You’ve undoubtedly heard the old saying that “you’ve gotta spend money to make money”.
In fact, as an entrepreneur, you’ve probably heard that quote so many times that it’s lost all meaning.
And that’s a good thing.
While it is true that you’ll have to invest in your business if you want to see it grow, this saying is…well…a bit short on information.
- It doesn’t address how much money you need to spend.
- It doesn’t address how much money you should expect to make.
- And, perhaps most importantly, it doesn’t address how you should be spending your money in the first place.
Okay, okay. Maybe we’re looking a bit too much into a silly throwaway line that’s been done to death.
The point is, as a first-time founder who knows “you gotta spend money to make money,” you also need to understand the importance of knowing how this money flows into and out of your business.
In this article, we’ll be discussing:
- Exactly what cash flow is
- Why managing cash flow from the onset of your business is essential to your success
- What you can do to maintain a firm grip on your cash flow as you grow your business
Without further ado, let’s dive in.
The most basic definition of cash flow, as we alluded to above, is the movement of money into and out of your company.
Now, there are two important things to focus on, here.
Firstly, cash flow centers on the movement of money through your company over a certain period of time. In other words, it’s not how much money you currently have – it’s how much you have now compared to how much you had at a previous point in time (typically the first of the month, or the beginning of the year).
The second thing to know, here, is that cash flow refers specifically to the actual cash you have on-hand at a given moment in time. Cash flow ignores money owed to lenders that hasn’t been paid yet, money coming to you for completed projects that is still in Accounts Receivable, the value of inventory, or anything of the sort. Keep this in mind, as we’ll revisit it a few times throughout this article.
Now, on the surface of things, it might seem that cash flow is pretty easy to keep track of. Sure, if you’re running a lemonade stand, you’ll only have a few things to worry about: “money in” is all the money you made from lemonade sales; “money out” is the cost of the ingredients, cups, and craft supplies to make a sign.
Obviously, most businesses are much more complex than this. Money isn’t just exchanged at the point of sale, or when purchasing inventory and equipment; . And it isn’t always exchanged at one specific moment, either. Because of this, the process of calculating cash flow can actually become quite complicated; we’ll come back to this in a bit.
It’s also worth mentioning that, for most companies, there are actually three different categories of cash flow.
While we’ll be talking about overall cash flow, which encompasses all of the following subsets, it’s beneficial to have an understanding of what each of them refer to:
- Operating Cash Flow: Also known as “working capital,” operating cash flow refers to the money spent on inventory and operations compared to the money made on sales of your product or service.
- Investing Cash Flow: Investing cash flow considers the money spent on equipment, property, and other assets, compared to the money made from selling assets of any kind (not related to main operations).
- Financing Cash Flow: Financing cash flow refers to money being paid to lenders, received from investors, and other such financial deals.
So it’s not just that cash flow is about knowing that money is flowing in and out of your company. It’s also about knowing where the money is coming from – and where it’s going to. We’ll come back to this in the next section.
Okay, so the overarching answer to that question is a no-brainer:
Obviously, you want to know your business is making more money than it’s spending every month. And you definitely don’t want to intentionally spend way more than you stand to make, either.
Right about now, I bet you’re picturing a “wantrepreneur” blowing his wad on an expensive piece of equipment, overspending on inventory, or hiring too many employees, and not bringing in nearly enough to recoup their losses.
Needless to say, turning that much of a blind eye toward cash flow is a recipe for imminent disaster. But, again, that’s fairly obvious.
Here, we want to talk about the more nuanced reasons that having a firm grasp on cash flow management is essential to the success of your business – and why letting go of that grasp even slightly can lead you to ruin.
As Richard and Anna Linzer explain in their book, The Cash Flow Solution: The Nonprofit Board Member’s Guide:
“The ability to accurately predict cash flow is the best, most universal, and most consistent standard for financial management (for organizations of any size).”
CEO and president of AmeriMerchant David Goldin lays it out plainly:
“The No. 1 reason people fail (as entrepreneurs) is, they run out of money.”
Again, on the surface this sounds like a no-brainer. Obviously, if you spend money you don’t have, you’re going to end up in a hole that you may not be able to dig out of.
