What is Cash Flow and Why is it Important for Small Business?

What is Cash Flow?

Simply speaking, cash flow represents incomings and outgoings of cash within a business at a given timeframe (usually on a month-to-month basis). Having a good understanding of your cash flow is vital when it comes to your business’s overall financial health. A study conducted by Jessie Hagan of U.S. Bank has found that 82% of businesses fail due to poor cash flow management. You’ve probably heard or seen the phrase, “Cash is King,” many times by now. As cliche as it sounds, it paints a painful truth: most small businesses cannot properly function without cash.

Think of all the expenses you have to incur to run your business’s day-to-day operations. These expenses, which make up your cash outflow, can include wages, equipment, inventory purchases, cost of raw materials, supplier fees, and investments. The money you receive from the sale of goods and services along with the interest you make from any investment make up your cash inflow, which ultimately pays for your outflow. Some small businesses’ operations can come to a complete halt if they fail to cover even one type of expense.

For example, imagine this: you’re a commercial building contractor who’s working on a new project. Your payment (account receivable) for your past project gets unexpectedly delayed, putting your bank account in an unfavorable situation. Payroll day comes around, but you don’t have enough money in your bank to pay your employees. Now you’re faced with three possible choices:

  1. Cover the payroll using your personal money
  2. Use the money that was set aside for future business expansion
  3. or you can’t afford to choose either, and forfeit payroll

You already realized that all those choices are simply bad for your business, especially option 3. The moment you fail to pay your employees, chances are, they will go on a strike or even a mutiny. Your employees are furious, the project is unfinished, your next project is inevitably delayed, and your cash is still low!

You can see how this situation can quickly go into a downward spiral.

The Importance of Cash Flow Management in Small Businesses 

  • Cash flow management is different from cash budgeting

Managing your cash flow gives you a better and more accurate insight on the “financial health of your business.” Your budget is used to estimate incomes and expenses, then distribute proper resources to help profit generation.

The key difference is that your budget gives you a rough estimate on a quarterly or yearly basis while your cash flow projections details when the receipts and payments are likely to occur.

  • Being Cash flow positive will give you a higher chance for a business loan approval

Cash flow is one of the biggest factors a lender would consider when approving a loan. To a lender, your business cash flow represents its capacity to pay back a loan. Most lenders like to see businesses with reasonable margins, meaning you want to show the lenders that you have enough cash flow for a debt, operational expenses, and any unexpected costs to increase your chances of approval. 

  • Good Cash Flow Management gives you better timing for business growth

You, as a business owner, are most likely reinvesting in your own business for its continuous growth. With proper cash flow management, you’ll know exactly when and how much money will be coming in and going out. You can also identify when the money will be tighter by using this information.

How to Generate Positive Cash Flow 

  • Incentivize Your Customers 

Late payments are notoriously known to be one of the biggest reasons for poor cash flow, especially among small B2B enterprises. This problem is more prevalent in certain industries, such as construction and healthcare spaces. You need to be diligent when it comes to collection, because no business owners like to part with their hard-earned money.

There is a method to alleviate this problem: incentivize your customers. You can offer discounts for early payments and penalize late payments. But, be aware that some clients may rather pay the penalty to extend the credit as long as possible. Getting that extra money could be nice, but it may not solve your immediate cash flow problems. You could instead just offer discounts as a way for your customers to save money.

  • Be Clear about payment details and collection policies

As we’ve mentioned before, overdue payments are one of the worst cash flow killers. Small B2B businesses that deal with larger clients tend to fall victim to this predicament more than their larger counterparts. It’s as if small businesses became bank-knockoffs that give out credit.

If you haven’t set any clear policies about penalties and collection with your customers, your business could be in the risk of running into cash flow problems down the road.

As an example, you could implement a 5 percent late-penalty fee after five days, and a 10 percent fee after ten days. You also need to be crystal clear on service termination policy if the payment is more than 30 days overdue. Don’t be afraid to take extreme measures (within jurisdiction) if your clients aren’t paying on time, it’s just business.

  • Challenge your customers

In many cases, small business owners feel pressured to accept overdue payments in fear of losing business with their larger clients. But, it’s important to be aware that the bigger players do expect resistance from small business owners whenever they roll out new payment-term programs.

Let’s say your business is getting paid by a client on a 30-day schedule, then the client decides to bump that number up to 45 days in the contract. Many clients who propose this type of change are crossing their fingers that you simply accept the term with no complaint, hoping your fear triumphs over logical calculation

Don’t fall into their tactic and work the numbers!

For instance, get in contact with your client directly and state that your quote is based on a previously agreed schedule. For you to accept the new policy, as an example, negotiate with your client that you will need to increase your quote by 15%. Or, you could instead impose advance payment: you will bill the client when your work is finished halfway, not when it is done.

As long as you are not being overly aggressive with your challenges, most counter-offers you put on the table were already in the other party’s calculation. 

  • Use Technology to your advantage

Implementing software to track your customers’ dues, amounts, and payment dates will not only help you manage your cash flow better, but it will also help you keep your sanity.

You can also use software to make your customer’s life easier. You could use accounting software such as Square, Zoho Invoice, or FreshBooks to digitize invoice transactions instead of dealing with physical invoices. This gets rid of any extra lag time between you handing out the invoice and getting that payment back.

If you have a large number of retainer clients, setting up auto-pay functions and online payments within your software can encourage your customers to make on-time payment. We all know business owners don’t like to waste time, and they sure don’t like to waste time on something that takes away their money (even when it’s done out of lawful obligation!).

By putting in online payments function, you’re doing nothing but making the payment process more convenient for your clients. In the case of auto-pay function, it allows your clients to “set-and-forget”. Out of endless tasks small business owners constantly have to think about and deal with, that’s one less thing both you and your client have to worry about.