How managing cash flow ups your business
Many of my clients talk to me about the annual income targets they have. But I often steer them a bit away from that topic. Why? Because there is another financial metric that I recommend they pay more attention to, and that’s cash flow. And that’s the topic of today’s article.
What is cash flow?
Cash flow is the amount of cash (money on hand) that you have coming into your business, compared to the amount you have going out, over a specific period of time. The most common period of time used is the month, and so we often hear the term monthly cash flow.
Cash flow does not refer to money earned, but to money actually received. So, if you have a new client that just purchased a $1,000 service from you, for which you won’t be paid until next month, none of that money counts in your current month’s cash flow calculations. Similarly, if you sold a service for which you will be paid in monthly instalments, say $1,200 spread out over 12 months, that sale only contributes $100 to your cash flow each month.
It works the same for expenses—only money actually leaving your business for the given time period is counted.
Cash flow is either negative or positive. If you have more money coming in than going out in any given month, you have a positive cash flow for that month. If you have less money coming in than going out, you have a negative cash flow.
Why is managing cash flow important?
The point behind managing your cash flow is to make sure you always have enough cash on hand to pay your bills and yourself. And that’s important, because earning a certain amount of money and actually receiving it are two completely different things. On paper, it is easy (and all too frequent) for a business to show a profit in their books, but not have enough cash on hand to meet its obligations.
Here’s an example.
A construction company wants to build a new sub-division. It has already pre-sold 10 homes at a price of $500,000 each, but they won’t receive any money for those homes until they are built. Until then, the company has many bills to pay: they need to pay the excavators, the road builders, and the construction workers who build the first houses. On paper, the company has earned $5,000,000, but in reality, they are broke—they have no money to pay their ongoing bills. They have high monthly expenses but no cash coming in, so they have a negative cash flow. If the company doesn’t have enough cash on hand to cover these bills, they may have to go out of business.
Here's another example.
A graphic designer who is just starting out needs a new, high quality computer. He purchases one in March for $3,000, and pays for it in cash as one lump sum on March 1. In all of March, he has two clients. Client A purchases services that total $500, for which the graphic designer is paid in full on March 15. Client B client signs a contract for $4,000, to be paid in 4 monthly instalments of $1,000 each, beginning in April. So, for March, the designer’s cash flow is:
Cash in: $500 (from client A)
Cash out: $3,000 (computer payment)
This leaves him with a negative cash flow of $2,500 for the month. On paper, his company has earned $4,500, but he’s still broke.
So, that’s the reason I try to steer my clients’ focus away from annual income. It is far more important to the survival of your business that each month you have a positive cash flow.
How do I effectively manage my cash flow?
Here are some tips to help you manage your own cash flow.
Have cash reserves on hand. Try to always have at least 3 months worth of cash on hand—enough to pay all your bills for those 3 months, and to pay yourself enough income. This money will help in case something comes up. Perhaps you have a delayed project (so you don’t get paid as early as you had expected). Or maybe a client pays you late, or you incur unexpected costs. (Depending on the type of business you have, you may even be wise to have more than 3 months’ worth of cash on hand.)
Don’t unnecessarily tie up money. In some businesses, it is normal for money to be tied up. Businesses that sell products have to buy inventory to have on hand, and don’t receive any cash until those items sell. For many businesses, they have active accounts receivable—items or services that have sold, but for which no cash has yet been paid. But think carefully about how you tie up your money. Try to tie up only what you absolutely need to.
Calculate your runway. Your runway is the number of months you can keep a positive cash flow. It is calculated by dividing the cash you have on hand by your total monthly expenses.
For example:
Total cash on hand: $3,000
Total monthly expenses: $1,500
3,000 / 1,500 = 2 months
When calculating your total monthly expenses, make sure you take into account one-time purchases as well as recurring expenses. And only count as cash coming in money that you know is guaranteed to arrive, and on time. By calculating your own runway, and continually monitoring it, you will be able to predict when your business might be heading for difficulty. The longer the runway, the greater your comfort factor will be. A runway of at least 6 months allows good breathing room.
Pay in instalments. Unless/until you have substantial cash reserves, try to pay monthly or in installments for services, rather than paying in one lump sum. This keeps more of your money in your pocket longer, which adds to your cash reserves and hence your runway, all of which helps to ensure you have a positive cash flow every month. This can be an especially important tactic for large expenses (e.g. annual accounting expenses, business income tax) because it avoids building up huge amounts owing at the end of the year.
Keep a cash flow spreadsheet. If you are a solopreneur, I recommend you keep a simple spreadsheet to record your income and expenses daily (or minimum weekly) so you can easily guesstimate your business’ health at any time. Such a spreadsheet can also help you estimate the amount of tax you have to pay in the year (HST, corporate) which in turn can help you plan for how you will make those payments.
Have a separate business bank account. Keeping your personal finances and your business finances cleanly separated makes it much easier to calculate cash flow. Set up a separate bank account for your business and put all business deposits in there and use that account to pay all your business bills.
Keep all your receipts. It sounds like a simple thing to do, but it is all too easy to misplace receipts. Each receipt you lose is a deduction you cannot claim. And don’t forget to make sure your business is reimbursing you personally for any out-of-pocket expenses. A coffee here and a parking meter there add up, and it is completely legit that your business picks up the expense (as long as the expense was incurred in the pursuit/delivery of business activity).
Hire a knowledgeable accountant. If at all possible, I recommend hiring an accountant. You want one who understands small business and who is familiar with the myriad tax-code changes made every year. Negotiate in advance what documents/numbers you will provide (e.g. your cash flow spreadsheet, receipts, monthly credit card statements, etc.). The more paperwork you do, the more likely it will be that you can negotiate a discount. The easier you can make it for your accountant to formally complete the year-end materials/submissions, the more money you can save on the cost of their service.
Let’s now revisit our graphic designer, and see how managing his cash flow could help him in his business.
Instead of purchasing his computer outright, he might pay for it in instalments (perhaps putting it on his credit card). This would change his cashflow as follows.
Cash in: $500 (from client A)
Cash out: $200 (computer payment)
This leaves him with a positive cash flow for the month of $300. That means he has $300 in the bank to pay for day-to-day business activities, as opposed to the negative cash flow of $2,500 he had when he paid for his computer outright.
Another approach for him would be to save money for a year before starting his business, using that money as his cash reserves. If there is enough there, he could buy his computer outright and still have money on hand for other business expenses.
Let’s say he saves $10,000 before he actually starts his business, and that he buys his computer outright at the beginning of his business operations, leaving him reserves of $7,000. If his monthly expenses are about $1,000, then he has a runway of 7 months ($7,000 / $1,000). That’s 7 months of being able to meet his bills even if he makes zero income in that time. Of course, he will have income, and as he works and adds to his business cash reserves, he will continue to have a healthy number of months in his runway.
That’s it for this week.
Cheers,
Tim
Helping you engineer the business of you
Information in this article is for general purposes and is not intended as professional advice.