How to Manage Your Cash Flow
Managing your business finances is like managing your personal finances. Nonetheless, it trips many people up because it sounds scary.
Let’s put that limiting belief to rest, shall we?
If you can add and subtract, you can master this. It’s even easier since we have the technology to do the heavy lifting.
Managing cash flow is like making sure you can afford rent and to eat for the rest of the month. You know when you're getting paid, and you know, roughly, the timing of your expenditures. The same principle applies to business. It's a little more complicated, but I’m confident you can do this.
Let’s go through how to manage your cash flow as a business.
Before we get started, if you’re saying, “Kate, I’ve never even balanced a checkbook. I don’t know personal finance.”
Don’t worry. I haven’t either.
But, I’ve reconciled many financial accounts, which is almost the same thing. Most often it’s easy. As long as you keep your books up to date, apps do the heavy lifting.
To best understand your business cash flow, you need to set up accounting apps.
Beyond QuickBooks (or accounting app of choice), a cash flow app will be your most important tool. Apps like CashFlowTool, Cash Flow Frog, and Liveplan pull data from QBO. Then they use complicated & interrelated formulas to create a cash forecast. They're smart and identify your past trends, although you can adjust as need be.
This forecast is paramount to cash management! Like a weather forecast, it will show your projected cash balance by the day.
If the forecast shows your cash balance going negative, then expect bad weather. You’ll be out of business if your cash balance is negative for an extended period of time. Your vendors and employees will not be happy if they aren't paid. As a result, operations and customer service will suffer. You'll need to take action, like one of the steps explained below.
If you have excess cash, you need to make plans for the great weather too. You have many choices on how to take advantage of your good fortune. You could spend it to invest in your business, pay down debt, or save up for a rainy day. (Regardless of your industry, you should have one to three months of expenses saved.)
The second important output from a cash flow app is metrics. In particular, days cash on hand and the burn rate. These are similar but not the same.
Days cash on hand is how many days of operating expenses you can cover with your current cash balance.
The burn rate is like days cash on hand, net of cash receipts. If the burn rate is negative, that's good. Negative burn means your bringing in more cash than your spending, a la profitable. If it's positive, your bank account balance will decrease over time.
You should look at days cash on hand and burn rate for regular operations. Do not include capital expenditures, new debt, or raising capital. These can obfuscate your metrics because they are uncommon.
The line of credit: Another handy cash flow tool for your business.
The tragic truth is that most banks reject small business loan applications. The latest Biz2Credit Small Business Lending Index shows just how hard it is and the impact of the Coronavirus pandemic. Pre-pandemic, big banks rejected 72% and small banks rejected 49% of applications. As of the end of 2020, those rejection percentages shot up to 87% and 81% respectively.
Since it’s so hard to get a loan, business owners turn to other more expensive sources. Many end up using credit cards in a pinch, which charge higher interest rates. Instead of using a card, it's best to set up a line of credit (LOC) before you need one.
A LOC is like a pre-approved loan. You're authorized to borrow up to a set amount. You don’t have to take it all out at one time, you can pay it back over time, and the interest rate is lower than credit cards. Even if you don't use it for several months, it's an extra layer of security.
The easiest time to get one is when you don't need it. Yes, it's very ironic! So this step requires some foresight. Since the rejection rate is so high, you may have to apply more than once. Setting it up before you need it gives you time to find a willing lender.
Plus, your books will look stronger when you don't "need" the funds. Banks like cautious business owners. They'll want to know your plans for using the funds. You need to create a compelling story to go along with the numbers.
Since you don't have to draw on it right away, there's no financial penalty for having one. But if your cash flow forecast shows negative balances or you want to expand, go ahead and set up one now.
A LOC is great to help plug any short-term cash flow gaps.
For example, you need to process payroll. You have several large invoices outstanding, but they aren't due for another week or two. To make payroll, you’re a few thousand short on cash. You pull up your cash flow forecast. It shows a negative balance between when you pay the payroll and are paid for the invoices.
