Small and medium enterprises (SMEs) are pretty resilient. They are surprisingly capable of withstanding most shocks, and can remain in business for a long time. But the day they stop being able to enjoy a positive cash flow and pay off critical expenses, is the day they’re most likely to fail.
This goes to show why understanding and managing cash flow is a critical aspect of business success. Every business should keep a close eye on how money enters and leaves their business, no matter how big or small they are.
If, like many business owners, you still struggle with understanding what cash flow means and why it is important, you’re in the right place. In this quick blog, we explain what cash flow means to a small business, the benefits of paying attention to your cash flow, and how calculating working capital can help show the financial health of your business.
What is cash flow?
Although you’ll find many technical definitions of cash flow, especially in accounting resources, the concept is quite simple really. Cash flow refers to the movement of money into and out of your business. It tracks your incoming revenue, compared to your outgoing payments and financial obligations.
Cash flow may be positive or negative. A positive cash flow exists where your incomings exceed your outgoings. This means you are receiving more money in the form of payments and other revenue over a period, as compared to the money you have to pay out during the same period. Positive cash flow is a good thing because it means you always have sufficient cash on hand to meet daily expenses and other financial obligations.
A negative cash flow, on the other hand, means you have more cash going out of your business than you have coming in. This is problematic for most small businesses because SMEs already typically operate on fine margins. They need customers to pay up quickly so they can refresh inventory, meet operating expenses, and pay salaries. So, if you have less money than expenses, this can be a significant problem.
Cash flow management is the practice of keeping a close eye on cash flow and acting quickly to prevent a negative cash flow situation. SMEs and startups that stay on their toes when it comes to monitoring cash flow have a better chance of staying in business longer and achieving real success. Here’s why that is the case.
Why is cash flow important to SMEs?
Just as sufficient flow of blood is critical to human health, positive cash flow is a critical component of a healthy business. With good cash flow understanding and management, small businesses can better understand their financial health and this can help them stay in business longer. Here are more reasons why it pays to stay on top of cash flow:
- Avoid business failure: Poor cash flow management and understanding are two of the biggest contributors to SME failure. According to one study, data indicated that 82% of the time, small businesses fail because they don’t understand or properly manage their cash flow. When businesses pay attention to their cash flow, they can quickly identify where things don’t look good and plug whatever holes need plugging.
- Deal better with payment obligations: Poor cash flow can really put a squeeze on SME finances. Considering that 1 in 5 SMEs experience delays with customer payments, there’s very little scope to get things wrong. Your business needs to be able to do more with the cash available to it, and proper cash flow management will be critical to this.
- Freedom to negotiate better financing terms: Businesses that are not feeling the breath of creditors up their necks are in a better position to assess and, where possible, renegotiate their borrowing terms. This helps the business maximize its financial assets at every turn, leading to a healthier financial profile in the long run.
- Ability to invest in new products: Have you been thinking about taking advantage of a new industry opportunity that just opened up? It will be suicidal to undertake such financial exposure without a proper understanding of where your business is cash-wise. Cash flow management helps you tell if your startup or SME is buoyant enough to take such a step, or if you have to trim some of your expenses first.
- Better financial planning: Lastly, a good understanding of cash flow leads to better financial planning. Knowing your financial health lets you identify what is working, what isn’t working, and what needs tweaking. For instance, if you consistently have negative cash flow, this can indicate that you either have too many short-term financial obligations, or your customers need to be paying quicker.
Now that you understand why cash flow is important to your business, let us turn to the role that working capital plays, and how to calculate both working capital and cash flow.
How to calculate working capital and cash flow
Every business should regularly assess its financial health. Calculating working capital and cash flow are an essential part of this.
Working capital refers to the amount of money you have to deal with the daily expenses of running your business. It includes how much cash is available to deal with your short-term financial obligations. These are financial obligations that will generally become due between one month to one year from the date of your calculation.
Working capital is an aspect of cash flow. It is essentially what you have left after deducting your financial inflows from outflows during a period. The two main aspects that you have to consider with working capital are your current assets and your current liabilities.
Current assets include assets such as accounts receivable (outstanding payments from customers), cash, inventory, marketable securities, and prepaid expenses. These are all assets that can be converted into cash within a year or less. Current liabilities include accounts payable (payment obligations you must honor), taxes owed, lines of credit, short-term loans etc. Next up, is how to calculate working capital.
Calculating working capital
When calculating working capital, there are two formulas you can use. The first is net working capital, which allows you see a dollar amount for how much working capital you have. The second is the working capital ratio, which lets you calculate the difference between current liabilities and current assets.
- The formula for net working capital is Net Working Capital = Current Assets – Current Liabilities.
- The formula for working capital ratio is Working Capital Ratio = Current Assets / Current Liabilities.
When calculating working capital ratio, an ideal ratio is between 1 and 2. If you have less than 1, it means your current liabilities exceed your current assets. But a ratio greater than 2 may indicate that you are not sufficiently utilizing your financial resources.
Calculating cash flow
There are quite a few cash flow calculations you can carry out to determine the financial health of your business. However, we will focus only on calculating your cash flow forecast here, which involves identifying what the difference between your inflows and outflows will look like over a period.
- The formula for cash flow forecast is Cash Flow Forecast = Cash in Hand + Projected Inflows – Projected Outflows.
One you determine the state of your cash flow, you will be better equipped to take the right corrective actions to keep your business healthy, whether that involves demanding quicker payment from customers or looking for a more favorable payments provider.
Stay on top of your cash flow with Reap
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