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Updated on September 19, 2022
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Daniel Rathburn
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Fact checked byDaniel Rathburn
Daniel Rathburn is an associate editor at The Balance. He has over three years of experience working in print and digital media as a fact-checker and editor. Daniel holds a bachelor's degree in English and political science from Michigan State University.
In This Article
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In This Article
- Importance of Cash Flow Management
- Examples of Cash Flow Management Problems in Business
- Acme, Inc. Cash Flow Statement for the Year Ended Dec. 31, 2021
- Solving Cash Flow Problems
- Debt Financing vs. Equity Financing
- Frequently Asked Questions (FAQs)
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The definition of cash flow managementfor business can be summarized asthe process of monitoring, analyzing, and optimizing the net amount of cash receipts minus cash expenses. Net cash flowis an important measure of financial health for any business.
Key Takeaways
- Cash flow management is perhaps the most important facet of running a small business.
- Extended cash shortages, which occur when there's a large gap between cash inflows and outflows is a common reason why businesses fail.
- Many accounting softwares have cash flow management built into it.
- One strategy to improve cash flow management is to shorten the conversion period.
Importance of Cash Flow Management
One of the most common reasons cited as why businesses fail is poor cash flow management. If your business constantly spends more than it earns, you have a cash flow problem.
For small businesses, the most important aspect of cash flow management is avoiding extended cash shortages, caused by an overly largegap between cash inflows and outflows. You won't be able to stay in business if you can't pay your bills for an extended period of time.
Examples of Cash Flow Management Problems in Business
Real estate development has always been a highly cyclical industry, and developers are often prone to cash flow problems. Property development requires significant initial capital investment, as well as ongoing cash outflows for operations.
Unless some or all of the development can be sold before construction, developers often run into cash flow problems before the development begins to sell off, particularly if the property market happens to soften during construction. Many property developers have been forced into bankruptcybecause of negative cash flow for extended periods of time.
Any business that's undergoing rapid expansion can run into cash flow problems as well. Business expansion generally involves higher labor costs as new employees are hired, higher rent for additional space, higher advertising costs, and more capital investment for new facilities, equipment, and so on. Having to maintain increased levels of inventory can also eat into excess cash.
Extending credit to other businesses is another common way for businesses to run into cash flow problems. Invoicingis normally done on 30- or 60-day terms, and it isn't unusual for customers to delay payment, which can leave a business in a cash flow crunch. An example of a business with cash flow management problems and a negativecash balance for the year is:
Acme, Inc.Cash Flow Statement for the Year Ended Dec. 31, 2021
| Cash Flow From Operations | $ |
| Receipts | |
| Customer Invoices | $80,500 |
| Other | $1,500 |
| Disbursem*nts | |
| Employee Salaries | -$45,000 |
| Suppliers | -$25,500 |
| Other | -$5,000 |
| Net Cash Flow From Operations | $6,500 |
| Cash Flow From Investments | |
| Equipment and Software Purchases | -$5,500 |
| Net Cash Flow From Investments | -$5,500 |
| Cash Flow From Financing | |
| Loan Payments | -$3,300 |
| Shareholder Dividends | -$5,000 |
| Net Cash Flow From Financing | -$8,300 |
| Net Change in Cash Balance | -$7,300 |
Solving Cash Flow Problems
As a business owner, you need to perform a cash flow analysis on a regular basisand use cash flow forecasting so you can take the steps necessary to head off cash flow problems.Many software accounting programs have built-in reporting features that make cash flow analysis easy.This is thefirst step in cash flow management.
The second step of cash flow management is to develop and use strategies that will maintain adequate cash flow for your business. One of the most useful strategies for your small business is to shorten the cash flow conversion period so that your business can bring in money faster.
If your business is expanding, you may need one or more injections of cash during the growth phase. This can take the form of a business loan from a financial institution known asdebt financingor equity financing from investors.
Debt Financing vs.Equity Financing
Debt financing is common for assets, such as equipment, buildings, land, or machinery, when the assets to be purchased are used as security orcollateralfor the loan. The main advantage of debt financing over equity financing is that the business owner doesn't have to give up partial ownership of the business and thus can retain full control. For short-term cash flow shortages, many small business owners make use of credit cards or lines of credit.
Equity financing involves raising money from angel investors or venture capitalists. Equity financing is much less risky because moneyinvested doesn't have to be repaid if the business doesn't succeed. However, in exchange for financing, the investor becomes a part owner and, as such, takes a share of the profits and has a say in how the business is run.
Whatever form of financing is required, it's vital to have an updated business plan in place to present to financial institutions or investors. The business plan should demonstrate the need (and effect) of financing for the future of the business.
Frequently Asked Questions (FAQs)
How do you solve cash flow problems?
The first step to managing your cash flow is running regular cash flow analyses. You should
review the credit history of your customers and stay on top of business indicators such as recurring busy or slow periods to ensure your business can manage inflows and outflows properly.
What's the difference between debt financing and equity financing?
If a company uses debt financing, it is borrowing money from a firm and will pay interest for doing so. In equity financing, a business' owners sell a portion of the organization in exchange for extra working capital.
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