a profitable company in the long run. But to be successful, you also have to manage your month-to-month cash flow.