It is pretty easy to oversimplify success or failure in a business by reducing it to commonplace terms: black and red, assets and liabilities, boom and bust, profit and loss.
The reality is more complex. In fact, it is so complex that it’s possible to be a profitable business without being an entirely successful one.
Confused? It’s all about cash flow.
There is a common misconception among many business owners that profits and cash flow are the same thing. They are not. For a business to thrive, it must generate profits while also operating with positive cash flow.
The availability of cash can truly make or break an organization. Cash flow, not profits, determines viability. In fact, one study found that 82 percent of businesses fail as a result of poor cash flow management.
Ninety percent of small business failures come from poor cash flow, according to Dunn & Bradstreet. Inability to manage costs, inexperienced management, poor business planning, insufficient capital, poor marketing and sloppy bookkeeping are all major culprits contributing to cash flow problems, a CCH survey of business owners indicates. Another contributor is misconceptions about cash flow. Many entrepreneurs mistakenly assume that because their business is turning a profit, their cash flow is good. This isn’t necessarily true, and clearing up
this kind of confusion can help business owners avoid potentially costly mistakes.
DEFINING CASH FLOW
Businessdictionary.com defines cash flow as operating inflow and outflow of cash through an organization. In accounting, this amounts to the difference between the opening balance of cash available at the beginning of a cycle and the closing balance of cash available at the end. A higher closing balance equals positive cash flow, a lower closing balance is negative.
Various factors can contribute to cash flow. Increasing sales, raising price points, selling assets, collecting payments faster, adding equity, borrowing loans, cutting costs and delaying expense payments increase cash flow positively. Reversing any of these variables, for instance, by a decrease in sales, promotes negative cash flow.
Cash flow affects both a company’s immediate operating capability and its ability to attract loans and investors. A company’s cash flow indicates its future solvency, making cash flow statements one of the major factors lenders and investors consider when evaluating corporate credit risk.
COMMON CASH FLOW MISCONCEPTIONS
Business owners often grasp basic cash flow concepts but labor under misconceptions about their application. One common mistake is assuming that profits automatically translate into positive cash flow. Profits show money businesses have coming on paper, but cash flow is what they actually have now. For example, they might have had profitable sales this month, but their receivables won’t be coming in for 30 days. Meanwhile, they’ve got bills to pay this month that exceed their cash on hand. In this case, despite profit, they still have a negative cash flow. A good rule to remember is that every naira owed in receivables is one naira businesses don’t have in cash flow.
Not only do profits differ from cash flow, but they can sometimes conflict with cash flow if a business is growing faster than their expenses can cover. For example, a company could double its sales and still almost go broke if it is building products two months in advance and getting paid six months late. This is often the case with companies that sell to other businesses who pay months later. Even when businesses are turning a profit, they can run into cash flow problems if their financing doesn’t keep pace with their growth.
For this reason, it isn’t sufficient to simply generate a cash flow statement once a month or review it once a year, which is another typical mistake businesses make. A monthly cash flow statement only tells businesses how they did last month, but if they’re going to avoid cash flow problems next month, they need to project ahead. Because of this, reviewing cash flow once a year does little to help businesses plan for the coming year or the year after that. Dun and Bradstreet research shows that companies that only review their cash flow once a year have a 36 percent survival rate after five years, while those that do monthly planning survive 80 percent of the time.
CASH FLOW MANAGEMENT KEYS
To avoid the problems that stem from cash flow misconceptions, there are two keys to successful cash flow: increasing cash inflow and decreasing outflow. To increase inflow, Strauss recommends sending out invoices on time, collecting payments on time and increasing sales activity enough to cover cash outflow. To decrease outflow, keep overhead low, cut back on non-essential expenses and reduce costs such as labor where possible.
Good cash flow management doesn’t happen by accident. It takes planning, and often, professional assistance such as what Getting rich staying rich group provides. Our team has a powerful combination of education, experience, and specialized training and certification to meet the specific needs of our clients.