The Importance of Cash Flow for SMEs
A small business can survive a surprisingly long time without a profit. It fails on the day it can’t meet a critical payment. Liquidity is the life blood of any SME, making cash flow more important than the magnitude of the profit or the return on investment. But what exactly is cash flow? Cash flow is the difference in the amount of cash available at the beginning of a period, referred in accounting terms as opening balance, and the amount at the end of that period, referred to as closing balance. Cash inflows result from the sale of goods or services. Cash outflows result from the need for the business to pay for costs such as raw materials, transport, labour, and power. The difference between the two is the net cash flow. A healthy, consistent cash flow position creates liquidity for the SME. This enables the SME to sustain its operations resulting in the generation of higher profits. Profits enable re-investment which drives growth. This life-cycle makes maintaining liquidity the priority of any manager of an SME. Cash flow is of vital importance to the health of all businesses, particularly SMEs. An SME may be able to continue to trade in the short term even if they are making a loss, by delaying creditor payments, but no small business can survive long without enough cash to meet its immediate needs.
Regardless of the size of the SME or what industry it is in, one key statement is relevant to all SMEs: If your expenses exceed your cash, then you have a cash flow problem. Too many SMEs struggle to properly manage and sustain positive cash flow. A recent study by U.S. Bank found that 82% of the time, poor cash flow management or poor understanding of cash flow contributed to the failure of a small business. With a negative cash flow the business is receiving less cash than it is spending, causing it to struggle to pay immediate bills. This may lead to the SME having to borrow money to cover the shortfall. However, traditional finance providers, such as banks, neither have the capacity or willingness to lend to SMEs due to inadequate technological infrastructure and higher regulatory capital requirements reducing risk appetite. At present, a $2.6 trillion global SME funding gap exists. Squeezed by the low interest rate environment, European and American Banks in particular, continue to reduce lending to the smallest SMEs and increase the APRs of traditional finance methods such as credit cards and overdrafts. As a result, more and more SMEs are failing due to cash shortages. A consequence of this is that 51% of new businesses do not survive beyond four years of operation as their ability to borrow is severely limited.
Such limitations mean that small businesses can seldom survive mistakes or misjudgements. To overcome the problems posed by resource poverty, SMEs must confront the problem of cash flow and often respond to large, severe, short-term fluctuations in cash flow. Over short periods, the difference in cycles of payments can be significant, making it difficult to track cash flow unless the SME is well prepared. Salaries and wages may be paid weekly, biweekly, monthly, and semi-monthly. Tax deposits are made monthly; some quarterly. Only a few expenses fall into the uniform monthly cycle portrayed by the income statement. In addition to this, SMEs face a payment battle with debtors, with one in four SMEs facing delays in customer payments. Because of this, cash flow management is key. Future forecasts and cost-benefit analysis of expenses should be seen as imperative to SME operations. It will heighten the awareness of the SME with regards to its cash flow and enable the business to invest in new products, pay down debt and finance other strategic initiatives, allowing the SME to achieve more sustainable growth. Strong cash flow also puts businesses in a better position to negotiate more attractive financing terms with lenders and steeper discounts with suppliers. Whether a company is flush with cash or experiencing a shortfall of funds, good cash management is critical to the success of every company. As the saying goes, turnover is vanity, profit is sanity and cash flow is reality.