The Importance of Cash Flow Management for Small Businesses

Managing a small business, or any business for that matter, means managing cash flow. The operating risk of any business is measured in the volatility of earnings. Ensuring a consistent cash flow stream makes it possible to promote a small business as a stable ongoing concern with the prospects to grow into the future. However one cannot build or manage something that is not measured or forecasted. In order to manage cash flow, small business owners need to forecast it and track it on a regular basis.

One key skill taught in any decent financial management class is forecasting and managing company cash flow. Too few business owners use financial forecasting to identify potential financial issues that can impact earnings. Once learned, forecasting can help small business owners smooth out the regular ups and downs that all companies experience as a normal course of business. In fact the firm’s financial statements and the forecast of future revenues and expenses are some of the most valuable management tools that small business owners have at their disposal.

There are several types of financial forecasts that an owner may need to prepare.  The purpose of all of them is to show a realistic picture of the firm’s future cash flow.  One type of cash flow forecast are those required by prospective lenders.  Creditors will look and stress a company’s financials and cash flow forecast, to determine if a business will be able to cover principal and interest payments during the life of a loan.  Stressing the cash flows means looking at scenarios where income and expenses are negatively impacted, to determine if the company can still fulfill its obligations in tough economic times.  The Small Business Administration distributes a cash flow budget worksheet on its website that can be used to develop a forecast used by lenders.

The second kind of cash flow forecast is one that business owners use to manage their cash flow on a periodic basis. There are several templates and software packages that can be purchased online, but with a little research you can find free tools to help you understand and prepare forecasts for cash flow management.  One free Excel template is available on AllBusiness.com. 13-week cash flow forecast Microsoft Excel template comes with instructions and can be easily modified for nearly any type of small business.

If you have a small business that is experiencing erratic revenues, or if your company is growing rapidly, has a seasonal income stream, or is being affected by a weakening economy, it is important that you forecast both revenues and expenses and identify any potential financial issues that may arise in the future. When managing cash flow, you need to remember three fundamental principles:

1. Cash equals purchasing power. An adequate amount of cash reserves is necessary to support the business against the risk of unforeseen financial issues. Each business needs a specific amount of reserves appropriate to that business.  The only way to determine if you have the necessary reserves is to forecast your needs and manage operating cash flow, so that you will always have the requisite amount on hand.
2. Change your operations accordingly.  If your forecast indicates either a period of decreasing sales or increasing expenses, it may be necessary to accelerate collection of receipts and decelerate payment to venders. The goal for cash flow management is to keep earnings consistent over time.
3. Reserve working capital.  Working capital is equal to cash (and short term assets) less current liabilities.  Cash management means making sure that short term liabilities are covered and that there is always enough cash to mitigate unforeseen risks. This also means not prepaying invoices without a significant discount and making sure that inventory balances are kept at a minimum.

Every small business owner should strive to reduce all business risks.  Although it impossible to forecast all potential risks, disregarding them and foregoing cash management is a recipe for failure.  A business is only a strong as its cash flow and its cash reserves.  Often, a small business’ ability to demand decent terms from vendors, financing from creditors, and retain customers is a function of its financial health, which is measured by the stability of its earnings.