How to manage your finances and cash flow
Your small business exists to make you money. And you can't do that unless you manage your finances and cash flow.
Money management matters
The first few years for any new business are crucial to its long-term success, with many challenges to overcome and lessons to be learned.
Cash flow problems and mismanaged finances are major causes of business failure in the early years. Some companies fail to plan properly, some set their sights too high or low, some don't keep track of costs, some fail to chase payment.
You can maximize your chances of business success by being aware of the pitfalls. Then you can manage your company's finances carefully and keep a close eye on its cash flow.
Taking sensible, practical steps will help you control spending and grow your business without taking excessive financial risks. Here are some useful tips to consider.
Use financial planning and forecasting
It's useful to develop a financial plan or framework to keep track of finances coming into and out of your company. For example, one model for your business might be to spend:
- 50 percent of revenue on expenses (such as payroll or supplies)
- 30 percent of revenue on building the business (such as expansion of equipment or recruiting costs)
- 20 percent of revenue on the future, for developing new products and services
Different plans work for different businesses, and you should discuss this with your accountant to see what works best for you.
But circumstances change. When they do, your financial plan should change too. Try to conduct some simple forecasting of your business for at least the next six months. Be realistic and try to estimate how much you will sell and how much you will spend. Plug these numbers into your financial plan and see if the results will still work for your business. If not, you may need to change your plan.
Be ambitious but stay realistic
Ambition and enthusiasm are important characteristics of business owners and managers. But so is the ability to make rational financial decisions based on the facts. When you start a new business the feeling of control can be exhilarating. Free from the constraints of employment, you can make any financial decision you want to. Some of those decisions will be good. Others won't.
Like any other area of life, learning to run a business comes through experimentation, successes and occasional mistakes. The mistakes are important – if you read any successful entrepreneur's autobiography or biography, mistakes will feature highly.
But successful entrepreneurs have two things in common – they learn from their mistakes, and they make small enough mistakes that they are able to recover from them financially.
This is a pragmatic approach to doing business. Few large companies became large overnight. They grew over a period of time, with setbacks along the way. Taking the occasional risk is part of good business. Taking unnecessarily big risks is not.
Chart your cash flow
Good accounting software can create charts of inflows (sales of goods or services) and outflows (accounts payable) for your business. It will let you change the time period and other variables so you can really understand what's happening. If you look at these charts over a period of weeks and months, you'll get an idea of the rates of flow of money into and out of your business.
Obviously you need the inflows to be greater than the outflows to make a profit. But the size of the difference is what's important. It will vary over time because few businesses make a consistent profit day in, day out. Some months or weeks will be good, some not so good. Looking at the charts will help you see the pattern as these values change.
Is the difference between income and expenditure often small? Does it sometimes dip into negative territory? Those are periods when your business is potentially at risk of cash flow problems. Try to find out what's causing this to happen at specific times. You can then attempt to restructure some aspects of your business to avoid the dips.
Make minor adjustments to regulate cash flow
Where possible you should have enough cash on hand to last you approximately three to six months. That way, if you have a rough month or two it shouldn't have a major effect on your business. But if your cash flow is causing problems at specific times of the month or year, don't panic. You may be able to improve the situation without dramatic changes. For example:
- Consider negotiating different payment dates to your suppliers to better align inflows with outflows
- Experiment with reducing your invoicing payment terms by a day or two to encourage your customers to pay faster
- Understand the negative impact of having inventory sitting in your back office or warehouse – it costs you space and revenue
- Establish a good line of business credit so you can access extra short-term money if necessary
Manage your company's debt
Debt is a fact of life for many businesses. It might be start-up funding, loans for capital equipment or commercial mortgage payments. Few businesses are entirely debt-free. And if the cost of the money you borrow is lower than the return generated by your company's use of that money, it makes sense to borrow.
It also makes sense to keep an eye on your borrowing costs. This is particularly true with variable rate loans, which can change due to any number of reasons, some of which might only be in the small print of the loan contract.
Assess your debts on a regular basis. Look at repayment costs, see whether your circumstances have changed, and decide whether you need to reduce – or increase – your debt funding. And don't forget to shop around. Get your accountant to see if there are better ways for you to borrow. Shifting your debts to a different lender can sometimes save you a lot of money.
And while you’re managing debt, don’t overlook managing any surpluses. ASB’s cash flow management guide has advice on using business savings accounts, term deposits, overdraft facilities, and business credit cards to manage cash flow, as well as other cash flow management tips.