To cover the gap, you "draw" a few thousand from your LOC. That gives you cash to process payroll on time and keep operations running like normal. Once you collect on the invoices, you pay back the LOC. You'll pay minimal interest and keep your employees happy too.
Again, set up a LOC before you need it. You may have a hard time getting approved. This is an extra layer of security, in case you ever need it.
Increase your cash flow by collecting outstanding invoices and money earned on your sales.
Within operations, you can make a few options to improve your cash flow. One way is to speed up when you collect your sales. Especially if clients pay you after receiving your product or service.
It’s nerve-wracking when at the end of the month you’re out of cash, have bills due, and unpaid invoices. You have the money coming, but it’s not in your bank account yet. You'll have to use a LOC, credit card, or put your own money back into the company to pay the bills.
If this happens month after month, you need to speed up your cash collections.
Here are a few ways to do so:
Change the terms - how many days customers have to pay
Adopt auto-billing for recurring services
Ask for a retainer before starting a project
Offer discounts for paying early, like 2% off if paid in 10 days
Factor invoices
Send auto-reminders on unpaid and late invoices
Charge late fees
If you send invoices after providing services, do so immediately and state a due date on the invoice. Invoices with a due date are 8 times more often paid on time. Also, your logo should be on your invoice. It increases your chances of getting paid by 3 times.
If you continue to be tight on cash every month, it's time to look at the other side of the equation. You’ll need to dig into the money flowing out.
You can manage your business cash flow by adjusting your payment schedules.
The second way to improve cash flow from operations is to slow down on payments. Again, managing cash flow is all about timing. Unless you get a discount for paying early, it’s best to pay bills when they are due. Not before.
Speak with your vendors to ask for longer payment terms. If you’ve been with them for a long time and always pay on time, you may get a yes. While it may be uncomfortable the first few times, you lose nothing by asking.
You can also ask if they offer early pay discounts. They may offer something you’re unaware of, so it’s good to check. Many subscriptions offer a discount if you pay in full for a year. From my experience, you save 15 - 20% or two months compared to paying monthly.
To ensure you pay bills when they're due and not before, track them by the due date. It's easy to do in QBO and most accounting software. During your regular finance date, review unpaid bills and schedule them as necessary. For recurring services, like utilities, you can set them up to auto-pay on the due date. As you set up these changes for more vendors, the benefits will compound.
These small changes, along with the other steps here, can compound into a big difference.
The best cash flow advice is to save where you can and watch your costs.
As a business owner, you want to maximize your profit. That doesn’t mean cutting costs as much as possible. Poor client experience and employee/vendor relationships are short-sighted. You have to strike a balance. You have to rank your priorities.
Before you can set priorities, it’s helpful to know your ideal profit. Net profit is what you can take from the business each year as your compensation. Especially if you need to support yourself and a family via the business, this is a critical number. A simple formula to back into how much you can spend while making your ideal profit is:
Sales - Ideal Profit = Spending Budget
This is the basic idea promoted in the book “Profit First” by Mike Michalowicz. It’s an easy back-of-the-envelope calculation to help you stay on budget and take home what you need to live.
With the spending budget in mind, review all your expenses. With limited funds and clear priorities, you’ll likely find unnecessary expenses. If your necessary costs exceed your budget, then it's time to get creative or increase revenue. If you’re unsure of what you can cut, check out this blog on 5 categories to cut first.
Managing your business cash flow, in summary
In an ideal situation, your bank account balance would be steady all year. But, we all know that’s not going to happen. Instead, you need to stay on top of your cash and understand it well.
The goal is to make sure you're a good steward of your finances. You need to have enough cash to cover all your bills at all times and a plan to use any extra cash to create more profits.
Managing your cash flow is about the timing of cash coming in and out. It’s not the same as profit, especially if you have expensive assets, loans, or take owner draws.
To manage your cash flow, start by using software to see how it fluctuates and forecast your needs. Next, secure a line of credit in case you ever need it. Once those two are in place, you can dig into your income and expenditures to find more ways to improve.
As your business grows, this will be a critical number to watch. Like how you need money in your wallet to buy lunch every day, a business needs cash too. By following these steps, prevent issues and keep operations humming along.