Whether you operate a mature, consistently profitable business or a loss-generating startup, cash flow is the oxygen of your business operations. Even for companies generating positive net income, poor cash flow management consistently ranks as a leading cause of business failure. If you only have the bandwidth as a CEO to focus on one financial metric, tracking and understanding cash flow can help you avoid failure and is essential to sustainably operating, growing, and selling a business.
Fundamental Concepts for Understanding Cash Flow as a Business Owner
Small businesses are typically not run by business or accounting graduates. In fact, a CNBC Survey found that a “majority of small-business owners in the United States don’t have a college degree.” A finance background is by no means necessary for business success, but the diversity of pathways does mean concepts like cash flow planning are foreign to a lot of business owners. Many founders can and should offload day-to-day financial metrics tracking to an accountant or CFO, but by staying close to the cash, owners have a much greater chance of running a business sustainably while avoiding a lot of heartache along the way.
Cash Flow Planning Process
At a high level, the cash flow planning process consists of three steps:
Understanding your current statement of cash flows
Forecasting your cash flow for business goals, e.g. income, growth, sale
Identifying and executing on opportunities to improve cash flow
To build a cash flow statement for the business, your CFO will likely start with your income statement. He or she will take any financing or capital expenditures into account and make the appropriate adjustments for non-cash benefits and charges. With the statement constructed, it becomes clear whether something like higher-than-expected cash burn was due to poor performance, accelerating growth, or one-time cash outlays.
With current cash flow understood, your CFO’s next job is to forecast the company’s future cash flows, ensuring first and foremost that you don’t run out of cash. At Ascent CFO Solutions, our Fractional CFOs construct a three-year rolling forecast financial model. We begin with the current balance sheet and cash flows to forecast your company’s cash position over the subsequent three years and include assumptions around variables like revenue growth, headcount, capex, and discretionary spending.
After understanding and forecasting cash flow, your company can optimize cash-related processes based on its operating model. This could involve tracking metrics like accounts receivable (AR) to bring down your average collection period or accounts payable (AP) to bring your average payment period in line with your industry. If your business involves inventory, optimizing inventory turnover will allow you to operate sustainably with higher growth potential and tax advantages. An early-stage business, operating at a loss, will inevitably want to include fundraising plans in its cash flow forecast in order to grow or reach a profitability inflection point. Because some cash flow optimization opportunities are specific to an industry or operating model, it is important to find a CFO with experience that’s most beneficial to your company.
Cash Flow Planning Pillars to a Sustainable Business
Tracking and forecasting cash flow is important to the overall health and profitability of your business, and there are a few key areas that warrant particular attention:
Cash Flow Planning for Working Capital
As part of a cash flow forecast, your CFO should be projecting the average collection and payment periods to optimize working capital. By tracking these metrics over time and collaborating with your customers, you may be able to reduce your average collection period and improve working capital. Accounts payable is often industry-specific, and a high percentage of business to business (B2B) sales will typically indicate delayed cash flows. For example, if your customer is a distributor selling to a retailer before a final purchase by an end-user, cash flows could easily be delayed several months. That said, businesses can be reliable, long-term customers. You certainly do not want to throw them into collections and ruin the relationship because your company is facing a cash shortage that could have been avoided with proper planning or more frequent invoicing. A proactive CFO can explore additional options like low interest loans secured by the company’s accounts receivable. Another option for unique or high demand products may be to fund manufacturing through prepayments from customers in exchange for being early on the delivery list or eligible for special offerings.
For companies with inventory, such as eCommerce, retail, and CPG, tracking inventory turnover days will help determine the level of inventory your company can afford. Sustainable inventory levels will be different for every company. That firm mentioned above with significant B2B sales may have a higher average payment period that necessitates lower inventory levels. Inventory mismanagement can have an additional cash sting from taxes. Because expenses associated with building inventory are not recognized until that inventory is sold, near term taxes could be higher and lead to a cash expense if not planned for properly.
Cash Flow Planning for Sustainable Growth
Even when all your business trends are positive - demand for your products and services is up, the economy is strong, and there is a clear path to achieving your goals - keep a close eye on cash flow because growth often burns cash before earning it. Whether your business is purchasing new equipment, adding staff, or increasing marketing, there are likely cash expenditures that may not provide a payback for months or years resulting in negative cash flow. Cash flow planning around growth will help you make smart investment decisions while avoiding a cash crunch. Imagine that you have a manual production process and you are trying to decide between adding more staff or purchasing more automated equipment to meet demand. Your CFO can conduct a net present value (NPV) calculation that relies on discounted cash flow planning to determine which growth option provides a better return. Furthermore, by developing estimates for the company’s cash outlays and resulting increased cash flows, you can keep enough in reserve to pay bills and other obligations.