But, it’s entirely too easy to overlook certain expenses, to assume money in Accounts Receivable is as good as yours, and to simply think you have more money on-hand than you actually do.
Data collected by CNBC shows that this isn’t an uncommon problem, explaining that “37 percent of experienced business owners sometimes fall short of the cash they need to cover business expenses.”
Let’s look at how even a minor misstep in this regard can lead to disaster:
ABC Retailer purchases 1,000 widgets from a supplier who requires buyers to pay for inventory upfront. ABC has allotted for the purchase of these 1,000 widgets on a monthly basis, and has been able to sell off all 1,000 each month.
The owner then decides to purchase 1,500 widgets from the supplier, seeing as sales have been pretty good of late. To afford the cost of the extra 500 widgets, the owner borrows from the company fund – knowing it’ll definitely be repaid in the near future.
Unfortunately, this leaves the company short when the first payday of the month comes around – causing three salesmen to quit. Without these salesmen, not only is ABC unable to offload the 1,500 widgets, they don’t even sell the original 1,000.
At this point, the owner either needs to borrow more money, or shutter up the operation before it even got off the ground.
To be sure, if those three employees didn’t quit, our hypothetical company would almost certainly have made their quota of 1,500 widgets sold. But, the point is, the owner’s faith in their business caused them to turn a blind eye to the many costs of running said business – which ultimately caused the business to fail.
It’s for this reason that you absolutely need to know where every penny your company sees comes from, and where it ends up going.
Paying close attention to cash flow is perhaps the best way to truly get to the “bottom line” of how your business is faring as…well…a business.
Let’s explain that a bit more.
It’s entirely possible for “business to be booming” for a company in terms of sales numbers, client acquisitions, what have you…and for this same company to go belly-up soon after. Sure, the company landed five new clients – but the owner also agreed to allow these clients to defer payment until their projects were completed. While the money is coming to the company, it’s not not there yet – meaning bills, payroll, etc. can’t be paid. Again, just like ABC Retailer, this company won’t be long for this world.
Obviously, this is a rather extreme example. But the results will be similar if, say, Accounts Receivable fails to track down a delinquent account in a timely fashion, or your credit agreement with your customers leaves you with too much money owed (and not enough money in-hand).
While having an entrepreneurial mindset and being able to provide value to your customers is important, none of it will matter if you don’t have a firm grasp of your company’s financial situation every step of the way. Understanding your current cash flow, then, becomes essential.
At the risk of sounding dramatic, having true control over your business’ cash flow truly does put you in the driver’s seat in terms of where your company is headed.
More accurately, not having control over your business’ cash flow simply means you’ll end up going wherever fate takes you. As we’ve pointed out a few times at this point, this is rarely a good thing.
When you have a firm grasp of your cash flow situation, you’ll know exactly how much you have in reserve, how much you can reinvest in your business, and how you should reinvest in your business. In turn, you’ll be laser-focused on not overspending on certain initiatives, and also on ensuring that the initiatives you do invest in end up being worth it in the long run.
You’ll also be better able to predict future up- or downturns, and be able to plan your spending accordingly. This will help you avoid going on a spending spree when you’re riding high – and also avoid hitting the panic button when you’re running low on funds.
But, most importantly, learning to manage your cash flow will help you avoid going into debt – and being forced to run your business just to get out of it. Needless to say, when faced with business loans or debts of any kind, your first order of business will be to pay them off as quickly as possible; that said, you won’t be able to make any other “business moves” until your debts are paid off. Rather than investing into your business’ growth, you’re essentially operating just to stay afloat. At this point, you’re not even in control of your own business anymore.
Again, this can all be avoided by maintaining focus on and managing your cash flow at all times.
Now that we understand what cash flow is, and why keeping tabs on it is so important, let’s dig into sme of the things you can do to actually maintain your grasp on it throughout your business’ lifespan.
The following tips aren’t sequential steps, nor are they listed in order of importance. Rather, each tip focuses on specific aspects of the “business side of things,” and explains how an understanding of cash flow plays into these aspects.