Review expenses regularly
It's important to keep a close eye on your business expenditure. Good accounting software will let you quickly draw up useful reports, such as:
- Profit and loss reports: These show your company’s income, expenses and profits over time
- Balance sheet reports: These show assets, liabilities and net equities
- Statement of cash flows reports: These show the cash flowing in and out of a business
- Accounts payable and accounts receivable reports: These show how much money is owed by, and to, your company
- Depreciation reports: These give you a breakdown of the value of the assets owned by your company
Keep an eye on your payroll too, even if you outsource some of it. For a growing company, this is often more complex than anticipated.
Review all of these regularly, preferably with the help of your accountant or financial advisor, who can act as a sounding board.
Remember to keep your personal and professional finances separate: use a separate credit card and bank account for business-related expenses. That makes it much easier to keep track of your company's costs and also identify business tax write-offs.
Five questions to ask before bidding for big contracts
Don't run before you can walk. If your business is ticking over nicely and you're given the opportunity to bid for a big new contract, stop and think first. It can be tempting to "punch above your weight" and go for the prestige associated with a big contract. But that might not be the right choice for you.
Ask yourself some questions before you bid.
1. Do I have the staff to fulfil the contract if I win it? If not, will I have to hire new employees or use contractors?
2. Do I have the funds to pay for any new equipment required?
3. What effect will the new contract have on my current business: am I likely to neglect my existing clients?
4. What happens when the contract ends, or if it's terminated early?
5. What happens if the new client takes a long time to pay?
Sometimes it's preferable to build up a number of smaller clients instead of trying to sign up one or two larger ones. Your cash flow is likely to be more predictable that way. And if one contract ends suddenly, or you experience payment problems, it's less likely to ruin your business.
Understand the true cost of money
The money you receive obviously has value to your business, but so does the money you spend. Getting value for money is important in both directions:
- Pay all your bills on time to avoid being charged interest and negatively impacting your credit score/rating
- Look into the pros and cons of accepting different payment options such as cash, credit cards, PayPal and other options – charges for receiving payments will eat into your profit margin, but convenience helps your customers to pay you
- Research the costs associated with buying or leasing equipment as there could be hidden fees for maintenance or damage, not to mention different effects on your tax bill
- Save money by educating yourself about tax legislation, insurance requirements and retirement fund financing
- Consider bartering (trading goods and services) if it will reduce payment costs – but be aware that many countries treat this as a taxable transaction
Good accounting software will break down your accounts in fine detail, so you can see the monetary cost of payments into and out of your business.
Adjust your margins and get your pricing right
What are the margins for the products or services you sell? This can be hard to quantify if you're in the service sector, unless you use sub-contractors to carry out the actual work for you. But it's easier for retailers. Some might simply apply a 50 percent mark-up to their cost prices, and sell an item for $30 that cost them $20 to buy.
Such basic pricing techniques are attractive for their simplicity, but there are often better alternatives. If you learn about price elasticity, or the price sensitivity of the things you sell, you can price your products or services more accurately.
For example, let's say you price an item at $50 and sell 80 of them in a week. If they cost you $20 each to buy, the $4,000 of revenue looks pretty good. But if you priced them at $30, would you sell 300 of them? Or if you priced them at $60, would you sell 70 of them?
There's no easy answer. It will depend on the desirability of the product, the location and visibility of your company, the effectiveness of your marketing and the pricing policies of your competitors.
What you can do is experiment. Test different pricing for a week or two, and keep track of how much inventory you manage to sell at each price point. Use good accounting software to compare the revenue and profit from differently-priced products over time. Remember to take into account any seasonal variation, cost overheads and other factors. With some fine-tuning you should be able to get the maximum possible profit from the items you sell.
Chase the money you're owed
Understand the importance of collecting money on time so that you don’t leave cash on the table. Use your accounting software to draw up ageing summaries so you can see who is taking the longest to pay. And then chase them, politely, and keep chasing them until they pay. Make your invoice payment terms and the payment due date very clear, to avoid any confusion.
If you have a lot of invoices to chase, you might consider using a factoring agency. They can guarantee your invoice payments within a certain number of days by buying your accounts receivable ledger at a discount. However, it could cost you a significant percentage of the invoice total, and some agencies exclude the chasing of bad debts. Still, in some circumstances such agencies could help stabilize your cash flow.
Put financial management at the heart of your business
Managing your finances and cash flow shouldn't be an afterthought. It should be a fundamental part of your business strategy.
To be a successful entrepreneur you must thoroughly understand the numbers that drive your business. That will give you the knowledge you need to keep your company running, and help it to grow when the time is right.
Good accounting software will make it easy for you to plan, forecast, chart and chase your company's money. But even with that support, only you can steer your business in the right direction.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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