In order to manage the investment potential of your small business it is crucial to manage your cash flow. Surveys that have been conducted of failed business show that up to 60% say that all or most of their failure was due to cash flow problems. Clearly cash management is the key to business success. Start-up businesses can often find themselves short of cash right off the mark. Existing businesses will be able to 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.
It is important to realize that cash flow and profit is 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 crucial for a small business. The actual gap between profit and cash flow could be very large. If you have rapid growth in credit sales, for example, profit could far exceed the actual cash received. This sort of situation makes smaller companies very vulnerable to running out of cash.
The term liquidity is often used in combination with cash management. Liquidity is defined as a firm’s ability to pay its short-term debt obligations. The bottom line is that if the firm has adequate liquidity, it can pay its current liabilities such as accounts payable.
There are methods that small businesses can use to measure liquidity. Financial ratio analysis can help you determine how liquid your business 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. Keep in mind that you need to have more current assets than current liabilities on your balance sheet at all times.
The quick ratio will also allow you to determine if you can pay your short-term debt obligations, or current liabilities, without having to sell any inventory. It’s very 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 and finding a buyer is not always easy or possible.
Most businesses prepare monthly cash budgets to keep track of their cash. Your cash budget will capture the timing difference between the profit you see on the income statement and the cash that is actually coming into and flowing out of the business. It is important to keep in mind that the purpose of the cash budget is not to set targets for cash but to anticipate needs. You should keep them up to date because the cost of running low on cash in a business is high. Having a cash budget should also help you be able to anticipate possible “what-if” scenarios in the future. Remember that your goal as the owner and manager of your company is to squeeze all the cash out of your balance sheet that you can.
There are other considerations that should be made as you manage your cash flow. Two of your current asset accounts are usually large drains on your cash. These are inventory and accounts receivable. Inventory is the products you sell and accounts receivable are your credit accounts or those the accounts that represent the credit you extend to customers. You should continually be working to convert the balances in both accounts to cash as soon as possible.