The importance of cash flow for start ups
Many a new business owner has asked, “What is cash flow and why is it so important?” The short answer is cash flow is the amount of money coming in to a business and the amount of money going out.
Think of it as a water tank: water comes in at the top and drains out the bottom. So to keep your tank nice and full, you want more coming in than going out. End of article, right? Well, not really…
Cash Inflow and outflow
Cash inflow is the lifeblood of your business and comes from sources like payments from customers, receipt of a loan, a cash injection from an investor, or interest on savings or investments.
Cash is also important because it later becomes payment for things that make your business run: expenses like stock or raw materials, employees, rent and other operating expenses. Naturally, positive cash flow is preferred. Positive cash flow means your business is running smoothly. High positive cash flow is even better and will allow you to make new investments (hire employees, open another location) and further grow your business. Conversely, there’s negative cash flow: more money paying out than being coming in. A negative cash flow means the business is receiving less cash than it is spending. It may struggle to pay immediate bills and need to borrow money to cover the shortfall.
Main kinds of Cash flow
- Cash Sales
- Receipts from debtors
- Sale of fixed assets
- Interest on bank balances
- Loans from bank
- Share capital invested by investor
- Payment to suppliers
- Wages and salaries
- Payment for fixed assets
- Interest on loans & overdraft
- Tax on profits
- Dividends paid to shareholders
- Repayment of loans
Businesses aim to provide greater financial returns than the level of interest earned by simply placing the cash in a bank. They can also hold too much cash. Cash does not earn anything so holding too much cash could mean potential losses of earnings.
The cash situation is referred to as the liquidity position of the business. The closer an asset is to cash, the more ‘liquid’ it is. Liquid assets are those that are most easily turned into cash.
Deposits at a bank or stock that can easily be sold are liquid. Assets such as buildings are the least liquid.
Cash flow is always important, but especially when it is not easy to obtain credit. When the economy is in recession, financial service providers are reluctant to lend money.
Borrowing also becomes more expensive as interest rates are raised to partially offset the risk of borrowers not paying back loans.
Controlling cash is essential and business owners deal with a range of cash issues:
- Ensuring that sufficient cash is available for investment by not tying up cash in stock unnecessarily
- Putting procedures in place for chasing up outstanding debts
- Controlling different levels of cash outflows in relation to the size of the business.
For example, a hairdresser buys shampoos, equipment and pays for power. If the business has cash problems it may be slow to pay its bills to suppliers. This creates further cash problems which spread throughout the economy. If small suppliers are not paid they may go out of business. This in turn may affect businesses further up the ladder.
Surviving Lean Months
We all know that there can be a lag between sales and receipt of payment. But the bills aren’t going to magically disappear or change their due dates because you haven’t collected payment. You’ve got to have enough cash to get you through lean months when the flow just isn’t there. Good cash flow management requires good information, professional training and good management decision making. A basic cash-flow forecast might look like the example shown. For a business the size of Marks & Spencer, the figures are likely to be in millions of pounds.
|Net Cash Flow||(£8,000)||(£7,000)||£3,000|
In this example, net cash flow shows the cash position forecast for that month, and in both January and February this is negative, so this would ring warning bells!
The cash flow forecast is vital here because the business can look for ways to improve cash flow and manage credit:
- Making better use of assets – empty warehouse space or unused transport could be hired to other businesses.
- Making sure as little interest as possible is being paid on borrowing – pay debts early if possible and consolidate debts into one long term, low interest rate, package.
- Negotiate payment dates with suppliers, perhaps paying later, or in instalments.
- Avoid offering discounts for early payment (an effective but expensive way to get more cash in sooner).
It seems like a no brainer doesn’t it? Well it does when over one third of small businesses in the UK have had cash flow problems in the first two years of business. Furthermore, 30 per cent of companies experienced cash flow problems so severe that they threatened to put them out of business in the same period. Nothing too surprising there then, that the cash flow forecast serves as a vital tool of making the better business decisions. Owners however must be aware that the forecast is your best “guesstimate”; it’s not going to be fully accurate! But with organization and planning, you’ll be best placed to predict the demands of the business in cash flow terms.