Why small businesses need cash flow

There's an old saying in business: "Profit is queen, but cash is king." If you're a business owner, it is critical that you understand the difference between profit and cash, especially with the economy still sputtering and banks reluctant to make loans. It could determine whether your business survives or fails.

If all sales were cash on delivery, cash flow would not be an issue. Your business would sell the product or service, collect your payment, and put your money in the bank. But that's not how most businesses operate these days and the vast majority depends on a healthy cash flow cycle.

This cycle is the time between when cash is paid out (for raw materials, equipment, salaries) and when accounts receivable are collected.

In a manufacturing business, for example, the cycle usually works like this:

  • Cash is used to buy raw materials
  • Raw materials are converted to finished goods
  • Goods are sold and accounts receivable are generated
  • Accounts receivable are collected and converted back to cash again

But if the cash flow cycle stretches too far, it can damage a small business. Let's say a company launches with $100,000 in cash and a new product. The product is so popular that it flies off of shelves in the first few months and the owners are raking in profit- at least on paper. Buoyed by their success, the company opens a second manufacturing facility to further boost production and sales.

Six months later, sales are still booming, averaging $50,000 a month, and profit margins are healthy. But a problem is looming: The owners discover that rather than collecting accounts receivable in 30 days, as they had projected, it's taking closer to 60 days, with some customers waiting as long as 90 days to pay their invoices.

This is when the dominoes start to topple. Without cash, the company falls behind in payments to its suppliers, which soon start refusing to ship raw materials. Without materials to manufacture product, sales plummet. It misses payroll and key employees quit. Less than a year after opening with such fanfare, the company shuts down and becomes another victim of a busted cash flow cycle.

Commercial financing alternatives

In a perfect world, small businesses would be able to access a bank line of credit to get the working capital they need to see them through cash flow squeezes. But in the current economic environment, many companies that would have once qualified for bank financing no longer meet the stringent underwriting guidelines.

So now many businesses are turning to alternative financing vehicles to get the money they need to support their cash flow cycle. These alternatives include factoring, accounts receivable financing, and asset-based lending.

In a factoring relationship, a small business sells its outstanding accounts receivable to a commercial financing company at a discount. Instead of waiting 60 or 90 days or longer to get paid, a business gets most of the cash it is owed as soon as an invoice is generated. The factor then handles collection and hands over the balance of the payment (minus its fee) when it collects on the invoice.

Accounts receivable financing is similar to a bank loan or line of credit. A business will submit its invoices to a lender, which then establishes a borrowing base. This is the amount the business can borrow against. The lender will usually charge a collateral fee and interest on the amount borrowed.

In asset-based lending, a loan is secured by business assets such as equipment, real estate, accounts receivable, or inventory, with interest charged on the amount borrowed as well as fees. The business collects and manages its own receivables instead of selling them to a factor, and it submits a monthly aging report to the lender. There are usually tighter constraints imposed by the lender due to the greater leverage that is available.

Real or paper profits?

A business should never focus entirely on the profits that are showing up on its profit-and-loss statement. Instead, make sure your profits are real, not paper.

To do that, you must forecast your cash flow cycle. Understand the constraints that can be placed on you by suppliers, the ramifications of expansion, and where capital for expansion will come from.

Anticipate what challenges customers can throw at you by paying slowly, starting disputes, etc. And always overestimate your cash gap so you can deal with unpleasant surprises.

If you're experiencing a cash flow crunch or see one coming, don't hesitate to consider alternative financing vehicles such as factoring, accounts receivable financing, and asset-based lending. These vehicles could be the lifeline that ensures your survival.

By Tracy Eden of AllBusiness.com

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