Without further ado, let’s get started.
1. Don’t Conflate Cash Flow and Profit
This is a big one, so repeat after me:
“Cash flow does not equal profits.”
As we’ve explained, the formula for cash flow (at its most basic level) is:
(Cash On-Hand Now) – (Cash On-Hand At Beginning of Period)
Keep in mind that it matters not where this money came from (as far as calculating cash flow is concerned). As we mentioned earlier, total cash flow refers to money gained or lost via operations, investments, and/or financial agreements (loans, etc.). The bottom line, again, is that cash flow looks at the actual cash your business currently has within its reach.
On the other hand, profit is calculated using the following formula:
(Revenue) – (Expenses)
Here, revenue refers to “money made through sales,” and expenses refers to “money spent on business operations.”
Again, if you run an ultra-simplified business (e.g., the aforementioned lemonade stand), in which cash actually trades hands during every single transaction made, then these two terms may be pretty close to synonymous.
But, of course, not many businesses operate in such a manner by today’s standards. That is, it’s not exactly uncommon for actual cash to not exchange hands at the point of sale.
This is where cash flow and profit diverge from one another. Say your business locks in a $10,000 contract for a month-long project, and your client agrees to pay $2,000 a month over a five-month period. If it costs $5,000 for you to complete the project, you’ll have profited $5,000 for that month ($10,000 revenue – $5,000 expenses = $5,000 profit). However, your cash flow for the project – at least at the present moment – is -$3,000 (Having spent $5,000 and only recouped $2,000 thus far).
As we illustrated earlier, if you need that $3,000 before your client’s next payment is due…well…you’re going to be out of luck.
Businessman Chris Chocola sums it up perfectly:
“Balance sheets and income statements are fiction, cash flow is reality.”
While the money owed to you – and the money you owe others – certainly does matter in the long run, it’s more important to focus on what’s actually in front of you at the present moment. Overlook that, and the rest isn’t going to matter.
Your break-even point, as the name implies, is the point at which your company officially…well…breaks even.
That is, it’s where your revenues equals your expenses; where you profit and cash flow for the month both equal zero.
Now, there are two different ways to look at your break-even point.
One way is to consider the number of sales that will need to be made to break even. In other words, here you’ll want to know how many products you’ll need to sell in order to cover the cost of running your business for a given time period.
You can also think about your break-even point as a moment in time. In other words, you’ll want to assess the average amount of business your company does per month in order to anticipate how long it will take to break even should business remain steady.
To calculate your break-even point in terms of time, you’d use the following formula:
(Break-Even Volume) / (Average Sales Volume Per Period)
So, let’s say you figured out that you’ll need to sell 50,000 widgets to reach your break-even point. On average, you sell 2,000 widgets each month: that would mean you should hope to break even in about 20 months’ time.
(Obviously, that’s an overly simplistic example, but it should help you gain a basic understanding of how to think of your break-even point.)
As we said in the intro, as a first-time founder, you know you’ll have to invest a ton of money in your business upfront to get the ball rolling. And you know it’ll likely take some time for you to recoup this initial investment. Understanding your break-even point essentially provides you a timeline of when this is likely to happen – and gives you something to strive for moving forward.
Now, if you reach your break-even point earlier than expected, you’ll know you’re on the right track – and can even start thinking about reinvesting into your business and beginning to scale. If you don’t reach it by the anticipated time, you’ll know something has gone wrong, and will need to go back to the drawing board.
But, if you don’t even pay attention to your break-even point in the first place, you either won’t be able to take advantage of the moment when it arises – or you won’t realize when things are going south until it’s much too late.
Ideally, the goal of any business is to keep costs to a minimum, while at the same time maximizing income.
This, to be sure, is the logical pathway to a positive cash flow.
But keeping costs down isn’t exactly easy, especially for first-time founders who are just getting their business off the ground.
That said, keeping close tabs on your cash flow can actually help you ensure that every penny you’ve spent was spent with good reason. Put a bit differently, managing cash flow can allow your business to operate with a lean mindset.
