Tips on Small Business Cash Flow Optimization

Managing cash flow is one of the most Important ways to achieve business success. Without keeping a close eye on how much working capital there is in the business, and how cash is flowing in and out, owners cannot accurately judge performance, see where to improve profits, or maximize reserves to prepare for times of hardship.

According to the Bureau of Labor Statistics, 20% of businesses fail in the first year, with 50% failing after five years. Over 80% of these failures are cash flow related.

Cash flow management can feel very overwhelming for small business owners but taking the time to master it is essential to ensure the business not only survives, but thrives. Getting cash flow in check then not only contributes to business success, but takes some pressure off the business owner, supporting their mental health. Here are a few tried and tested steps to boost cash flow optimization for small businesses.

What is Cash Flow?

Cash flow is the net amount of cash coming in and going out of the business—for example, the revenue from customer purchases compared to the costs of payroll, taxes, manufacturing and rent.

If the incoming cash from orders exceeds outgoings, the business’s cash flow is positive. If outgoings exceed revenue, cash flow is negative. This information can be found on a business’s cash flow statement (CFS). This is one of the three main financial statements a business needs to produce on an ongoing basis, alongside a balance sheet and income statement.

The CFS is reviewed by creditors to understand how much liquidity (cash) is available for the business to pay for operating expenses and to cover debts, and investors to support their decision to invest in a business.

Cash Flow vs. Profit

Cash flow is often confused with profit. Profit measures the revenue a business has left over once all expenses are paid. Cash flow, on the other hand, examines the amount of money moving in and out of the business, so it gives a more holistic view than profit alone.

It may sound surprising, but a business can be profitable on paper and still experience negative cash flow. For instance, if a business is selling lots of products but customers are taking too long to pay for these products, cash flow will fall into the negative.

Cash Flow vs. Working Capital

Although the two are interconnected, working capital and cash flow are also distinct. Working capital demonstrates the difference between a business’s assets and liabilities. In simple terms, the amount of cash it has available to pay for business costs, like filling new orders, at any given time. Working capital can be identified by reviewing the balance sheet on a business’s financial statement.

Fluctuating working capital affects cash flow, and vice-versa. If, for example, a business secured a short-term loan, more cash would be injected into the business. This would mean more working capital would be available, which could support cash flow management, although the loan repayment would need to be considered.

Accounts Receivable vs. Accounts Payable

Not all incoming or outgoing payments happen automatically and this can make cash flow harder to keep track of. Many customers make purchases on credit, serving as an IOU to the business, in the form of accounts receivable (AR). AR is listed as an asset on the balance sheet because it is money owed to the business.

When a business has to pay its suppliers and creditors, these are listed as accounts payable (AP). They represent all the outgoings that a business owes other businesses or entities. AP is listed a liability on the balance sheet because they are obligations to be paid off within a specific time period.

Businesses need to work with customers and suppliers to ensure AP goes out and AR comes in at times that complement each other so the business never falls into negative cash flow where no working capital is available to continue operating.

The Cause of Cash Flow Problems

Cash flow problems emerge when business expenses exceed revenues, but it can be hard to keep track of the constant movement of money in a business and identify the root cause. The most commonplace causes of negative cash flow include:

Lack of Budgeting

A major cause of business cash flow problems is a lack of a budgeting plan. Without a budget, businesses will find it difficult to set clear and realistic goals. It can be a good idea to make conservative forecasts and overestimate the amount of money to be spent, so that the business can ensure there’s always working capital available for emergencies.

Late Payments

Delinquent payments—those made after the payment due date—are another all-too-frequent occurrence. These are especially harmful for small businesses who need to pay other liabilities on time, often with the revenue they expect to receive from customer purchases.

Inaccurate Forecasting

Many business owners use forecasting to anticipate how cash flow levels will change, but this isn’t always a perfect science. Forecasting can help plan for shortages and have oversight over future costs, but can often rely too heavily on the best estimates and historical data, failing to account for unforeseen events.

How to Optimize Cash Flow

A cash flow optimization strategy can combine internal changes, like building a thorough budget, and external support, like alternative financing:

1. Manage Receivables

Giving customers too much flexibility often leads to a culture of late payments. As a small business owner, it’s important to outline clear payment terms for customers from day one, and align them with the master financial data on that customer. Offering early payment discounts and creating a regular schedule for following up on collections will also help to incentivise timely payment.

Business owners or financial teams should closely monitor the accounts receivable report to see how many payments are overdue, systematically checking for overdue payments. The billing process can be made more efficient through automation and setting a schedule for reminders and escalation steps.

2. Accounts Payable

With payables, businesses are subject to the terms of suppliers and creditors, but they can still optimize the process of paying their liabilities. By negotiating payment terms upfront, businesses can secure the most favorable conditions for repayment. 

This can also involve negotiating advance payments. Just as the small business can offer early payment discounts for customers, suppliers and creditors may offer a cheaper price for those businesses that settle invoices before the maturity date.

3. Inventory Management

Producing and holding inventory requires investment and this can be made more efficient in several ways. To ensure there isn’t too much cash being used for inventory, businesses need to be strategic in how they order stock, aiming to produce and hold a level that can meet varying levels of demand, without purchasing an excess amount.

It’s also useful to properly categorize inventory according to: safety stock, replenish stock, and obsolete stock. Inventory management software can also be used to generate an inventory value report, showing businesses the value of their total inventory at any given time.

4. Alternative Financing

When businesses need fast access to cash, they often turn to external sources of finance. However, traditional bank loans subject applicants to lengthy approvals processes and strict funding criteria that can be hard to meet as a small business.

Many alternative financing solutions, however, are tailored to small businesses with short-term cash requirements. Some examples include invoice factoring, working capital loans, and purchase order (PO) financing.

5. Enhanced Forecasting

Improving forecasting accuracy is essential to manage cash flow and improve profitability. Businesses can do this by regularly examining income and cash flow statements, along with linking cash flow forecasts to working capital figures in the balance sheet.

The process can be refined by regularly reviewing the differences between forecasts and actual outcomes. When times are tight, weekly cash flow reporting can also help with the visibility and reliability of the information, allowing the business to be agile with confidence.

Forecasts can also be automated, which not only reduces the time and labor-intensive process of keeping spreadsheets, but the risk of human error at the same time.

Optimize Your Cash Flow With PO Financing

Small businesses frequently work within tight margins as they grow. It can be difficult for them to keep operations moving smoothly and make purchases for short-term needs, like filling large orders, or long-term investments into staff, sales and product development.

With PO financing, businesses can reduce strains on cash flow by covering the cost of production when an order comes. PO financing has a faster turnaround than traditional bank loans, and helps businesses balance operational costs with meeting demand. Find out more about how PO financing can support small business’s cash flow needs.

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