While market conditions can change over time, one thing remains true for every company: Cash is essential. Without proper cash flow optimization, businesses can be profitable on paper and yet still be at risk of bankruptcy if they can’t pay their bills.
Small and medium businesses are especially prone to irregular cash flows and limited liquidity, making it crucial to pay close attention to working capital and set processes in place to manage it before challenges—such as a pandemic—arise.
Even though COVID-19 didn’t affect every industry the same way, the uncertainty it generated put working capital top of mind for many owners. And for good reason: A 2021 Federal Reserve study showed that 65% of small businesses had trouble paying operating expenses in 2020, and nearly half struggled to pay rent or pay down debt.
In my time as a fractional CFO, I’ve seen many companies struggle to implement an effective strategy to manage their cash flow. Often, they look to external funding sources before looking internally, which can be tempting for a growing business, but companies rarely raise enough cash that way.
Less than 5% of startups raise venture capital. And applying for loans is no sure bet, either: According to a 2019 Federal Reserve survey, barely half of the US small firms that applied for financing received the full amount sought. For more than half of small businesses, external financing involves adding personal guarantees as collateral for the debt. As these owners are seeing now, those debts may be coming due before business rebounds.
A better first step is to create a structured approach to cash flow management and make sure it’s fully optimized. This will not only provide sufficient liquidity to sustain operations and fund growth during the good times but will also add a layer of stability during difficult times—while eliminating or reducing the need for additional financing.
A structured approach rests on three key pillars:
Working capital is the difference between current assets and current liabilities, and it represents the liquidity available for a business to meet its short-term financial obligations. Before you make a plan to manage this cycle and improve cash flow, start by understanding and optimizing each of these elements: receivables, payables, and inventory.
It can be tempting to relax your payment terms in order to generate more business, such as offering discounts or allowing clients to pay late because there are no formal follow-up processes. But there’s a trade-off between liquidity and profitability: If you give your customers too much slack, you may make a lot of sales but not a lot of cash.
Seize these three important opportunities to optimize your receivables:
While you can set the terms for receivables, payables require you to follow somebody else’s terms. Payment terms can vary widely across your supplier base, creating both opportunities and challenges.
Here are three great ways to optimize your payables:
Inventory is often the biggest money pit for a business. Not all companies deal in inventory, but if yours does, keep these three practices in mind:
Once you have laid the foundations for disciplined cash management, you can start to monitor your cash flow and plan ahead. Many businesses monitor their cash flow closely only when they encounter liquidity problems, but regular monitoring can help you take advantage of surplus cash. Automation is extremely helpful here, but when that’s not an option, here are some practical steps to manage it by hand:
A 12- to 18-month forecast is a good rule of thumb, but it may not make sense for your company or industry. Once you define a reasonable forecast period, you will then be able to roll forward as more data becomes available.
There are two methodologies to consider for cash forecasting, depending on your period and needs:
Outputs should provide key results to aid decision making. The complexity of the forecast can vary based on your company’s needs and size, but it should contain three key elements:
Operating cash should be your primary area of focus because that will determine your needs for financing or the opportunity to reinvest the capital in strategic initiatives.
The main goal of the cash flow forecast is to give actionable information so it should be fit for purpose. Keep your model as simple as possible—the more complex it is, the more prone to error it may be and the less useful the information may become. Keep your inputs organized, processing simple, and output clear.
During ordinary times it may suffice to review your cash flow on a monthly basis, but when conditions get tougher, you may want to move to a weekly review to improve the accuracy of the information. Compare your forecast with your actual statement and analyze the variances to improve accuracy. Schedule the review before the company’s defined payment day so that it will be possible to manage adjustments to the payment plan.
In uncertain times—such as a pandemic—it may be useful to do some scenario planning and determine the actions your business may need to take in order to stay afloat. Identify the best case, medium case, and worst case outcomes. For each case, estimate how long the crisis may last and what measures should be put in place to sustain your business during that period.
If you are planning in more stable times, you can still stress test your forecast. Pinpoint what could trigger a liquidity problem (such as hiring new staff, opening a new branch or factory, investing in capital projects, or adjusting for significant exposure to a single client that becomes a less reliable customer), define how that could impact your forecast, and identify what you can do to mitigate the risk.
Shortage and liquidity crises could derive from external factors (e.g., changing market conditions) or internal (e.g., operational inefficiencies). In both cases, the most important thing to do is buy enough time to address the challenges within your organization or to tide you over until market conditions stabilize.
Before tackling strategic or operational change, have as clear an understanding as possible of how much time you need to buy. (As we saw during the pandemic, some shocks are harder to predict than others.) During this period, focus on solving the short-term problem in a way that supports your long-term goals as much as possible.
Pay particular attention to immediate actions that can generate cash without affecting the business, and execute as many as you can. Some practical examples include:
Perhaps the most important of all: Communicate with your creditors. Open communication is critical to buying time. When a liquidity crisis strikes, it’s natural to want to keep that information from your vendors so you don’t damage the company’s reputation, but silence will damage your reputation more. Delaying payments without explanation will invariably compromise your vendors’ trust. Let your vendors know what is happening with your business, why they’re not getting paid, and when they can expect payment based on your crisis plan.
While it can be less stressful to manage excess liquidity compared to a shortage, it can be just as easy to get it wrong. The major risks are allocating capital in areas that are not strategic for the business or returning money to shareholders before analyzing whether you have enough cash to make strategically significant capital expenditures first.
The best way to optimize your excess cash is to:
Creating discipline in your organization is critical for optimizing your cash flow, increasing your resilience against liquidity shocks, and capturing opportunities when excess liquidity arises. To do this: