Cash flow management is one of the most important aspects of small business management. A continuous cash flow shortage, which occurs when there is a large gap between cash deposits and cash expenses, is a common cause of business failure. Many accounting programs have cash flow management built into them. One strategy to improve cash flow management is to shorten the conversion period.
Importance of Cash Flow Management
One of the most cited reasons for business failure is poor cash flow management. If your company is consistently spending more than it earns, then you have a cash flow problem.
For small businesses, the most important aspect of cash flow management is avoiding a continuous cash flow shortage, which results from having a very large gap between cash deposits and cash expenses. You will not be able to stay in business if you cannot pay your bills for an extended period of time.
Examples of Cash Flow Management Issues in Businesses
The real estate development industry always experiences severe fluctuations, and developers often face cash flow management issues. Real estate development requires significant upfront capital investments, in addition to ongoing cash for operations.
Unless some or all of the project is sold before construction, developers often face cash flow issues before the project even starts selling, especially if the real estate market dwindles during construction. Many real estate developers have been forced into bankruptcy due to cash flow shortages for extended periods of time.
Any company undergoing rapid expansion can also face cash flow issues. Business expansion generally involves increasing labor costs by hiring new employees, higher rent for additional space, increased advertising costs, and increased investment in new facilities and equipment, etc. The need to maintain high inventory levels can also drain excess cash.
Extending credit to other businesses is another common way for companies to experience cash flow issues. Invoices are typically issued on a 30 or 60-day basis, and it is not uncommon for customers to delay payments, leaving the company in a tight cash flow situation. An example of a company facing cash flow management issues and a negative cash balance for the year is:
Cash Flow Statement for Acme, Inc. for the Year Ended December 31, 2021
Cash flow from operations: $6,500
- Deposits: Customer invoices $80,500, Other $1,500
- Expenses: Employee salaries -$45,000, Suppliers -$25,500, Other -$5,000
Cash flow from investments: -$5,500
- Purchase of equipment and software: -$5,500
Cash flow from financing: -$8,300
- Loan repayments: -$3,300
- Shareholder dividends: -$5,000
Net change in cash balance: -$7,300
Solving Cash Flow Issues
As a business owner, you need to conduct cash flow analysis regularly and utilize cash flow forecasting so you can take the necessary steps to avoid cash flow issues. Many accounting programs have built-in reporting features that make cash flow analysis easy. This is the first step in managing cash flow.
The second step in cash flow management is to establish and use strategies that will maintain adequate cash flow for your business. One of the most beneficial strategies for your small business is to shorten the cash flow conversion period so that your business can bring in cash faster.
If your business is expanding, you may need one or more cash injections during the growth phase. This can come in the form of a business loan from a financial institution known as debt financing or equity financing from investors.
Debt Financing vs. Equity Financing
Debt financing is common for assets such as equipment, buildings, land, or machinery, when the assets to be purchased are used as collateral or security for the loan. The main advantage of debt financing over equity financing is that the business owner does not need to give up partial ownership of the company and can therefore retain full control. For short-term cash flow shortages, many small business owners utilize credit cards or lines of credit.
Involves
Equity financing is about raising funds from angel investors or venture capital. Equity financing is much less risky because the invested money does not need to be repaid if the business fails. However, the investor becomes part of the ownership and thus takes a share of the profits and has a say in how the business is managed.
No matter what form of financing is needed, it is essential to have an updated business plan to present to financial institutions or investors. The business plan should demonstrate the need (and impact) for financing on the future of the business.
Frequently Asked Questions (FAQs)
How do you solve cash flow problems? The first step in managing cash flow is to conduct regular cash flow analyses. You should review your customers’ credit history and stay updated on business indicators such as recurring or slow activity periods to ensure your company can manage deposits and expenses properly.
What is the difference between debt financing and equity financing? If the company uses debt financing, it borrows money from a company and will pay interest on it. In equity financing, business owners sell a portion of the organization in exchange for additional working capital.
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Source: https://www.thebalancemoney.com/cash-flow-management-2947138
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