More than 95% of small American businesses close down after just 5 years. Of these, 85% fail because of cash flow problems. The plain fact is that in the face of such difficult market conditions, your business can’t afford to not optimize its cash flow. Everything from how early you pay your vendors to how much leniency you give your customers impacts whether your businesses succeed in the short and long term. And, with unexpected events like the COVID-19 pandemic sending cash-strapped startups to the scrap heap, you’ll also have to prepare for the next unexpected crisis.
Why do I need an optimized cash flow?
Market conditions change over time. Sometimes the economy does well, and other times not so much. But one thing that remains constant in a bull or bear market: your business needs cash. Why? Because you can’t pay your bills without it, no matter how profitable your business is on paper. You can only borrow so much, especially if you’re a small business.
In fact, Small and medium businesses (SMBs) are the most at risk of irregular cash flows and limited liquidities. You can’t borrow the big bucks because banks and lending institutions don’t trust you yet. Only 30% of small businesses receive the full loan they applied for in 2021. And only 5% of all startups receive venture capital funding. So you can’t depend on financing.
You also probably don’t have a predictable, regular income, which makes things even harder. Lending institutions don’t like financial uncertainty. You might do alright under normal times, but during challenging times, like during a pandemic, you probably fall off the bandwagon.
Economic disruptions
Speaking of pandemics, the recent COVID-19 one did a number on small businesses. Around 65% of small business owners struggled to pay their operating expenses in 2020, according to this 2021 Federal Reserve study. The same study claims another 32.5% also struggled to pay rent or existing debt during the same time.
You don’t want your business in the same position. The best way to prepare yourself against all types of potential crises is to have an optimized cash flow to prevent bankruptcy.
How do I optimize my cash flow?
You need to take a structured approach built using these three pillars:
A. Use best practices for working capital management
B. Create a cash flow forecast that you regularly review
C. Prepare for potential scenarios beforehand
A. Use best practices for working capital management
Working capital is the difference between your current assets and liabilities. It’s effectively the liquid capital you have for meeting your short-term financial obligations.
The best way to optimize your working capital is to improve each of its three elements:
1. Receivables
Receivable refers to the payments customers owe you. You may be tempted to offer relaxed payment terms, like giving discounts and letting clients pay late. Doing so could increase business.
The problem comes when you’re so relaxed with your receivables that your business receives little money even though it has a lot of sales on paper. Avoid this problem with these 3 tips:
- Align finance and sales
Your finance and sales departments need to cooperate to develop practical payment terms. You want to be lenient enough to attract business but not enough that no one pays you on time. It’s a fine balance you can best achieve with a data-centered approach.
- Automate billing
Automating invoicing helps keep better track of who owes what. But companies often suffer from ineffective automated invoicing when they have an inefficient approval chain or use inaccurate data.
You can avoid suffering the same with a lean process. Do that by setting internal deadlines for submitting invoices, like within a day of signing the contract. It’s also vital to clearly define the owner of your customer master data to avoid confusion.
- Build a solid collections strategy
Ensure you have efficient account tracking before performing this step. You’ll want to automate alerts for overdue payments, then build a system of scheduling reminders and other escalation steps. Continue close cooperation with your sales team to facilitate easier client outreach.
2. Payables
Payables refer to the money you owe to others, like your suppliers and vendors. Unlike receivables, you rarely set the terms for your payables. So expect unique challenges and opportunities.
Optimize your payables with the following 3 tips:
- Negotiate non-price terms
New businesses often focus solely on price with their suppliers. That’s a mistake. You also want to negotiate on everything from advance payments to credit terms. Ideally, aligning both items to your needs.
Don’t grasp the first quotes you receive. Negotiate back and forth till you get the supplier to budge in a direction that eases things for your budget. This will initially be hard, but you’ll benefit long term.
- Ensure your procurement data is visible
Identifying and planning for new problems is challenging when your procure-to-pay process doesn’t provide reliable data for cash forecasts. Fix this by ensuring your purchase orders and invoices are promptly matched to give at-a-glance information on whether you’re meeting expenses.
- Optimize payment timing
Generally, it’s best not to deviate from your established payment schedule. Yet, it’s better to pay early in some instances, like if your supplier offers early payment discounts. It makes sense to spend a little of your cash surplus if paying early reduces your bills.
3. Inventory
This section only applies if your company has a physical inventory. Not all businesses do. Inventory management is frequently the biggest money pit for most companies.
Avoid that with these 3 tips:
- Designate minimal inventory levels
It’s better for small businesses to have smaller inventories since they have less cash. Ideally, you want enough inventory to satisfy fluctuating demand without excessive overage.
One strategy for achieving this would be to reduce your SKUs and keep only the most popular items well stocked. Order the rest when needed. Naturally, delivery times will probably increase for those items, but you’ll have greater liquidity.
- Monitor demand patterns
Monitoring how your businesses’ demands change over time helps optimize inventory levels. For example, if you experience increased demand, you could improve your inventory by switching to closer suppliers. Doing so would reduce delivery times.
Also, knowing which products customers want and how much of them also prevents you from bulk-ordering products that go to waste.
