There is a reason why the International Reporting Standards require corporations to create cash flow statements: many businesses have crashed due to cash flow problems, usually those in their early stages.
Cash flow mirrors a company’s health, which makes cash flow statements a required document for all businesses.
Studies show that 9 out of 10 failed small businesses have shut down due to poor handling of their cash flow. While the formula for cash flow management looks simple – it can be challenging to make sure that money comes in more quickly than it goes out. Thus, we see a high rate of business failures related to cash flow issues.
Cash flow explained
Companies have three kinds of cash flows. These are investing, operating, and financing. One way of measuring cash flow health is free cash flow.
Free cash flow is the amount of operating cash flow created over the needed cash for vital expenses like those for capital spending.
One of management’s responsibilities is to pay attention to the time difference between cash collection from customers coming from a sale and when cash has to be spent to pay suppliers and other costs. If there is a wide time discrepancy between these two events, then that signals a cash flow problem.
While monthly cash flow analysis is critical, a business’ management team that is spending their time worrying about cash flow issues can get distracted from making long-term strategic decisions that are critical to their business’ success. The difference here is attention spent on short-term versus long-term thinking, but both are important.
How cash flow deficits ruin early-phase businesses
To further understand how problems with cash flow arise and how they ruin companies, let’s take a look at how startups work. For this article, let’s take a simple business model of a coffee shop as an example.
An entrepreneur needs to rent a space to build their store. This will take cash; either owner equity, or borrowing. If the entrepreneur has no access to funds, then the business will never take off and the business idea dies.
Next is the inventory. Since a coffee shop cannot operate without supplies, much of the time businesses pay on credit, usually for 30 days. If you are the business owner in this situation, you have just 30 days to generate enough money to pay your suppliers.
Now, the owner needs to hire and pay salaries. There will also be bills to pay, and the owner needs to set aside money for marketing costs. These are all expenses to be dealt with and the business has not even started operating yet!
The solution, of course, is to get plenty of customers as soon as they open so they can pay off all the people they owe money to. Those that do not generate enough sales die in less than a year of operations.
Operating, financing, and investing
We separate cash flows into three categories to make reporting simpler.
Operating activities, as its name suggests, are functional requirements for the business to run. These include things like collecting payments from customers, paying salaries and utilities, taxes, and loans.
Financing activities mean borrowing money or inviting new investors to participate in the business. Cash outflows in financing activities include paying off loans and paying dividends.
Tips on how to avoid cash flow problems
1. Profitable businesses also have cash flow problems
Profitability does not necessarily equate to cash and a viable business may still be in danger due to cash flow problems. Lowering your expenses can help free up some cash.
2. Do not forget to forecast regularly
Forecast as regularly as you can because it can help you deduce your future cash situation. Also, forecasting can help you prevent any surprises and diminish any risks before it is too late.
3. Businesses do not realize revenues until expenses are paid
Even if your monthly budget is balanced, you will still have a cash flow problem if your clients have yet to pay before the due date of your monthly bills.
4. Suspend your loan payments
Lenders are lenient, so you may be able to negotiate with them regarding payment of loans. Your lender will most likely consider a loan payment suspension or partial payment rather than receiving no payment at all.
5. Plan for emergencies
Emergencies and unexpected expenses like natural calamities, illness, and so on, and can affect your revenues. Be prepared for these eventualities, by having business insurance, emergency funds, and business continuity plans.
6. Learn how to be an effective collector
For many businesses, especially small ones, late-paying clients are a big problem. Studies show that only fifty percent of clients pay on time, and sixty-four percent of small businesses say clients do not pay for at least 60 days.
The key here is to search for ways to invoice promptly, setting reminders to clients, and collect as soon as the due date comes.
7. Understand seasonality
Seasonality in business can greatly affect cash flow. If the products or services you are offering are seasonal, you should assess trends closely and determine the highs and lows so you can manage your inventory and hire accordingly.
To prevent any cash flow problems from happening, analyze the operating, investing, and financing cash flows in your business. Devote some time figuring out your operations and the time lags associated with collecting cash and paying your bills. Also, recall that many profitable organizations have died an untimely death because they did not handle their cash flow accordingly.