Poor cash flow management or a lack of understanding of cash flow is often the reason for business failures. The top reason for small business failures is that they run out of money. Here, Statista shows that running out of cash is one of the reasons why startups fail. Without proper cash flow management, a business struggles to pay bills, meet obligations, and invest. If poor cash flow management is the main reason why most companies fail, then you and I must be aware of this. This blog post covers the basics. It answers questions like what is cash flow, how it works, and what are the ways to manage it properly.
What is Cash Flow?
Cash flow is an important aspect of any business’s financial health. So, what is cash flow? Simply put, it’s the movement of money in and out of a business or organization. A company with a positive cash flow means it is receiving more money than giving it out as expenses. Therefore, a positive cash flow indicates that the business is financially stable and sustainable. On the other hand, a negative cash flow is a sign that the company is giving out more cash than receiving it, which could lead to financial difficulties.
Main Reasons for Cash Flow Problems
If you can learn how to identify the signs that indicate cash flow problems in your business, you can do something about it. Here are some of the main reasons for cash flow problems in firms:
- Poor Sales: Sales should be sufficient to cover business expenses. If not, then it could lead to a cash flow problem. If your company isn’t generating enough revenue to cover the costs, then the key focus should be to determine the cash outflows. You should also identify ways to control them. The next thing to focus on is making your sales figure higher.
- Businesses often suffer from cash flow problems because they do not collect money fast enough. This especially happens if you sell to large companies or the government. It can be a big challenge as large companies usually take a long time to pay. Small companies should take steps to collect money. They can adopt follow-up processes if they don’t receive payments in time.
- High expenses: A bit obvious yet another important reason for cash flow problems can be that the company’s expenses are very high. Monitoring your business’s expenses and justifying each expense can prevent your company from having a high amount of cash outflow.
- Inefficient inventory management can result in overstocking. Overstocking ties up cash. It is money that is lying around and not working for your business. It’s the money that could be used for other purposes. Companies should learn to have a great inventory management system. A system where you do not know overstock while simultaneously keeping your suppliers and customers happy and not impacting your cash flow too. Bad inventory management can lead to financial problems in the company. Read here to learn more about ways to manage your inventory effectively.
- Businesses that are growing rapidly will be employing people, increasing receivables, and spending more money, leading to cash flow problems.
There have been plenty of real-life examples of companies that have failed due to poor cash flow management. One example of such a company is Blockbuster LLC. Like Kodak and RadioShack, Blockbuster LLC was once a dominant player in its field. The company was one of its kind in the video rental industry. Unfortunately, its inability to adapt to the changing market trends and competition from streaming services (Netflix) resulted in its downfall. The company was also criticized for its poor cash flow management, including excessive debt and a failure to invest in digital technology. Despite efforts to stay afloat, Blockbuster ultimately filed for bankruptcy in 2010.
Profit Vs. Cash Flow
Often people confuse profit with wrong cash flow. Profit and cash flow are two different metrics. Profit and positive cash flow are other financial metrics that measure a company’s financial health. Profit refers to the amount of money a company makes after all its expenses are deducted from its revenue. Positive cash flow, on the other hand, refers to the amount of cash that a company has after paying all its bills.
A company showing a positive net profit in its statement of comprehensive income doesn’t necessarily indicate a positive cash flow. Neither does a positive net profit suggest that it may be doing well. To determine a company’s overall financial health looking at the profit figure isn’t enough. There are multiple factors that have to be analyzed. (A topic for another blog post, perhaps.)
Coming back to the profit vs. cash flow debate. So, what is cash flow exactly? Cash flow is the amount of cash the company has after it has paid all its bills (direct and indirect costs such as rent, salaries etc.) and other relevant expenses. Cash flow indicates the company’s ability to turn its assets into cash. In contrast, profit is money left after deducting expenses from the revenue (Basically, profit= revenue-expenses). A company can generate a positive net profit. Still, it may have, for example, made significant investments in long-term assets such as equipment, or it may have extended credit to its customers leading to an increased amount of receivables (and hence more money on hold there). These factors can reduce the company’s cash flow even though it is making a profit on paper. A negative cash flow indicates poor liquidity of the company. This means the company faces difficulties paying its bills and meeting its financial obligations.
In summary, profitability does indicate a company’s financial health. However, cash flow tells us about the company’s liquidity, i.e., whether it can have enough cash to pay its expenses and invest for growth in the future.
Expert Outsourced Cash Flow Projections from EA
Many startups and small businesses fail due to poor cash flow management. Poor cash flow management can make even a profitable company face liquidity problems. EA’s Outsourced Cash Flow Projections help clients ensure they have adequate cash to meet their operational and strategic commitments. The business environment today is constantly changing. Companies that plan early and keep up to date gain an edge over their competitors. Cash flow projections help companies estimate the expected cash inflow and outflow in the future, allowing them to prepare for the future. Companies can have a clear picture of their expected cash position, enabling them to identify potential cash flow problems in advance.
Let EA’s Cash flow projections help your company make informed decisions about its finances by:
- Anticipating future cash needs: By projecting future cash inflows and outflows, companies can better plan for their cash requirements and make arrangements to secure funding if necessary.
- Managing debt: Companies can use cash flow projections to assess their ability to meet debt obligations, such as loan repayments and interest payments.
- Forecasting cash surpluses: If the projections show that the company will have a cash surplus, the management can make informed decisions about investing or utilizing that cash.
- Identifying cash shortfalls: Cash flow projections can help companies identify when they may be facing a cash shortfall and take steps to address the problem before it becomes critical.
- Improving financial planning: By providing a clear picture of expected cash inflows and outflows, cash flow projections can help companies make better decisions about their future financial planning and investment.
This guide answers questions like what is cash flow, how it’s different from profit, and how cash flow projections can prevent companies from facing solvency and liquidity problems. Profit and cash flow are often wrongly interpreted as the same thing. They are, in fact, two different metrics. Profit may indicate a company’s financial health; however, if a company doesn’t have enough cash flow, it may have liquidity problems. Cash flow projections provide companies with valuable information as they prepare for the future. Using this information, companies can make informed decisions about their finances and take proactive steps to manage their cash flow and financial health. Therefore, it won’t be wrong to state that cash IS indeed king in business. However, businesses must carefully manage their cash flow to ensure they have enough to keep moving forward.