A Guide to Cash Flow for SME: The Role of Cash Flow for Small- and Medium-sized Businesses Explained
Cash flow is vital for any business. As a rule, strong cash flow indicates the success of an operation. According to the statistics, in 82% of cases, businesses fail because of bad cash flow management. The statistics are staggering; from it, we can see that the majority of businesses lack an understanding of why it’s important to manage cash flows.
Understanding this is important because otherwise, you risk making wrong, non-informed financial decisions. Ultimately, cash flow is the reason why many businesses fail, and you don’t want to be among them, do you?
As a small business owner, your job is to keep continuous liquidity to make a good use case for potential lenders. Today, we will help you make informed decisions when managing your cash flows with our guide to cash flow for SME.
What is Cash Flow?
Cash flow is your revenue after you pay off your daily expenses. This is cash that you can use for handling business debts. Lenders consider cash flow when reviewing your loan application. Cash flow indicates a business’s ability to repay debt, including its capital, collateral, and creditworthiness.
In other words, to calculate cash flow, first, you need to divide net income by net loss. Then, divide depreciation by amortization and add up both numbers. Finally, add interest paid on debts to the resulting number, and you will get your cash flow.
In practice, you should hire an accountant who will keep financial records reflecting the current status of your business finances. However, if lenders find out that your real financial status differs from what you indicated in the records, your loan application will likely be rejected.
What if Cash Flow Turns Negative?
If your cash flow calculations return you a negative value, that may mean you are no longer able to take care of your immediate financial needs. One of the most likely reasons for having negative cash flow is payables exceeding receivables. In turn, low receivables may be the result of low sales and past-due invoice payments.
To get out of this, manage expenses, maximize margins, and build a steady customer base to ensure you have a positive cash flow balance. Another tip is to reconsider your payment terms. For instance, you may request your customers to make payments within 30 days and ask your vendors to give you 45–60 days to make invoice payments. This way, you will recover your receivables and have enough time to pay invoices. And, most importantly, you move past the situation in which you had to apply for a working capital loan that only added the interest to your payables.
Alternatively, you may be dealing with low sales and consequently low receivables per se. If this is the case, it’s advisable to apply for a loan, but check your interest rates beforehand. You may use credit cards to cover regular expenses; at any rate, the credit should be paid as early as possible so that you won’t accumulate it as debt.
How to Improve Cash Flow at Each Stage of your Financial History
The historical data on your cash flow reflects the current and future state of your business. And if you apply for a loan to expand your business, the lender will consider your past cash flow to see if you are able to repay the debt. In general, there are three ways in which you can improve your cash flow situation.
The first one is when you don’t have cash flow history, for example, when your business is at the pre-launch stage. Here, you may only project your cash flow based on your estimates. Make sure to get accurate estimates. Next, think about how you can reduce your business expenses without affecting your business launch plans and further goals. Mind that at this stage, lenders will check how realistic your plans and estimates are rather than expect to see profits from you.
But if your financial history has a year or two, the expectations will rise. At this point, lenders will look at how profitable you are. Has your net income increased? Do your expenses correlate with the growth goals? These are the questions you should ask yourself before lenders ask them to get ready for their meticulous review of your business. Better, in this way, you will help yourself properly plan your purchases without getting short on cash.
For lenders with a long financial history of three years or so who find themselves running out of cash in the next few months, we advise making an assessment first. Define where you invest your budget; it can be marketing, inventory, growth, staffing, or other areas. You will need that to show your potential lenders how these investments affect your net income as good proof you are entitled to a loan. In addition, by doing that kind of research, you may find new ways to cut your business expenses.
More Benefits of Digital Cash Flow Data
The financial crisis of 2008 only intensified the search for alternative data sources. Credit bureaus, lenders, and other financial organizations looked for new ways to predict risk as accurately as possible. As the digital space evolved, they tried to avoid traditional means, relying solely on electronic data in their forecasts. At this point, small businesses’ financial data attracted much interest, in particular, when it could be accessed digitally.
In general, there are several aspects of digital cash flow data that make it valuable for evaluating credit risks among SMEs.
Detailed and timely. Cash flow data from accounting software or bank accounts can provide a more detailed view of the overall financial situation than traditional credit reports, scores, or regular financial statements. Typically, traditional credit reports contain payment history of particular expenses, yet, accounting software and banks accounts’ data is a more detailed overview of inflows and outflows in real-time. Sometimes, present-day financial history proves itself more useful than the past data as relying too much on the past data, lenders risk missing the signs that business is now recovering.
Available. Digital cash flow data is available even for companies without credit histories. Business checking accounts are significantly more affordable than credit ones. As a result, small businesses increasingly rely on accounting software, e-commerce platforms, and payment card processors, generating new types of cash flow-related digital data.
Specialized. Finally, this type of data can help lenders build tailored credit risk models based on the type and size of the related business. For instance, businesses without lending histories may find it difficult to prove their credibility to local banks. In contrast, online lenders with years of experience and data from versatile sources can easily predict when a loan should be granted to them.
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