How to avoid cashflow problems and their common causes
Updated 08 November 2019
The term ‘cash flow’ describes the movement of cash into and out of your business. It’s different from both turnover (which is the total amount of revenue you generate) and profit (which is your revenue minus costs), because cash flow is specifically about the amount of money you have available to spend now. It also considers money coming in from all sources, including loans and investments, rather than just how much money you get from clients.
Why is cash flow important?
Every business should strive to have positive cash flow. This means simply that you have more cash coming into the business than going out, so that you always have enough to meet your debts as they fall due (failure to do this can cause cash flow insolvency). Also, the more positive your cash flow, the more money you have available to make new investments in your business.
Negative cash flow means that you have more cash going out than coming in. This doesn’t necessarily mean your business isn’t profitable, but it does mean you are using up your accessible cash faster than you can replace it.
Positive cash flow is important simply because there is so little your business can do without cash to spend. Everything from buying new stock to paying staff wages and business rates depends on having cash available. Think of cash as your business’s fuel – without fuel flowing in, the engine will stall.
Problems with cash flow
It’s possible to have a thriving business and yet still have a problem with cash flow. High turnover and healthy profits are of course great goals to aim for, but if they come at the expense of cash flow you may run into difficulties. Many factors can reduce the level of ready cash you have available, such as unexpected costs, late payments from clients, or an overdrawn director's loan account. As a result your business may find it has no cash with which to settle bills, acquire new stock or pay tax. This is what we mean by a cash flow problem.
Cash flow difficulties can have severe knock-on effects, such as making you late paying tax bills and incurring fines from HMRC. In the worst cases, they may even result in your business folding despite being highly profitable on paper.
Every business needs to remember that money isn’t money until you have it in your hand. New and smaller businesses are especially vulnerable to cash flow problems, as the monthly income may be unreliable and may sometimes be lower than your outgoings. You therefore need a strategy to manage your cash flow to avoid your business becoming insolvent.
Common cash flow problems and how to avoid them
Here are four of the most frequent causes of negative or unreliable cash flow, and solutions for preventing them.
- Tight margins
The profits you make from your products may be too low to cover the total cost of delivering your business. This is a common mistake with new startups that haven’t fully worked out their business model. When pricing a product, do your best to factor in all the costs of getting it to market, and consider dropping it if you can’t find large enough margins.
- Clients who pay late or not at all
Clients will typically try to delay payment for as long as they can – the larger the client, the more they feel they can get away with this. This can put a great strain on your cash flow, especially if the larger clients account for the bulk of your revenue. With key clients like this, try negotiating early payments in exchange for a small discount.
More serious problems can occur if clients miss deadlines or fail to pay at all. The best solution here is to prevent it happening, by checking the payment records and creditworthiness of new clients in advance. In addition, develop strong credit control practices to help you chase and recover bad debts.
- Too much stock
If your business is based on you buying in stock or raw materials to sell on, it doesn’t make sense to keep more stockpile than the business can handle within a set timeframe. Unless you are anticipating a sudden massive order, try to keep only as much stock as you are likely to need before the next delivery window. This is the principle behind ‘just in time’ (JIT) manufacturing, to avoid tying up lots of cash in stock that merely sits around waiting.
If you need to buy in stock that exceeds your cash flow, trade finance (a form of short-term business credit) can be an option.
- Excessive overheads
Your overheads are the expenses that are necessary for keeping the business running, but which don’t relate directly to the business itself. Examples might be literally ‘keeping a roof over your head’, paying for your IT equipment, heating and lighting bills, employing cleaners etc. Often it’s possible to find savings here.
How do I calculate my cash flow?
In principle, it’s simple to calculate your cash flow. Essentially, you just need to work out what your starting balance is for the month, add on how much income you’re expecting and then subtract everything you’ll be spending that month. The final figure is your net cash flow – i.e. how much cash has come into the business. If you end up with a negative figure, it’s a warning that you’ll need to find extra cash this month to cover outgoings. Here is is as a simple equation:
Cash Flow = Balance + Income - Expense
In practice calculating cash flow can be trickier that it sounds, because the key variables (monthly income and outgoings) are not 100 per cent predictable. You will therefore need to make the best estimates you can (your accountant is probably better at this) and err on the side of caution. Various bookkeeping and accounting software is also available to help you manage cash flow.
What is a cash flow forecast?
A cash flow forecast is an estimate of the business’s cash flow over a future period – say, the next quarter or financial year. A strong cash flow forecast can be a vital tool for business planning, as it lets you know how much cash is likely to be available to deliver your plans at any given point.
For example, if you are looking to take on new staff over the coming months, or increase your marketing spend, you can feed these figures into your cash flow forecast to see if your finances are likely to cover these additional outgoings. On the other hand, if there are particular months where business tends to be slow, your forecast can factor these in so you can reduce your expenditure for those periods. In both cases you can predict potential issues before they arise and avoid cash flow problems.
A particular kind of cash flow forecasting is sometimes called cash flow modelling. A cash flow model is a forecast based on a particular future scenario or range of scenarios. For example, if you’re trying to decide between two different growth strategies for your business, cash flow models can provide you with forecasts for both scenarios, to make them easier to compare.
Why are cash flow forecasts important?
A good cash flow forecast or model can be key to business success. Not only can you reduce the risk of cash flow problems, but you can also gain the confidence you need to make longer-term plans. A cash flow forecast need not be just a warning to take care; it can provide reassurance that you will be able to afford your more ambitious business goals, and show you what you need to do to prepare for them.
On the other hand, if you don’t have a good system of tracking your cash flow, planning can become very tricky if not impossible. It can also make it harder to apply for business loans or attract investors. Solid cash flow records and forecasts are a visible sign that your business is well-run, and can pay for themselves many times over in both the benefits to your business, and the investor confidence that they inspire.
An accountant (or financial adviser with business expertise) can help you with cash flow management, forecasting and modelling.
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