There are a couple of old sayings in business. One is, "Cash is king." Another is, "Happiness is a positive cash flow." Surveys are conducted constantly of failed businesses. Most failed businesses, up to 60%, say that all or most of their failure was due to cash flow problems. Businesses have to have as their guide another old saying. Nothing matters more than cash. Making a profit is nice, cash flow is necessary. Cash management is the key to business success.
Start-up businesses often find themselves short of cash right off the mark. Existing businesses can find ways to survive if they can find ways to generate cash. Cash is the single most important element of survival for a small business. Small businesses often say that an inability to control cash is their single biggest problem.
Just like an individual or a family, companies need a cash cushion to rely on. This gives them security in unstable times. It also gives them an opportunity to take advantage of strategic investments or take advantage of opportunities to reduce costs. Small businesses also have to focus on the concept of free cash flow in order to establish that cash cushion.
Duncan Connor, of Company.com talks about how companies used their cash flow to remain successful during the 2009-2009 recession, "It's a simple case of managing how much flows in or out of your business and when. Successful businesses managed their expenses, maximized margins, and built their customer base."
"One of the first things that successful businesses did during the recession was to look at their borrowing and renegotiate the terms to something that, while it may be over more years and ultimately more expensive, has lower payments now. Yes, adding more debt is probably a bad idea for most businesses, but if refinancing existing debt allows you to stay in business, there's a definite upside to doing it."
"Other businesses negotiated longer periods for making payments to suppliers, while at the same time requiring faster payments from customers."
Another way that recession-surviving businesses management cash flow was to manage how much inventory was being carried at any given time - inventory costs money, and inventory which sits on your stock-room floor for weeks has an opportunity cost which can bankrupt your business."
The least desirable expense control is always in human resources, but as orders reduced, many manufacturing businesses laid off staff, instituted freezes or cuts to pay and benefits, reduced investment in hiring and training."
Connor concludes, "On the other side of things, the making money flow inside, there were a few tricks, too."
"Accounts receivable factoring has appeared on the radars of more small business operators in the last two years, but the highlights are that you sell your invoices for between three and ten percent less than the invoice amount. Now you're asking why any business would do that. The answer is that for most businesses, 90 percent of an invoice now is better than 100 percent of an invoice in ninety days. That's if the customer pays in full. Factoring allowed businesses to get almost all of their invoices paid by a third party and focus on doing business and generating leads rather than chasing payments. The third party chases the customer for payment."
"Many sole proprietorships and partnerships cut the amount the owners were paid, and in many cases, the owners injected more of their own cash into the business to continue operating, while others moved their business into more diverse or profitable areas."
Cash and Profit
Cash flow and profit are not the same thing. Financial accounting is not focused on cash flow. It is focused on net income or profit. Over the long term, profit and cash flow are approximately the same but the crucial difference is timing.
Timing can be so important for a small business. For example, when you make a sale to a credit customer, you recognize that sale immediately on your income statement. That's called accrual accounting. However, you don't get the money immediately. On your cash budget and your statement of cash flows, you don't show that credit transaction until you actually receive payment.
You can see how the gap between profit and cash flow could be very large. If you have rapid growth in credit sales, for example, profit could far exceed actual cash received. This sort of situation makes smaller companies very vulnerable to running out of cash.
What is Liquidity?
You often hear the word liquidity used in combination with cash management. Liquidity is a firm's ability to pay its short-term debt obligations. In other words, if the firm has adequate liquidity, it can pay its current liabilities such as accounts payable. Usually, accounts payable are debts you owe your suppliers.
There are methods you can use to measure your liquidity. Financial ratio analysis will help you determine how liquid your firm is or how successful it will be in meeting its short-term debt obligations. The current ratio will help you determine the ratio of your current assets to your current liabilities. Current assets include cash, accounts receivable, inventory, and occasionally other line items such as marketable securities. You need to have more current assets than current liabilities on your balance sheet at all times.
The quick ratio will allow you to determine if you can pay your short-term debt obligations, or current liabilities, without having to sell any inventory. It's important for a firm to be able to do this because, if you sell have to sell inventory to pay bills that means you have to find a buyer for that inventory. Finding a buyer is not always easy or possible.
There are various other measure of liquidity that you will want to use to determine your cash position.