In simple terms, your cash flow is a measure of what you’ve got coming in and what you’ve got going out. On that basis, it’s all too easy to assume that if the former figure is higher than the latter, then all is well. But remember, cash flow isn’t the same as profits.
A large number of unpaid purchases sitting in accounts receivable that aren’t arriving for a number of weeks may look profitable on paper. In reality, it can place your business in a precarious situation. Especially if you have outstanding accounts receivable and your suppliers are demanding payment immediately.
These kinds of voids are, ironically, particularly dangerous for product-based businesses that are fast-growing and profitable. Why? Because every time you land a new customer, you will need to purchase raw materials to fulfill their orders (not to mention investing in new people and equipment) before you get paid.
So what steps can you take to prevent cash flow problems and improve your cash position overall?
1. Keep a Cash Flow Forecast
There’s always uncertainty in business, but keeping your cash flow forecasts accurate and up-to-date, can help you face that uncertainty with certainty. Looking at last year’s sales should give you a good idea of what you will make this year. If a crisis or loss of sales has occurred, shift to a month-by-month reflection and build from there.
Then calculate the cost of producing your goods and services, as this will help you adapt your projection should substantial new orders suddenly come in.
At the same time, remember to include all your fixed expenditures—the cost of maintaining your premises and paying your staff, including salaries, rent, business rates, bills—and of course tax demands.
2. Actively compare your projections to reality
Your forecasts will be useless unless you continually compare them to reality to see whether you got your figures right.
Doing so on a month-by-month basis will enable you to fine-tune your figures, in turn enabling you to project how much cash in hand you will have a week, a month, or even a year down the line.
3. Prepare multiple cash flow projections
A good way to protect yourself against any unpleasant surprises is to prepare three different projections:
- A best-case scenario
- A worst-case scenario
- A middle-of-the-road option
To produce these figures, you will need to look at the way your market is evolving; consider seasonal cash flow problems; consider whether new competitors are likely to present a threat, and think about whether your existing customers are fully satisfied or are considering other suppliers.
Now you can separately manage these projections through traditional spreadsheets, or if you’re looking for a more efficient solution, you may want to consider a business planning solution like LivePlan. Whichever option you choose, just be sure to keep them up-to-date based on the trends you’re seeing and ensure that one realistically reflects your current financial standpoint.
4. Keep things realistic
Don’t give in to the temptation of assuming that all will be well; an unrealistically optimistic forecast will quickly lead to trouble.
Make sure you don’t tweak dates this way and that to ensure that the figures look good. If there are going to be problems down the line, you want to know about them now so you can mitigate them.
Symptoms of common cash flow problems
Speaking of problems, it can be difficult to identify them even when you’re actively maintaining and forecasting your cash flow. But it doesn’t have to be and all it takes is understanding the potential symptoms that foretell incoming or ongoing problems.
As you work through the list of refining your process to prevent cash flow problems, keep the following five signs in mind to help you avoid common cash flow issues.
1. Your accounts receivables are high
Many businesses invoice their clients and receive payment after the service or product is delivered, so it’s normal to have some unpaid invoices at any given point. The trouble is that until your customer pays, you don’t have their cash available to you to meet your expenses. You just have the promise of their payment.
If you find that month after month, your receivables are higher but you’re not bringing in more cash, it’s time to take a serious look at your payment terms and invoicing system.
To see whether your business is doing well with collecting its accounts receivables, consider keeping track of your receivables turnover ratio (net credit sales over average accounts receivables balance). A low ratio might indicate it’s time to reassess your payment terms and policies.
2. You have high inventory and low order volume
Businesses that sell their products to other businesses may like to have a lot of inventory on hand to ensure they’re able to accommodate orders of all sizes. But if a majority of your cash is tied up in that inventory, and your customers aren’t racing to buy, you might start to see problems.
Until your inventory items are sold, you don’t have liquid cash available to pay your bills. Plus, you’re probably paying to store it, and you start running the risk of your inventory being damaged or stolen, or simply becoming obsolete or less in demand before you can move it.
3. You’re overextending your business
Though you might be very eager to scale or grow your business quickly, it’s important you make sure to do so at a reasonable rate. If you overextend your company, chances are a lot of your cash will be tied up in capital and operating expenses, leaving your business less flexible in the short term.
To avoid having to deal with cash flow problems related to overextension, be sure to thoroughly plan your growth well in advance. Don’t just spend and hope for the best—reviewing your key financial statements regularly—cash flow statement, income statement, and balance sheet—will help you get a fuller picture of where your business is and where it’s headed.
4. Your sales are declining
Maybe the economy is in shambles. Maybe you’ve got a lot of new competition. Whatever the case may be, if sales have been steadily declining over the last few quarters, there’s a good chance your profit margins are getting sliced as thin as possible—if they still exist at all.
Since your overhead costs likely won’t change, declining sales may indicate that cash flow problems are imminent. To combat declining sales, you might want to adjust your strategy, or at least your expense budget.
From there, look a little deeper:
- Where are your losses coming from? Is there a particular demographic where you’re selling less than you used to?
- Is there a technical or process-related problem? Is your sales page on your website broken? Are in-person customers dissatisfied with customer service?
- Are there macro-level changes happening in your industry right now that are affecting common benchmarks overall?
- When was the last time you redefined your buyer personas or looked at updating your messaging?
- Does your business model still make sense?
- Is your business experiencing a seasonal fluctuation?
If sales are off for a month or two, you might not have a huge problem to solve. But it is a good time to make sure you have a plan in place if you start noticing a longer-term trend. Mitigate risks by being aware of them, to begin with, and making a plan to remedy.
5. Your business just isn’t profitable
At the end of the day, if you’re spending more money than you’re taking in, it shouldn’t take a rocket scientist to tell you that you’ll probably have cash flow problems sooner or later.
If you find yourself in such a position, you might want to reexamine your business model to see how it can be changed to enhance profitability. It might also be time to think about whether it makes sense to increase your prices.
Noticing one of these symptoms in your business isn’t necessarily an emergency. Take the opportunity to look deeply at your financial performance, and make sure you’re thinking far enough into the future that you can get a loan or line of credit if you’re coming up on a tougher period.
Improve your cash flow
Even after extensive planning and identifying the symptoms you may still find yourself needing to drastically improve your cash flow. This may be due to a simple financial oversight, an economic crisis or a number of other reasons.
If you need to find quick and proven solutions to increase your liquidity, check out our article on improving your cash flow to get started.