The lean business model operates using the following concepts:
- Total Quality Management: Close analysis of and control over processes, ensuring the minimum necessary amount of resources are used and waste is produced
- Just-In-Time Production: While originally tailored to manufacturing, JIT production refers to the act of accomplishing tasks as they’re requested and/or expected (as opposed to doing them ahead of time in anticipation of the potential need for them to be done). Again, this cuts down on waste, and ensures resources are allocated appropriately at all times.
- Throughput Analysis: Similar to Total Quality Management, Throughput Analysis looks at ways to increase productivity in the most efficient way possible.
While you don’t necessarily need to adopt the lean mindset as a whole, the notion of getting full use out of the resources you have – and ensuring every dollar you spend will lead to gains for your company – should be at the forefront of your mind at all times.
Money owed to you is not money owned by you.
If a client owes you $5,000, you can’t use that money to pay your rent. If you can’t pay rent, you can’t operate your business. Yes, you’ll eventually get that $5,000…but you’ll have lost everything else in the meantime.
But, even if you have everything planned out (e.g., your client has agreed to pay the full amount of their invoice by a specific date, enabling you to pay your bills with ease), you’re still relying on your client to hold up their end of the deal. If they don’t…well…refer to the previous paragraph.
The thing is:
Your clients probably aren’t exactly going to be eager to pay you. Sure, they agreed to pay their invoice in full by such and such a date…but if you aren’t keeping close tabs, here, they’re not going to be the ones to call it to your attention.
That said, you absolutely cannot afford (literally) to be lackadaisical with your Accounts Receivable.
And you can’t assume your clients will pay you by the time they say they will.
Rather, you need your Accounts Receivable processes to be systematic, to the point that they run like clockwork. This involves:
- Setting specific parameters in terms of payment schedules
- Creating internal timetables and guidelines regarding when to follow up with clients regarding payments
- Establishing penalties for clients late on their payments
Without such processes and agreements set in stone, you’re essentially running your company at the mercy of your clients. On the other hand, by taking control of your Accounts Receivable processes, you’ll be that much more in control of your company’s destiny.
What’s better than getting paid on time?
Getting paid early, of course!
If you expect your clients to bust down your door looking to give you money before they have to, you’re going to be sorely disappointed.
But, it goes without saying that the sooner you get paid for services rendered, the better off you’ll be. You won’t have to worry about tracking down late payments – and you won’t have to worry about having to take out a loan while waiting, either.
Most importantly: You’ll have money immediately on-hand with which to reinvest into your business.
The question, of course, is:
“How do I get my clients to pay early?”
Well, the most basic tactic is to simply not offer lines of credit freely – if at all. While you’ll likely want to offer such a courtesy to your high-value and long-standing clients, you don’t want to allow everyone to purchase your products or services on credit. As we’ve said, your startup probably can’t afford to have your income stretched out over long periods of time in the first place. And, again, you don’t want to have to rely on your clients’ monthly payments to pay your bills, either.
If offering lines of credit are typically expected within your industry, though, your next best bet is to incentivize early payments (or, ideally, payments on delivery) in some way or another. Perhaps the only way to actually get clients to knock down your door looking to make an early payment is by giving them a discount for doing so. If the difference is palpable for your clients, you can be all but certain they’ll do whatever it takes to reach their deadline.
Finally, as we mentioned above, you’ll want to set clear terms within agreements with specific clients regarding late payment penalties. By setting these terms in writing, and having both sides agree to them, there’ll be no confusion about when payment is expected, and how you’ll proceed if payment isn’t made on time. On your company’s end, this will also mitigate instances in which you compromise for a client “just this once,” which ultimately leads to a slippery slope that costs you a ton of money.
(As an added bonus, setting such terms will also help you identify trustable and untrustable clientele moving forward. Without these terms in-hand, it can be difficult to sever ties with a client who could potentially end up putting your company in jeopardy.)
On the other side of things, you’ll want to stretch out payments you owe (to lenders, equipment providers, etc.) as much as possible.
Needless to say, when you’re just getting your business of the ground, an investment of, say, $24,000 in equipment might be enough to completely tank your bank account. On the other hand, paying $4,000 a month over a six-month period will not only allow you to get what you need to start producing, but will also keep your bank account stocked for any necessities that may arise.