- Achieve a real-time view
Downloading an inventory management software gives you a real-time view of your stock and its location. As a result, you won’t accidentally over-purchase. If you can’t acquire inventory management software, at least ensure your business has processes for selling the oldest items first to reduce waste.
B. Create a cash flow forecast that you regularly review
Too many businesses only review their cash flows after falling into liquidity problems. Don’t be like that. Instead, take a proactive approach by regularly reviewing your cash flow forecast to avoid future problems.
The best way forward is with these 3 tips:
1. Choose a forecast period and methodology
The standard forecast period is 12 to 18 months. That period may or may not be suitable for you, depending on your company and industry.
After deciding on a period, select one of these 2 methodologies:
- Direct method
The direct method is normally, but not always, used for periods of fewer than 12 months. The direct method uses a cash basis forecast, instead of an accrual one, to create a separate schedule for projected cash in and out. This is generally a good approach for short-term liquidity planning.
- Indirect method
This method is generally best for periods longer than 12 months. The indirect method uses a forecast income statement linked to
Balance sheet days sales outstanding (DSO)
Balance sheet days payables outstanding (DPO)
And balance sheet days inventory on hand (DIO)
The indirect approach is less accurate than the direct one. So it’s best suited for long-term capital expense planning.
2. Concentrate Only on Useful Outputs of Cash Flow Statement
A cash flow’s goal is to provide you with clear financial data to make decisions. The best way to ensure it achieves that goal is to focus only on useful information. Don’t overcomplicate your cash flow statement.
Regardless of your business’ complexity, your cash flow statement should always have these 3 components:
- Operating cash
- Investing cash (capital expenditure or disinvestment)
- Financing cash (debt or equity)
Of the three, operating cash is the most important since it determines your financing needs. So orient your cash flow statement around your operating cash and keep the model simple.
Remember that complexity increases the chances of errors.
3. Create a Cash Flow Review Schedule
Reviewing your cash flow statement once a month is good enough for ordinary times. During difficult periods, you should move to a weekly review schedule to ensure the accuracy of the information it contains. Also, schedule your review before your company’s payment day to give time for adjustments.
During your review, you should compare your forecasts with your actual statement to analyze vacancies for improving accuracy. Be thorough in your analysis.
C. Prepare for potential scenarios beforehand
Uncertain crises are inevitable. Just think of the COVID-19 pandemic. Who’d have thought the entire world would shut down in 2020 because of a disease? You’ll likely experience many more unexpected events over the course of your life. You want to prepare for them.
Now, you can’t realistically predict what future crises will happen, how long they’ll last, and what impact they’ll have. But you can prepare yourself for the most likely consequences of different crises, like bankruptcy, liquidity crisis, or reduced demand.
You’ll also want to plan on how to respond to these events. Ideally, you should also stress test these scenarios in your company to ensure you’ll survive unstable times.
Specifically, you should test these two scenarios:
- A cash shortage and liquidity shortage
- Excess liquidity
1. A shortage and liquidity crisis
Shortages and liquidity crises can be caused by external factors, like changing market conditions, or internal ones, like operational inefficiencies. In either case, your goal is to buy enough time to either survive the new market conditions or address your operational inefficiencies.
The best way to survive a shortage and liquidity crisis is to identify which actions would immediately generate cash without affecting your business.
Such actions could include:
- Reducing non-strategic overheads
- Taking pre-orders for products
- Focus on products and services with the highest margins
- Prioritize less risky clients
- Lease assets instead of buying them
The goal is to generate the cash needed to keep your business alive during the crisis. Don’t make the mistake of hiding the crisis from your creditors because they’ll eventually find out anyway.
After all, they suspect something when their payments are delayed without any explanation. They may even suspect the crisis is worse than it actually is when you deliberately choose not to inform them.
So don’t let things spiral into an even bigger disaster. Openly tell your vendors that you’re in a liquidity crisis to maintain their trust. Inform them of your liquidity crisis plan and when they can expect normalcy.
Long story short, you want to survive a liquidity crisis by taking control and buying time for the company by liquidating whatever you can without affecting your business.
2. Excess liquidity
Excess liquidity isn’t as stressful as a liquidity crisis, but it’s still a crisis. The worst thing you can do with excess liquidity is to invest it in non-strategic areas that don’t provide returns. That will cause your company plenty of long-term issues, especially during a liquidity crisis when you won’t be able to easily liquidate the undesirable assets you’ve collected.
These are the 3 best things you can do to optimize excess liquidity:
- Identify and assign sufficient capital to your company’s strategic priorities.
- Identify strategic ways to use your capital, like paying vendors in advance for a discount.
- Assign sufficient cash as emergency liquidity.
Essentially, the best thing to do when you have excess liquidity is to invest in strategic areas that either further decrease costs or increase your long-term revenue.
Final Thoughts
And with that, you now know how your small business can minimize risk with cash flow optimization. The entire process is all about having a clear big-picture and preparing in advance for the worst.
Author: Ramish Kamal Syed | Editor: Syed Hamza Ali | SEO Editor: Muhammad Waqas Aslam