It’s tragic where a company that would be healthily profitable fails because of short-term cash flow problems. Yet this is the way the world works, it’s difficult to pay people with money that hasn’t arrived. Suppliers, banks, and other stakeholders can’t rely on your promise they will get your payment if you keep delaying its delivery.
Even if you know you will be profitable in the long run, cash is constantly flowing through a business and it’s not uncommon for your clients to take longer to pay than you might like. Seasonable businesses are particularly at risk where most of their income comes in large deluges rather than spread evenly throughout the year. If you think you may find yourself in this predicament there are several ways you can prepare to protect your business.
You may think this is obvious yet still the median small business holds only 27 cash buffer days in reserves. Despite everyone knowing an emergency fund is needed, it seems few actually ensure they have enough in reserve in their pursuit for growth.
There is much confusion about exactly how much is needed but clearly, 27 days is subpar and leaves small businesses at high risk of any unexpected shock. A good benchmark is three to six months’ worth of cash which allows your business to ride most reasonable complications.
Jody Grunde of the Summit CPA Group explains why “Have cash on hand. We advise that 10% to 30% of annualized revenue be in the bank, which equates to having three to six months of expenses saved up in case of an emergency. That will aid in making good decisions, not the reactive decisions that are often made in economic uncertainty.”
Line of credit
A line of credit business loan acts as a lifeline when times are tough. Although it is termed a loan, it more closely resembles what a credit card is for consumers. It is an agreement between a business and a bank whereby a certain amount of money is made available at any time the business should need it. It is far less stressful than needing to apply for loans for specific items as you do not need to provide evidence of why you need the money. The access is always there which gives constant reassurance.
Interest rates on lines of credit are generally pretty low and the limits tend to be high relative to credit cards as banks have more trust in businesses to be able to pay back in the longer term. It’s also good if you want to apply for a loan in the future as Bank of America says “Maintaining a line of credit in good standing may help build your business credit rating and position you for better loan terms if you seek future financing.”
Analyze customer creditworthiness
Although you may want your business to appear friendly, it’s important to not be naive. Accepting large orders with the promise of future payment can crush a company’s finances if the customer is then unable to pay back. This has taken down countless companies because they did not have adequate checks. You must consider the likelihood of completed payment.
A well-established formula to use is the 5Cs. These stand for:
- Capital – This means in the worst-case scenario they claim they cannot pay, there is legal recourse to attempt to gain the money back through the courts.
- Capacity – The customer’s previous finances and current obligations can be used to decide whether or not they are healthy enough to pay you back.
- Conditions – These are the terms of the agreement itself. Are these likely to be met or are they unrealistic?
- Character – This is a difficult judgment to make for a new customer but it is trying to determine what their past is like and whether or not they have been trustworthy in the past.
- Collateral – This is where the customer gives you temporary ownership of their assets such that if they do not pay then you can keep them.
While this formula is not perfect, it’s a good baseline of things you should be checking for when dealing with customers, especially for high ticket orders.
Make regular forecasts
To add resilience to your cash flow, you need to be forward-thinking, not just reactive. This is good business practice not just with cash flow but across all parts of your business. In order to spot potential crunch moments, you need to forecast what your cash flow will look like in the future. This means you can take preemptive action that could be the difference between survival and failure.
You should regularly create forecasts 6-12 months in advance and take note of seasonal fluctuations. There are three steps to creating a forecast.
Firstly, list out all your estimated income including non-sales income. You should base this on past numbers whilst taking into account any growth or expected challenges.
Secondly, list all your expected outgoings. This should include all costs both operational, financial and ad-hoc.
Finally, you want to combine the two numbers to work out your net cash flow and you can see which months are in the negative. From this, you can ensure you increase your savings if you need to and put off any unneeded expenses.
It’s important to regularly repeat this exercise as soon as any new information invalidates old predictions. Forecasts are only as useful as the quality of information that has been used to generate them.
Running a small business is difficult and cannot be taken lightly. Managing your cash flow is essential to keeping it running smoothly and these four tips can make the business more resilience:
- Have a 3-6 month emergency fund
- Open a line of credit with an established bank
- Analyze customer creditworthiness
- Make regular forecasts to preempt any issues
Always remember there is professional help available if it becomes too much to bear. It’s better to ask for help earlier than later!