82 percent of small businesses fail due to cash flow management. But what exactly is cash flow? The concept of cash flow is one most entrepreneurs are familiar with on a fundamental level. Simply put, it is the difference between the amount of money earned and the amount of money spent by the business at any given time.

Why is cash flow management important? What does poor cash flow management look like and what are the do’s and don'ts of cash flow management?

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Cash flow Explained

Every business needs cash to survive. Without cash, it can't pay off suppliers or employees, and it will be difficult to pay for the day-to-day expenses that keep the business running. But cash flows both ways - in and out. As much as businesses have to spend money, they are also making money.

If the business makes more money than it spends, then cash flow is positive but if the business spends more money than it makes, then cash flow is negative. Clearly, having a positive cash flow is a sign of a healthy and thriving business. But a negative cash flow only sometimes spells doom, as long as you know how to manage it.

Impact of Negative Cash Flow

Like I said, negative cash flow is not so bad, if it was done intentionally. Many profitable businesses sometimes operate with negative cash flow due to some strategic business decisions that cost the business a huge sum of money. Example;

• Buying a new business or opening a new store location
• Creating a new line of products or services
• Launching into a new market

These activities are cash-heavy, meaning they require heavy financial investments from the business. As such, the business may run out of cash, temporarily. This is acceptable as long as there is a plan to cover the expenses and keep the business running until the balance is restored. Aside from financing a project, it’s common to see new businesses with negative cash balances.

This is why founders need investors to provide the cash needed to keep the business afloat until it becomes profitable and self-sustaining. The point here is, that businesses can survive with a negative cash flow for a while, but if it drags on, then there will be consequences including employee layoffs, bounced chèques, compromising on product quality as a cost-saving measure, and eventually shutting down the business for good.

To avoid getting to this point, business owners need to understand how to manage cash flow effectively.

Tips for effectively managing negative cash flow

Track your burn rate

Negative cash flow doesn’t just get bad suddenly. This is because businesses can often find ways to cover their expenses temporarily. However, any slight change in income or expenses - like losing a major customer, a huge fine, bad debt etc, will put the business in a bad position. One way to avoid surprises is by tracking the burn rate of the business.

The burn rate refers to the amount of money the business spends within a given time (mostly calculated per month). This will inform the business owner on how long the present cash can sustain the business. This metric is commonly used by startups to know how long it will take before they need another round of funding. It is a helpful metric in the strategic management of cash flow.

Cut costs where possible

This goes without saying but still worth the mention. Cutting down costs to prevent the inevitable collapse of the business (if the business is losing money) has remained one of the most effective cash flow management strategies used by business owners.

Some cost-saving strategies include employee layoffs, budgeting, shutting down certain operations/administrative privileges, reducing employee pay, and other non-essential expenses. If a business’s cash flow is in the red, implementing any of these cost-saving measures can be the difference between surviving and going bankrupt.

Lean on your business’s competitive advantage - raise prices

Competitive advantage is simply an edge a business has over the competition. It could be anything from innovation to quality of product sold or customer service. This makes the business stand out from the rest of the competition and can easily be leveraged in times of financial distress.

One benefit of having a competitive advantage is the ability to raise the prices of goods or services offered by the business without worrying so much about customers jumping ship.

Aggressive marketing to boost sales

If you need more cash inflow, all you have to do is make more sales. This can be a bit challenging, nevertheless, it’s also a good alternative in the absence of any competitive advantage. Some businesses crunch down prices to boost sales by offering discounts or promotions. In essence, if you can’t raise your price, then go lower, as long as you can make enough sales to keep the business profitable.

Another approach will be to find a secondary source of income for the business, either by developing new products or entering into a new market. This should only be considered when the business has a strong competitive advantage or goodwill that will validate launching a new product or entering a new market.

Monitor cash flow

Business owners can track their cash flow using the balance sheet. This is a financial statement that outlines the assets and liabilities of a business. The information on the balance sheet can be used in calculating a very important metric - the debt-to-income (DTI) ratio. This ratio tells the business owner how much debt the present income can handle.

The higher the ratio, the more vulnerable the business is. Although this metric is often used to determine a business owner’s creditworthiness, it also serves as a strong determinant of a healthy cash flow. A high DTI means less cash availability and a low DTI means more cash is available. A business with a high DTI can be easily crushed when interest rates rise.

Conclusion

Businesses should aim to be as liquid as possible. Liquidity is a financial term that refers to the availability of cash to cover short-term liabilities. A negative cash flow indicates poor liquidity while a positive cash flow indicates adequate liquidity. Without proper cash flow management, businesses can fall into debt and even go bankrupt. In our next article, I’ll be talking about liquidity and everything an entrepreneur needs to know.

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Recommended Read - An Entrepreneur's Guide To Understanding The Business Cycle

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