The Importance of Cash Management to Small Business Success and Tips to Do It Effectively

woman managing cash flow

Last Updated on October 11, 2022

Keeping cash flowing is a business’s key to success. Sadly, companies that do not manage their cash smartly tend to fail quickly. Along with making a profit, keeping the cash flowing is vitally important, especially for small businesses that are getting started.

Young businesses often suffer from cash flow problems, and they need that money to pay their debts and operations. Business owners need to learn how to manage their cash flow, especially regarding ratios and timing.

Along with learning about ratios, business owners need to understand how to manage their cash flow and the difference between profit and cash.

What is Free Cash Flow?

Free cash flow is the cash a business has once it has recorded credits and debits, like:

  • Operating cash flow
  • Capital expenditures spent on fixed assets
  • Working capital between periods
  • Dividends to shareholders

Once those standard operating credit and debits are accounted for, the remainder is free cash. Businesses can use that free cash for other purposes.

Before deciding what to do with the free cash, stakeholders should consider how money is more valuable now rather than later. So, stakeholders should use the cash to work for the business.

What is Ratio Analysis?

Ratio analysis helps businesses understand whether they are liquid or if they will struggle to meet their short-term debts. A business with liquidity can pay its short-term debts, while a business without liquidity does not have enough cash flow to cover them, an important discovery from cash flow analysis.

Businesses can use two different methods to figure ratios: current and quick.

Current Ratio

With the current ratio method, you can see how your assets and liabilities currently match up. To determine your existing assets and liabilities, add up your cash, inventory, and accounts receivable and divide the total by your next 90 days of liabilities.

Quick Ratio

The other method, quick ratio, lets businesses see if they can pay their debt and liabilities with their cash and accounts receivable.

The difference between the two methods is whether companies need to sell inventory. To figure quick liability, add up cash, securities, and accounts receivable, then divide the total by 90 days of current liabilities.

Accounts Receivable Turnover

Businesses can also analyze their accounts receivable turnover as part of their overall cash conversion cycle to see how effectively their inventory becomes accounts receivables.

The analytics tool called accounts receivables turnover is figured by looking at a set period and adding beginning accounts receivable and ending accounts receiving, then dividing by two, then taking that product and dividing it into net annual credit sales.

What is a Cash Budget?

To keep track of the cash flowing in and of your business, consider using a tracking budget. When you check your cash-flow statement regularly (different from your cash budget), you can see if your business is using it effectively. Then, you can better budget how much cash you need to keep your business liquid.

When you create a cash budget, you can use it to determine what you need. Some businesses set their budget for six to twelve months, then adjust as needed. Rather than using your cash budget for targets, use it for needs, so you spend it wisely to help your business.

You can also use your cash budget for unexpected situations and for changes that help your business. For example, you could use your budget to alter the timing you use to increase your inventory.

You could also use it to change your accounts receivable timing. When you make changes to your budget, you can generate cash more quickly.

How to Make Your Cash Flow More Efficient

Your inventory and accounts receivable affect your cash flow. You bring cash into your business when you sell inventory and when your customers pay their accounts receivable credit. If you can collect on inventory and accounts receivable faster, then you can increase your cash flow.

Optimize Your Collections Process

When you submit an invoice to your customer, you’ve likely attached terms of anywhere from 15-90 days, unless that invoice is due on receipt. With longer payment terms, it becomes more and more difficult to stay on top of collections. At some point, every company will experience issues with getting their customer to pay on time – or sometimes at all. This puts an immense amount of stress on you and the business as working capital gradually dries up. So how do you improve your collections process? Below are some tips. Also be sure to read our entire article on how to collect unpaid invoices.

Keep your cool

It never helps to let your emotions get in the way. Getting upset will not likely increase the speed of payment, and it may cause you to lose credibility or authority in the eyes of your customer. Be direct and confident, making sure you’re not coming across as a pushover. Getting confrontational without losing your edge will be critical in making sure you eventually get paid. Use our email templates to learn how to ask for payment professionally.

Know your rights

Read up on what rights you have when attempting to collect from your customers – you may be surprised what you’re able to do. For example, it is within your legal rights to search for your customer’s social security number if they are refusing to pay an invoice. That said, make sure that you have a written agreement in advance of completing work for your client. That ensures that you have a legal defense when attempting to collect payment.

Keep everything in writing

Not only should you have a contract in writing, you should keep a written record of all correspondence between you and your customer. When you have documented proof of multiple collections attempts, it can prove helpful if you need to hire a collections agency or, unfortunately, take a customer to small claims court.

Offer a discount

If you’re not convinced a customer will ever pay, try offering them a 10-20% discount on their invoice. Outstanding invoices and non-paying customers cause a lot of stress – more stress than the final 10-20% of your invoice amount. While adjusting your fee may not be ideal for your business, it’s a significantly better option than 1) never receiving payment at all, or 2) having to pay a collections agency to get involved. Sometimes, your customer may see this offer as a good opportunity to settle a debt.

Hire a collections agency

If all else fails and you feel as though you’ve spend too much time, energy and stress on collecting payment, hire a collection agency. They know the ins and outs of the law when it comes to collecting on delinquent invoices, and they can often help secure payment faster. Make sure you do your research and find a qualified and registered agency, as you’ll want to avoid any potential legal risk of outsourcing your debt collection to a third party.

Optimize Your Accounts Payable

You can also improve your cash flow by planning the payments you make. To make your cash flow last longer, pay your accounts payable on their due dates. If you pay them before the set due date, you are not maximizing your cash flow. The idea is that you get to keep your cash on hand longer, and you can use it for your business, rather than sending it to another business.

Remember that paying your bills on time prevents having additional fees added to them. Your suppliers also have expenses to pay so they need your payments. To maximize your cash, request that your accounts receivable payments in a shorter time and your accounts payable to extend your time.

The goal is to keep your cash for as long as possible, to have more cash entering your business and less cash leaving it.

What is the Difference Between Cash and Profit

Cash flow and profit are often confused. They are different, especially in financial accounting. Cash can factor into profit, but it depends on how you use it and what is left over after using it.

Financial accounting includes cash flow but is not directly focused on it. Instead, financial accounting focuses on profit, which is also called net income.

Consider how credit sales eventually become cash. The credit sale is an inventory debit and a receivables credit. That credit sale will become cash, but it takes time to get your account. Despite not having the cash in your hand, you did make a profit, according to your accounting.

With financial accounting, profit can outpace cash flow, especially if you rely on credit sales. Credit sales are just as good as cash sales when considering profit.

How to Manage Cash Successfully

When it comes to successfully managing your cash flow, knowledge is power. You can learn to time the cash that comes in and goes out so you can get the most out of every dollar.

Understanding that profit matters more than cash flow also helps you better understand how your business stays liquid and your cash balance keeps flowing positively.