Cash Flow Planning Around Financing
Growth fueled by free cash flow is safe but it can also be slow. For business owners with a desire to expand faster than their free cash flow will allow, fundraising is the most common solution. Early stage companies often turn to venture capital (VC) firms to provide funding in exchange for equity. While your current operating cash flow may be negative, cash flow projections are critical for two reasons:
The projections determine how much cash you need to raise in the current round
The projections influence the value of the equity you need to sell
Your CFO can also help you plan beyond the current round of financing. A financial model like the 3-year rolling forecasts built by your Ascent CFO helps ensure that your business has enough cash to achieve milestones that will earn it a higher value in future rounds.
For more mature yet still fast-growing businesses that lack the cash flow from operations to meet their objectives, debt can be an ideal financing source. Your CFO should investigate all options to identify the appropriate products and secure the best terms for your company. A business credit card can help bridge the gap between AR and AP. For real estate or equipment purchases, a secured loan could reduce your interest rate by proportionately reducing your lender's risk compared with unsecured debt. Your business may qualify for subsidized or special temporary programs put in place by the government that an experienced CFO can navigate. Finally, business lines of credit (LOC) are a flexible form of borrowing that can be put in place for either growth or contingency planning. Whether you choose to expand through equity or debt, your CFO can guide you through the process, avoiding pitfalls along the way.
The Intersection of Cash Flow and Exit Planning
A previous post discussed the link between thoughtful exit planning and sound business operations. Cash flow planning can be as important to a potential sale as it is to ongoing operations. Often a venture capital (VC), private equity (PE), or strategic acquirer may construct their own discounted cash flow (DCF) model to determine a valuation for your company. DCF values a company by estimating how much cash a company will generate in the future “discounted” for various factors like risk, inflation, and opportunity cost. It is a model based on assumptions, with expected future cash flows being one of the most difficult to pin down. If your CFO has consistently projected cash flows as a standard business practice, you will be able to provide an acquirer with realistic estimates and sound explanations that lower your company’s risk profile and earn a higher business valuation.
For business owners planning to make their exit in the form of a transfer to children or sale to key employees, cash flow and growth projections can be even more important. These buyers are unlikely to have the same cash resources as VC, PE, or strategic buyers. The “buyout” may take the form of your receipt of a percentage of cash flows over many years as you separate yourself from the company’s operations. If you rely on the income to retire, it may be prudent to build certain triggers into the transition process where you re-take control if metrics like cash flow deviate from pre-determined bounds. Finally, cash flow planning can help guide when you exit because you will have an idea when the company is generating enough cash for you to meet your personal financial goals.
Fractional CFO for Cash Flow Planning
Cash flow planning requires a holistic view of your company’s finances to bridge the gap from the profit/loss reflected on an income statement to the company’s cash flow. Cash projections are multi-faceted calculations requiring inputs including:
projections of collection, payment, and inventory days
variance between income and cash flows
growth rates, tax rates, and financing options
changes in business dynamics, like customer and product mix
the business owner’s risk tolerance
As such, cash flow planning is a science and an art that requires the knowledge AND experience of a seasoned CFO to make the correct assumptions and allow for variances in unknowns. The problem for many small businesses is that they do not have the financial capacity or the operational need to support a full-time CFO. An effective alternative might be a Fractional CFO that can offer your business flexibility to match what you need with what you can afford, prioritizing mission critical objectives. If your business needs are unclear, a Fractional CFO can assess the situation from the ground level and make recommendations based on their findings. On the other hand, your investment decisions might be clear, and your income statements reliably match projections, but you have struggled managing cash flow in the past. A Fractional CFO could take on a specific task like cash flow planning to fix what’s broken and keep what’s working.
Cash management can be the difference between a flourishing organization and a company struggling to meet its obligations. Proper cash management depends on an accurate cash flow plan built on tracked metrics and reasonable assumptions that incorporate future business goals. Given the skill set required, coupled with potential uncertainty around your current cash position, a Fractional CFO could be a great resource to figure out where your business stands today and help create a roadmap to where it’s going.
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About the Authors:
Dan DeGolier is the founder of Ascent CFO Solutions and a Fractional CFO with nearly 30 years of experience. He is passionate about working alongside leaders of companies to help them “upward” to their highest potential. Andrew Dudar is a registered investment advisor representative whose background and career in engineering allows him to conduct financial analysis by breaking down complicated subjects and making them easier to understand.