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:
- Implement best practices for working capital management.
- Create a cash flow forecast and establish a discipline for review.
- Engage in scenario planning and prepare for both challenges and windfalls.
Implement Best Practices for Working Capital Management
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:
- Align Finance and Sales. These departments need to work together to develop payment terms that are reasonable for both the customer and the company. Once the policy is defined, review the customer master data, check for any anomalies, and reconcile those you may find. For example, if the policy is net 30 days, the customer master data should not be net 60 days.
- Create an efficient billing process. Automation is key here, but even automated invoicing can contain errors or go out late. This could be due to an inefficient approval chain, inaccurate data, or other errors. Focus on creating a lean process, set an internal deadline to send the invoice—ideally, within one day of signing the purchase order—and define the owner of customer master data to make sure someone is in charge of keeping it up to date.
- Formalize a collections strategy. First, make sure it’s easy to track aging on your accounts receivable report so you can tell at a glance if any accounts are approaching overdue. Next, define a regular review schedule—for example, checking for overdues every week or every month, depending on your business needs. Then, define a process and schedule for reminders and subsequent escalation steps. Finally, while it’s traditionally the finance department’s role to handle collections, maintaining a close relationship with the sales team can facilitate more effective outreach to delinquent clients.
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:
- Negotiate payment terms in addition to price. We often focus so much on price that we forget to consider how payment terms may affect our cash flow. When evaluating a new vendor, always negotiate payment terms, such as minimizing advance payments or agreeing to credit terms that align with your cash forecast. This may be challenging for a newer business, but as a business grows and its reputation improves, it’s a good idea to renegotiate these terms.
- Increase visibility into your procurement data. When your procure-to-pay process is not strong enough to provide reliable information for your cash flow forecast, it can be difficult to identify problems and plan effectively. Make sure your purchase orders and invoices are promptly matched to make it easy to tell at a glance whether you’re on track to meet your expenses or not.
- Optimize your payment timing. It’s generally best to stick to your established payment schedules in order to ensure predictability, but don’t completely rule out an early payment when it makes sense. If your planning shows that you have surplus cash, consider advancing pay to suppliers that offer early-payment discounts.
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:
- Define minimal inventory levels. To avoid tying up excessive cash in inventory, aim to maintain an inventory level that is sufficient to satisfy fluctuating demand without too much overage. An initial strategy for a small or newer business could be to focus on reducing the number of SKUs. Keep only the most popular items on hand and order the rest as needed. It may increase delivery time for those items, but it will keep your cash free for longer.
- Monitor demand patterns. It is important to understand how your demand changes throughout the day, week, month, and year in order to optimize inventory levels. If you’re having difficulty estimating, consider choosing nearby suppliers that can deliver more quickly so you can order smaller lots more frequently rather than taking your chances on discounted bulk orders that may go to waste. Depending on what you sell, you might be able to order your inventory on demand.
- Get a real-time view. There are many software programs that enable you to manage your inventory. Make sure yours can provide you with a real-time view of your stock and its location (if applicable) so you don’t overpurchase by accident. If you don’t have a software solution, make sure there’s a process in place to sell or use the oldest items first in order to reduce waste.
Create a Cash Flow Forecast and Establish a Discipline for Review
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:
Choose Your Forecast Period and Methodology
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:
- Direct method—usually for less than 12 months. It uses separate schedules for the projected cash in and out based on a cash basis forecast (rather than an accrual basis). This method is best for short-term liquidity planning.
- Indirect method—usually for more than 12 months. The cash flow forecast is based on a forecast income statement that links to balance sheet DSO (days sales outstanding), DPO (days payables outstanding), and DIO (days inventory on hand). This approach can become less accurate than the direct method, which means it’s best for planning capital expenses or allocating capital long-term.
Focus on Actionable Outputs
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
- Investing cash (capital expenditure or disinvestment)
- Financing cash (debt or equity)
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.
Establish a Review Schedule
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.
Engage in Scenario Planning and Prepare for Challenges and Windfalls
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.
How to Manage Shortage and Liquidity Crises: Take Control and Buy Time
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:
- Reduce non-strategic overheads.
- Focus on products and services with higher margins.
- Don’t buy assets—lease them. Sell non-strategic assets and, if feasible, sell and lease back strategic ones, too.
- Prioritize less-risky clients to raise the probability that payments will arrive on time.
- Take pre-orders for products if you have any in the pipeline.
- Don’t cut costs in areas that directly affect business performance if they don’t create any cash benefit.
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.
How to Manage Excess Liquidity: Align Capital to Strategy
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:
- Identify strategic priorities for the business and allocate sufficient capital to reach these objectives.
- Explore strategic opportunities to spend the excess cash (e.g., paying suppliers in advance to get discounts).
- Determine an appropriate level of cash to keep on the side as a cushion for bad times.
- Return any cash left over to shareholders.
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:
- Set the foundations for cash flow management.
- Create a structured approach to planning and review.
- Buy time during liquidity crises to take control of your cash flow, and be careful to address the short-term situation without compromising your long-term goals.
- Align capital to strategy and create competitive advantage when windfalls occur.
Understanding the basics
To optimize cash flow, understand the fundamentals of cash flow management, create a structured process for planning and review, and engage in scenario planning to anticipate liquidity shocks and windfalls.
Your forecast should provide key results to aid decision making. It should include: operating cash, investing cash (capital expenditure or disinvestment), and financing cash (debt or equity). An 18-month forecast is common, but you may want to shorten that period depending on your business needs.
Cash flow represents the ability of your company to pay its bills. Without sufficient cash, your company may be profitable on paper but still risk bankruptcy. Good cash flow management will enable you to reinvest in your company when times are good and weather the storm when times are bad.