Of course, you’ll need to deal with the things we just mentioned (payment schedules, late fees, etc.) from the other side of the exchange. But, to be sure, as long as you keep up with your end of the bargain, you’ll have nothing to worry about.
(In fact, the more reliable you prove to be to your lender/vendor/etc., the more likely they are to continue doing business with you in a way that benefits both parties.)
Now, if you can afford to make early payments, you might want to consider doing so. After all, the less you owe, the better, right? But, again, in the early goings, you’ll want to keep as much cash on-hand as possible in case some unforeseen circumstances come about. That said, as a first-time founder, it may be best to simply designate money to be spent on debts owed and pay them when the time arises. That way, you won’t spend it on anything other than paying off your debt – but will still have it on-hand in case you absolutely need it.
We’ve touched on this a few times throughout this article, but now we’re going to lay it all out:
Believe it or not, generating too much business in the “early goings” can actually be incredibly detrimental to your company.
Going back to one of our previous examples, it may feel like a big win to land a $10,000 contract for a brand new client. But if the project costs $5,000 to complete, and you won’t get the full $10,000 for 2-3 months, you’re basically operating in the red. Again, when payroll, rent, and other debts become owed, you won’t be able to pay them; unfortunately, that “big win” actually ends up sinking your business entirely.
In his book Managing Cash Flow, John M. Kelly addresses this quite simply:
“Focusing on cash flow is the best way to determine whether the proposed project is feasible.”
To truly get a handle on understanding whether a specific project is doable at the present moment, you’ll want to conduct a cost-benefit analysis on the project. This involves asking questions such as:
- What Are the Goals and Objectives of the Project?
- What Is the Outcome of Costs and Benefits?
- What Is the Net Present Value of the Project Options?
- What Do You Do?
Essentially, answering that final question involves taking an objective and realistic look at your business’ current financial situation to determine whether or not you can afford to take on a large project.
This may go without saying, but if the answer is “no,” don’t force it. Not only will you run the risk of not being able to pay scheduled bills on time, but you’ll definitely not have cash on-hand to pay for any spur-of-the-moment costs that may come about as you complete the project.
Play it safe. There’ll come a time when taking on these larger projects will be a cinch in terms of affordability; for now, just focus on getting your business to that level.
Hopefully by now we’ve made it clear that keeping track of cash flow (and all other financial aspects of your business) will only continue to get more and more complicated as time goes on.
While you may be able to manage your business’ cash flow as you get the company off the ground, it won’t be long until doing so becomes a part-time job (and, eventually, a full-time job) in itself.
That said, once you’ve managed to get your business up and running – and are pulling in a couple million dollars in sales – you’ll want to look into hiring a bookkeeper or accountant to keep track of your finances.
Eventually, you’ll want to hire a dedicated CFO to pretty much take complete control of your business’ finances.
Going back to our previous point about cost-benefit analysis, it’s worth thinking about it like this:
If you hire an accountant, will you be able to use the time you’ve now saved to make enough money to cover the cost of said accountant (and then some)?
If the answer is “no,” obviously you’ll need to keep “going it alone” for the time being.
On the other hand, if you could use the time you’ll save to keep growing your business, you absolutely should make the hire.
I mean, it’s pretty simple:
The more leads you generate, the more clients you’ll land. The more clients you land, the more money you’ll make.
More leads = more cash flow.
But, when we say “consistent,” here, we don’t just mean “constant.” Yes, you do want to generate a constant flow of new leads – but you also want each of these leads to be consistent in terms of who they are and what they need from you.
That is, you don’t want to take on just any new potential customer just because the opportunity is there. As we said earlier, taking on too large of a project could end up decimating your business. On the other side of things, taking on simple projects that don’t pay as much in return might not affect your bottom line all that much.
So, again, if you want to keep your cash flow positive, you need to be generating leads on a consistent basis.
Mitch is currently running a free training webinar which will teach you how to generate all the leads you need to grow your business and increase your revenue.
You can learn more and save your spot here.