It is a common misconception that businesses fail purely because they are unprofitable. A profitable business can fail if they do not effectively manage their cash flow. Cash flow is the movement of money in and out of the business, and is one of the most important indicators or financial health as it impacts such a large amount of a business. At best, poor cash flow will limit growth and re-investment, but at worst, it can stop a business dead in it's tracks. Keep reading for five ways to make sure your cash flow stays healthy.
“We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.” Michael Dell
1. Manage credit control
Critical to maintaining healthy cashflow is ensuring that you are getting paid for what you provide. The quicker you get paid, the better. Remove the barriers that delay payments,. Make payment terms clear, so customers are clear on expectations. Make it easy for people to pay, perhaps by directing them to a payment page via the invoice, or enabling a number of different payment options. Where possible, make it automatic (for example direct debits). Finally, follow up promptly when the terms of payment are not met and establish a clear process for recovering unpaid invoices, and be sure to follow up on each one.
"Never take your eye off cash flow because it's the lifeblood of the business." Richard Branson
2. Manage your expenses
Naturally, your business expenses have an impact on your cashflow. If your costs are too high relative to your income, you're of course going to quickly encounter challenges. However, just as damaging can be the sequencing of expenses relative to income. You can be highly profitable, but if income and expenses occur at the wrong time relative to each other, you could still go out of business. If your expenses are due before you're due to get paid, your working capital could come under pressure - this might be manageable month-to-month, but leave you exposed if an unforeseen cost presents itself. Similarly, if income and expense payment frequencies are mis-aligned, for instance if expenses are paid quarterly and income monthly, you risk not having the necessary cash to hand when you need it most.
“The fact is that one of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality.” Chris Chocola
3. Adopt lean practices, streamline your processes
One of the best ways to optimise your cashflow is to eliminate wasteful activity in your processes that increase the cost to deliver your product or service. Organisations driven by lean thinking & practices achieve competitive advantage because they are based on a customer-first philosophy, recognising that the market ultimately determines the price of goods and services.Therefore, the best way to increase profitability is to lower the cost of delivering your product/service, increasing the margin on each unit.
Think of this as reversing the traditional profit formula:
From: Price = Cost + Profit
To: Price – Cost = Profit
The way to improve this is to understand the work to be done (how you deliver your product/service), which can be split into three parts:
Value-Added – tasks that add value to a product or service
Essential but nonvalue-added – activities that do not add value but must be done to complete the value-creating work
Waste – any action that creates no value for the customer. These are broken down into categories, which you can find here.
Your aim is to eliminate identified waste to deliver value to the customer in the most effective way possible. Identify an ideal future way of working, and begin making the necessary changes. In the first instance, it can often be helpful to bring in a coach or mentor to build your understanding of lean thinking and practices and guide you through the initial stages of your journey.
“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” Peter Drucker
4. Improve stock management
The attraction of economies of scale can be tempting - buy in bulk at a cheaper unit price, and have the security of knowing that you will never run out! The challenge with this is that by doing so, you tie up your valuable cash in stock that you are not due to use, and risk in some cases, if it is not used in time, that stock becoming obsolete. Not only that, the cost of holding inventory can eat into your margins, so holding stock longer than necessary is a no-no.
A helpful way of minimising inventory levels and storage costs, is to calculate 'safety stock'. Safety stock takes into account the amount of stock you'd need to hold to cover your highest daily demand or longest delivery lead times.
The way to calculate it is:
[maximum daily use x maximum lead time] – [average daily use x average lead time] = safety stock
Let's take a coffee shop as an example. On the busiest days, 3kg coffee beans are used up, but on average, usage is 1.5kg per day. Supplier lead times averages at two days, but the longest it could be is three.
The calculation would be: [3 x 3] – [1.5 x 2] = 6kg safety stock
In this case, 6kg coffee beans would be the ideal level of safety stock, therefore you would aim to put in place an inventory system to re-order as stock levels reduce to this level. This covers the possibility of your busiest days, but minimises the level of stock you are holding. There are other variables to consider, such as storage costs, shelf life and shipping costs, but using the Safety Stock calculation will give you an excellent starting point for more effective e stock control.
“There is really only one way to address cash flow crunches, and it’s planning so you can prevent them in advance.” Elaine Pofeldt
5. Maintain a buffer
Imagine a situation where your business income dried up overnight. How long could you survive? This was a very real prospect in 2020 when the COVID-19 pandemic struck. Nobody saw it coming, and whilst the government provided support, many businesses who did not have that safety net were unable to continue trading, and folded.
Understand your business expenses - how much does your business cost to run on a monthly basis?
Identify the fixed costs that you need to pay regardless of your income or how much you sell
Set aside the equivalent of three months expenses. Yummy not be able to do this immediately, but contribute a little per month and build up the pot - it can be helpful to do this in a separate business bank account to 'ring fence' your buffer
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