One of the most common reasons for business failure is running out of cash. This may seem obvious, but even profitable companies go bankrupt because they don’t have the cash to fund their growth. Everyone understands that a business’ revenue must exceed its expenses to survive long term (or at least it must have a feasible plan to get there with investment capital).
However, profitability alone is not enough. Manufacturers need cash to purchase raw materials and pay their overhead expenses before they ship to and collect from customers. Retailers need to purchase inventory before customers visit.
As the CFO of several startup companies, one of my top priorities is cash flow planning. The following are four things I have learned about managing business cash flow:
1. Religiously maintain short-, medium-, and long-term cash flow projections
The tighter your cash flow, the more time you’ll need to spend on projections. Cash flow is tight in all of the companies I work with. I usually spend at least some time every day updating short-term projections, every week updating medium-term projections, and every month updating long-term projections.
Long-term typically means 1 to 5 years. Cash flow projections are built into the financial models I use for generating pro forma financial statements. The models take into account budgeted profit or loss, working capital needs, capital investments or sale of assets, and expected financing to be received or repaid (notice this follows the sections of the cash flow statement). Information about projected cash excess or shortfall can be used in strategic planning decisions.
Medium-term usually means 1 to 12 months. The process is similar to long-term planning but more detailed to make sure we can handle temporary dips.
Short-term means within the next month. This is where we get very detailed. Medium- and long-term plans have to make assumptions about expected receivables, inventory, and payables balances, for example. But within the next month we need to know what invoices we expect to collect, when inventory purchases will be made, and what bills need to be paid (especially payroll!).
Diligence in this area is incredibly important. It takes time to make adjustments for cash shortfalls, such as by raising money, selling assets, or cutting costs.
2. Overestimate your needs
You’ve probably heard the following business advice: figure out what cash you think you’ll need, double it, and then double it again. In most cases, businesses take a lot more time and money to build than we expect. Especially when planning for long-term cash flow, err on the high side.
If you need cash to grow and are raising money from investors, raise much more that you think you’ll need. A little extra dilution is better than running out of cash.
3. Build an emergency fund
This is related to point 2. Hold an emergency (or reserve) fund that is double or quadruple the size you think you’ll need. It is standard advice in personal finance to have savings equal to between three and six months of expenses. I think a business emergency fund should be even higher to allow it to weather downturns and take advantage of good deals.
If your business doesn’t have an emergency fund, build one a little bit at a time. Your survival could depend on it.
Bill Gates wasn’t comfortable with Microsoft’s cash flow until he had a year’s worth of payroll in the bank. As a software only company at the time, most of Microsoft’s expense was payroll.
4. Prioritize
Despite their best efforts to manage cash flow, many businesses have times when they simply can’t pay all the bills on time. In this case, it is important to prioritize wisely.
I again draw a parallel to personal finance. Dave Ramsey talks about taking care of the necessities of life first - food, clothing, shelter, and transportation. You wouldn’t allow your electricity to be shut off or your children to starve while you pay your credit card bill. Your credit card company may not be happy, but there’s not a lot they can do while you meet your needs in the short term.
A business is similar. First focus on bills that allow your business to keep operating. You won’t be able to pay anyone if your business fails. Payroll is usually at the top of the list. Most vendors will have some level of patience with late payments. You don’t want to risk losing credit terms, which will hurt future cash flow. But as you build relationships with your vendors you will find that some will be more patient and understanding than others.
Conclusion
Cash is King. Paying careful attention to cash flow is just as important to a company’s survival as building and selling a great product.
Question: What tips and tricks do you have for managing cash flow?