Businesses fail for many reasons but the #1 reason SMEs fail is due to cash flow problems. We have seen the construction sector reeling from the aftermath of the pandemic with listed firms being liquidated due to their inability to repay debts. Some of these are What went wrong?
Cash flow is the lifeline of any business, both big and small. It is the movement of money in and out of your business just like how water is necessary for your survival. Proper cash flow management ensures that your business has enough funds to cover expenses, invest in opportunities, and navigate through tough times. In this article, we will dive into the basics of cash flow, why it is essential for SMEs, and how to manage it effectively.
What is Cash Flow?
Cash flow refers to the net amount of cash and cash equivalents moving in and out of a business. Cash flow analysis (categorising your cash flow) allows for effective financial management because it provides us with more insight into our financial. For example, if only 10% of your net profit is derived from operating cash flow, it could mean that the core business model is not generating much cash and this could present as a red flag. The 3 types of cash flow include:
- Operating Cash Flow: This is the cash generated from your main business activities. It includes revenues from sales and payments made for expenses such as salaries, rent, and utilities. If you are a fashion business and sub-renting your warehouse, revenue and expenses generated from sub-renting is not considered. In the simplest terms, a positive number is generally good while a negative one is generally bad.
A common usage of operating cash flow is to calculate:
Operating cash flow ratio (or liquidity ratio) = Operating Cash Flow / Current Liabilities
If you are struggling to pay salaries and rent every month, there is a high chance that your ratio is below 1, indicating that your main business activities is not generating enough cash to cover its current liabilities.
- Investing Cash Flow: This includes cash used for purchase in long-term assets such as property, plant, equipment, or other businesses. It also covers the cash received and expenses associated from the sale of these assets.
A negative Investing Cash Flow does not mean bad news. If you just purchased a business for $1,000,000 that can generate $200,000 after-tax profit a year, this number will be negative for you.
- Financing Cash Flow: This includes cash transactions related to financing the business. It includes proceeds from loans, issuance of shares, and repayments of debt.
Likewise for this, a negative Financing Cash Flow does not mean bad news. You may have repaid your bank loan due to excess cash generated from operating activities, resulting in a negative number.
If you do not have an accountant in-house that can help you gather these numbers in a timely and accurate manner, you may want to consider getting an outsourced accountant.
Importance of Cash Flow for SMEs
For SMEs, maintaining a positive cash flow is vital for several reasons:
- Meeting Obligations: Regular expenses such as salaries and CPF contributions, rent, and utilities must be paid on time. Positive cash flow ensures you can meet these obligations without delay. A company that doesn’t pay timely worker’s levy may have all their company work passes cancelled.
- Business Growth: A healthy cash flow allows you to reinvest in your business, whether it is expanding your operations to a new market, purchasing new equipment, or hiring additional staff.
- Handling Emergencies: Unexpected expenses or economic downturns can strain your finances. Adequate cash reserves provide a buffer to manage such situations without jeopardizing your business. Before I withdraw our profits to distribute as dividends, I will look at the business trajectory for the next 3 years to determine how much cash is necessary to reach that goal. A rule of thumb is to set aside at least 20-25% of your net profit as retained earnings.
- Securing Loans: Lenders and investors look at your cash flow to assess the financial health of your business. Positive cash flow improves your chances of securing loans because it means you have the ability to repay your loans or attracting investors because it means your business is more valuable.
Common Cash Flow Problems for SMEs
Despite its importance, many SMEs face cash flow challenges. Here are some common issues:
- Late Payments: Delayed payments from customers can create cash flow gaps, making it difficult to cover your own expenses. I have heard of customers claiming that they will definitely lose the business if they chase for a payment even though it’s a month late.
- High Overheads: Excessive operating costs can drain your cash reserves quickly, leaving little room for investment or savings. A good example is WeWork, a company once worth $47 billion. They ended up in bankruptcy as they could not sustain their expensive leases when the pandemic led to many corporate clients cancelling their agreements.
- Poor Inventory Management: Holding too much inventory ties up cash that could be used elsewhere in the business. There is no 1 right number because it varies from industry to goods type. Studying your cash conversion cycle over time may give you an indication
- Seasonal Fluctuations: Businesses with seasonal sales patterns may struggle to manage cash flow during off-peak periods.
Managing Cash Flow Effectively
Effective cash flow management involves monitoring, planning, and taking proactive steps to ensure your business remains financially healthy. Here are some strategies to help you manage your cash flow:
- Cash Flow Forecasting: Regularly forecast your cash flow to predict future cash needs. This helps you anticipate shortages and take corrective action in advance. Use historical data and adjust for anticipated changes in sales and expenses.
- Invoice Promptly: Send out invoices as soon as a sale is made and follow up on overdue payments. Consider offering discounts for early payments to encourage customers to pay promptly.
- Control Expenses: Regularly review your expenses and identify areas where you can cut costs without compromising on quality. Negotiate with suppliers for better terms or bulk discounts.
- Manage Inventory: Optimize your inventory levels to avoid overstocking and understocking. Use inventory management systems to track stock levels and forecast demand.
- Access Financing: Establish a good relationship with your bank or financial institution. Having a line of credit or a short-term loan can provide a safety net during cash flow shortages.
- Diversify Revenue Streams: Explore additional revenue streams to reduce dependence on a single source of income. This could include offering new products or services or entering new markets.
Tools for Cash Flow Management
Several tools and software can assist you in managing your cash flow effectively. Here are a few popular ones:
- Accounting Software: Programs like QuickBooks, Xero, and MYOB can automate invoicing, track expenses, and generate cash flow statements.
- Cash Flow Management Apps: Apps such as Float and Pulse integrate with your accounting software to provide real-time cash flow forecasts and insights.
- Spreadsheets: For those who prefer manual tracking, spreadsheets can be a simple and effective way to monitor cash flow. Templates are available online to help you get started.
Call-to-Action: Take Control of Your Cash Flow
Understanding and managing cash flow is crucial for the success and sustainability of your SME. Take a moment to review your current cash flow situation. Are you frequently short on cash? Do you struggle to meet your financial obligations on time? If so, it’s time to take action.
- Assess Your Cash Flow: Conduct a thorough review of your cash flow to identify any issues. Look at your cash inflows and outflows over the past few months.
- Create a Cash Flow Forecast: Use your findings to create a cash flow forecast. This will help you anticipate future cash needs and plan accordingly.
- Implement Management Strategies: Apply the strategies discussed in this article to improve your cash flow. Monitor your progress regularly and make adjustments as needed.
- Seek Professional Help: If you find it challenging to manage cash flow on your own, consider seeking help from a cash flow consultancy. Professionals can provide valuable insights and customized solutions for your business.
By taking these steps, you can ensure your SME remains financially healthy and poised for growth. Don’t wait until it’s too late—take control of your cash flow today and secure the future of your business.
Proper cash flow management is not just about keeping your business afloat; it’s about positioning your SME for success in a competitive market. With the right tools and strategies, you can turn cash flow management from a challenge into an opportunity for growth. Start by taking a close look at your cash flow, identify areas for improvement, and take proactive steps to ensure your business thrives.