Before diving into the how of it, I need to stress the sheer importance of managing your SMB’s cash the right way.

Cash will make or break your business.

This is for 3 reasons.

1. Cash is the lifeblood of your business. With efficient cash flow management comes efficient capital allocation. Too little cash on hand and you risk taking on unnecessary debt. Conversely, keeping too much on hand might signal that you’re missing out on growth opportunities.

2. Cash flow gives you a better picture of the business. Tracking the amount and timing of your inflows and outflows gives you a much more realistic picture of revenue vs expenses than the income statement ever could. That’s because there's no shortage of accounting tricks out there to make your earnings look better than they really are. With cash flow, there’s no hiding the ball. At the same time, maximizing visibility into your outflows helps reduce unnecessary expenses.

3. When done right, cash flow management allows you to keep just enough cash on hand while deploying the excess to grow. This is done by matching your inflows to outflows so that you’ve got the cash you need on hand + a margin of safety for anything unplanned. Anything above that is yours to plow back into the business.

Here’s How to Do It + 5 Quick Tips

Generally speaking, the best opportunities for optimizing cash flow lie in your A/P, A/R, and budget. That said, limiting inventory to just what you need to meet demand is another great way to maximize cash if applicable to your business.

But before diving into my tactical tips for improving cash flow, I’d suggest making a few calculations to quickly assess your situation.

1. Free Cash Flow (FCF)

   Free cash flow tells you how much cash your business has available to use. It’s also helpful to revisit this calculation when considering the purchase of assets or growing headcount.

   Here’s how to calculate it.

   FCF = Net Income + Depreciation/Amortization - Changes in Working Capital in Period - Capital Extended in Period

   Note: Once you have your result, make sure that you also understand which liabilities are still outstanding and your timeframe for paying them.

2. Operating Cash Flow (OCF)

   Operating cash flow is similar to free cash flow, but its formula also accounts for transactions outside of normal business activities such as the sale or purchase of an asset. Calculating operating cash flow rather than free cash flow is more important when obtaining financing or determining the traditional cash flow of your business.

   Here’s how to calculate it.

   OCF = Operating Income + Depreciation/Amortization - Taxes + Changes in Working Capital in Period

3. Days Payable Outstanding (DPO)

   DPO is the number of days it takes to pay an existing invoice. Increasing DPO can improve cash flow for businesses looking to acquire assets or make purchases. That said, a higher DPO should be approached delicately as it could strain vendor relationships or signal a lack of cash available to pay. Bottom line, be intentional about increasing DPO and pay special attention to your most strategically important suppliers.

   Here’s how to calculate it.

   DPO = Accounts Payable * # of Days / Cost of Goods Sold (COGS)

Alright, onto my tips.

Tip #1 - Create a budget based on actual rather than perceived spending

In order to manage cash effectively, you’ll need an accurate accounting of money owed, the timeline for paying those bills, an exhaustive list of your operating costs, and a summary of receipts for the period.

To get started, pull accruals from your accounting software and compare that with actual receipts and disbursements. This will give you an idea of when expenses tend to outrun revenues over the course of a typical month and help you adjust accordingly.

Once you know where you stand on timing, implement 13-week cash flow forecasting. Doing so gives you a short enough time frame for historical data to still accurately reflect your business, while still giving you enough of a time horizon to coordinate your financing and investing activities.

Tip #2 - Negotiate payment terms with clients and suppliers

They may not all go for this, but you never know. Most owners rarely ask in the first place. And if you get a “yes,” you stand to gain a few things.

• Shorter cash collection periods let you get cash in the door before your bills come due. Even with healthy margins, quicker receipts can offer you a margin of safety when unexpected expenses inevitably arise.

• Extending payment terms lets you build up the cash buffer you need to take advantage of strategic opportunities. For example, paying a supplier in 60 days vs 30 days might give you enough cash on hand to purchase new equipment while still paying your bills on time.

Tip #3 - Develop process controls for paying A/P and collecting A/R on time

Many owners think this is trivial, but it actually makes a material difference.

I often see SMB’s pay their bills weekly to ensure no missed payments, but a better approach is to track actual due dates and pay just in time. This is because those early payments tie up cash that could be used for investment.

If you still prefer to pay your bills early, at least ask for early pay discounts. Not every vendor will grant them, but taking advantage whenever they’re offered can lower your outflows without making any changes to business operations.

At the same time, following up on late payments keeps your business from leaving money on the table. That alone is a pretty easy way to boost your net income. It’s also pretty straightforward. If you charge net 10, make sure that’s when you actually get paid. Circle back on late accounts.

Tip #4 - Inject liquidity as needed

Three ways to do this are A/R factoring, asset-backed loans, and lines of credit.

We’ll tackle factoring first.

Unlike a loan, factoring is an advance on your receivables and there’s no monthly payment. Factoring also frees you up from collections since the factor manages your unpaid invoices and receivables for you. Simply put, when your company issues an invoice, the factor will pay up to 90% of that outstanding amount to you as an advance. The factor then collects the full amount.

With factoring, even though you’re selling your invoices to a third party, you’re not giving up any equity in the company. Another important note on factoring is that it’s determined by the quality of your customers’ credit rather than yours.

Asset-backed loans can either be term loans or revolving lines of credit for you to access as needed. Your credit limit is determined by the company’s assets, which are put up as collateral.

One advantage of an asset-backed loan is the fact that it’s based on the liquidity value of the company’s assets, allowing for more stability in the event of temporary market fluctuations or a brief downturn.

Generally speaking, a small business line of credit has more in common with a credit card than a typical small business loan.

Unlike a loan, there’s no lump sum issued and there’s no required monthly payment. Instead, a credit line is subject to credit review and renewal. And much like a credit card, interest accumulates as you withdraw funds. And as you make payments, the amount that you’ve paid apart from interest becomes available to access again.

Tip #5 - Pull forward demand or cash

You can do this either by discounting sales to get more cash in the door, or by offering early payment options to clients (usually in the area of 1-7% based on how early they pay). The former is a better option if you’re looking for a one-time or seasonal influx of cash. The latter works better for shortening cash collection cycles year-round.

Putting It All Together

Here are your top takeaways from this week’s post.

1. Effective cash flow management leads to effective capital allocation.

2. Quickly assess your business’s situation by calculating free cash flow, operating cash flow, and days payable outstanding.

3. The best opportunities for maximizing cash flow are typically in your A/P, A/R, and budget.

4. My 5 easy tips to better manage cash are to create a budget based on actual spending, to negotiate payment terms with clients and suppliers, to develop process controls for paying A/P and collecting A/R on time, to inject liquidity as needed, and to pull forward demand or cash.

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‘Til Next Time,

Connor