How to prevent a cash flow crisis

Ninety per cent of small business failures are caused by inadequately managing the money going in and out of a business, and it is usually this poor cash flow that pushes a business over the edge. With just weeks to go until the new financial year, now is the time for SMEs to ensure they have their books in order to prevent a cash flow crisis.

Understand the difference between profit and cash flow

Profit and cash flow are two very different things, and this distinction should always be recorded in a business' forecast or budget. Your business may be generating a large profit margin and may be experiencing strong growth, but at the same time may not have cash to pay its suppliers.

This may be due to a number of reasons, such as not collecting debts on time to bring anticipated funds into the company, or having cash tied up in excess stock. Alternatively, you may have substantial cash reserves but may be generating a minimal level of profit or even a loss.

Once you understand that profit and cash flow is not the same thing, you can then begin to make profit and cash flow projections. A profit projection is a tool that shows you how much profit you expect to earn over the next 12 months, allowing you to address the viability of your business, according to the South Australian government website.

Learn more about developing a profit forecast plan here >>

However, a profit projection doesn't provide you with a true depiction of your cash position- it doesn't account for:

  • Timing differences (e.g. the length of time between paying your creditors and receiving payments from debtors)
  • Capital payments (e.g. loan repayments, purchase of equipment)

Factoring the above points into your business budget means that you can be alerted to trouble before it occurs, such as having not enough funds at any given point in time.

Learn more about cash flow forecasting>>

Review your credit terms

If you are already experiencing a strain on your cash flow, you may want to review your credit terms as this influences when you receive the money owed to you. Extending credit to your customers is always a good idea to expand your business, but it if your terms are too long, this means you are not getting paid for longer.

Thirty day terms are standard for most high transaction businesses, but some choose to provide fifty day terms or more depending on whether they have the excess cash to pay off their own financial commitments. As small businesses generally don't have large reserves of cash for this purpose, it is a good idea to limit your terms to 30 days or even stagger payments out over a few weeks. This can also reduce the chances of bad debts, which will be further explained below.

You can also implement a similar policy when it comes to paying your own bills- negotiate a payment plan with your suppliers to avoid paying in one hit, particularly for a big job, which can significantly reduce your liquidity. Instead, you can try paying in installments to ensure that the gap between your accounts receivable and accounts payable is not overly large.
Reviewing and updating your credit terms to reflect your risk appetite as a business will help you avoid a cash crisis in these difficult times.

Minimise bad debts

Bad debts are inherently bad for business. Bad debts refer to amounts that cannot be collected and have to be written off as a loss or expense to the business, which can have a severe impact on cash flow. So how can you minimise bad debts?

For low-volume transactions, you may want to institute an upfront payment policy where your customer gives you the full payment in advance, with written assurances that the good or service will be delivered to them. This works for online retail businesses, in particular, as the customer usually pays for the product via their credit card before receiving the goods a few days or weeks later. Ensure that the customer doesn't have to wait too long before receiving the goods and communicate this policy clearly to him/her.

To ensure that your customers pay on time, you may want to institute an early payment discount or some other reward as an incentive. Alternatively, a 'punishment' can work as well, such as charging interest on outstanding payments after a set period.

Lastly, you should consider running a credit reference check on a customer, particularly if you are establishing a long-term relationship with him or her. A credit check can confirm a business' existence or identity, predict financial stability and payment patterns, and provide insight on legal records to help you make the right decision before extending credit.

Determine the level of risk associated with your customer>>

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