Cash Management Basics

While it's normal for small businesses to be in debt for the first few years of operations, maintaining adequate cash flow is crucial at all stages. In fact, business analysts often say that poor cash management is among the most common reasons why small businesses fail soon after starting up. This article explains the basic concepts of cash flow and effective cash management in business organizations.

The Difference Between Cash and Cash Flow

The term cash refers to actual currency in the bank and does not include the value of inventory, accounts receivable or other such items that may be converted into cash. Simply subtracting expenses from revenues will indicate the amount of profit, but not available cash. That means even a highly profitable business can have problems if actual cash, which is needed for day-to-day operations, is not managed properly.

Cash flow is a term used to describe how cash moves in and out of a business operation. Cash spent on wages, creditors, facilities and materials is called "outflow." Cash coming into the business from lenders and customers is called "inflow." The goal is to manage the inflow and outflow so that your business always has enough cash not only for day-to-day operations but also to cover unforeseen expenditures.

• Positive Cash Flow - When cash inflow is higher than cash outflow, it is called positive cash flow. A business with positive cash flow typically is in good financial health.
• Negative Cash Flow - When cash inflow is lower than cash outflow, it is called negative cash flow. Businesses with negative cash flow often must borrow money (and pay interest) just to keep the lights on. Poor collection practices on accounts receivable often results in negative cash flow.

Cash Flow Components

Accountants and business managers often divide the cash flow statement into three main categories:

• Operating Cash Flow - This is also referred to as working capital and consists of cash from your company's sales.
• Investing Cash Flow - This also is generated internally but from non-operating activities such as investments in fixed assets or other sources and expenditures of cash not related to the company's normal operations.
• Financing Cash Flow - This consists of cash flowing to and from lenders, investors and other external sources.

Practicing Effective Cash Management

Good management involves the following three factors, according to the U.S. Small Business Administration (SBA):

1. Understanding your cash needs and knowing when, where and how they will occur
2. Knowing how to access additional cash when needed
3. Keeping positive relationships with bankers and other sources of cash in order to be prepared

One of the first things businesses can do to maximize cash flow is to audit billing, collections and payables systems for efficiency. Billing promptly and quickly following up on overdue past balances—perhaps even requiring up-front deposits or credit cards—can help increase the rate of cash flow. Likewise, on the cash outflow side, you should take as long as possible to pay your company's bills without incurring interest or late fees.

Stockpiling some extra cash, above and beyond what is needed for day-to-day operations, can help avoid problems in a fiscal emergency. For example, a company may want to squeeze out extra profits by reinvesting excess cash. But if an expensive piece of equipment needed replacing, for example, it's much cheaper to pay with cash on hand then to pay the interest on a new loan.

Every business has its own unique cash needs but effective cash management is universally vital to a healthy organization.