Managing cash flow effectively is not just a good practice, it’s a necessity for the survival and growth of any business. According to a study by U.S. Bank, a staggering 82% of small businesses fail due to poor cash flow management. Another study from Intuit found that 60% of small businesses face cash flow issues every year. These numbers are not just statistics, they are a wake-up call. Effective cash flow management can truly be the difference between thriving and barely surviving.
Over the past five years, I have managed the finances of almost 40 different businesses and consulted with almost 100 more. In this time, I’ve come to understand that cash flow management is a universal challenge. I’ve found four predominant areas where business owners often grapple with cash burn. If I had to rank the most common problems in business finance that small businesses encounter, cash flow management would be in the top 2 (sales would be the other).
In this article, we will explore three areas that can alter a business’s cash burn within 60 days. We’ll discuss practices related to accounts receivable and inventory management. Lastly, we’ll review common issues around pricing.
What Success Looks Like
In October of 2022, I was brought on to be the outsourced CFO of a food manufacturer. In 2022, this client ended the year with almost $8 million in sales, but a net loss of $1.7 million.
For manufacturers, a critical measure of the effectiveness of their working capital strategy is how much inventory they have on hand. As of December 31, 2022, they had 49 days of inventory on hand. If you think about this momentarily, you’ll identify a quick problem. How can a food manufacturer hold this much inventory and not have a spoilage issue?
To finance this loss, the company had to resort to drastic measures. They increased their short-term debt (accounts payable and credit cards) by $569,000. They also took advantage of the EIDL program, which increased their long-term debt by $500,000. This was in addition to raising additional capital from their investors.
What it Takes to Turn Cash Burn Around
In December of 2022, the owner of this company and I sat down to develop a budget. During this process, we took a deep dive into inventory, payroll, and pricing practices. We determined that by hiring someone to manage and purchase inventory, we could save hundreds of thousands of dollars. Additionally, we adjusted our pricing to increase our materials margin by 10%. We put strict benchmarks around production labor that each department could not exceed.
The result was a remarkable 12-month turnaround. In 2023, the company finished the year with $9.9 million in sales and a net loss of just $180k. This was an improvement of over $1.5M in the bottom line in 2022. Additionally, the last 6 months of the year the company actually had net income of $500k.
Beyond the 10% pricing increase, direct production labor decreased dramatically. In 2022, it amounted to 26% of revenue; in 2023, it was 19%. This alone accounted for a savings of almost $700,000!
Inventory had also drastically improved. The days of inventory on hand were reduced to 19 days. This alone represented a one-time cash increase of $490,000.
The results were amazing! Best of all, nothing was done in any sort of cash-burn mad science. It was basic blocking and tackling with a sharp eye on monthly benchmarks.
Issue #1: Collection of Accounts Receivable
Understanding Accounts Receivable
In practice, accounts receivable represent customers’ financing. If your business allows customers to take possession of services or sales now and pay 30 days later, you are, in effect, financing at 0% interest for 30 days.
There is a real cost to this practice. It’s hard for businesses to see because it doesn’t directly show up on the income statement. However, as businesses grow, and in turn, accounts receivable grow, owners often struggle with cash management.
The most important metric in cash flow management is days sales outstanding in accounts receivable (“AR Days”). This metric will tell you the average days that customers are taking to pay. The less this number, the less a business must finance. Most of my clients will give net 30-day payment terms. This means that while a business extends credit, they do expect to be paid within 30 days. As such, if AR Days show 31+ days, this can harm cash burn.
Why 30 days? Most businesses can finance, often interest-free, many of their expenses for 30 days. However, the one expense they can’t finance is payroll. This is often where their must be cash management strategies put in place.
Consequences of Poor Accounts Receivable Management
When businesses struggle with accounts receivable management, they often face tough cash flow decisions. Owners may have to put additional capital into the business. Even worse, owners may need to turn to high rate financing.
This is a very common scenario: The business doesn’t get paid for 60 days from their customers. They must use a combination of credit card debt and short-term funding to bridge the cap. That debt has an average interest rate of 20%. Their margins have been cut in half because of having to finance this gap.
Best Practices for Accounts Receivable Management
Efficient management of accounts receivable is crucial for maintaining a healthy cash flow. Start by automating your invoicing processes to ensure timely and error-free billing. Clear, detailed invoices with standard payment terms help avoid confusion and delays.
Offering early payment discounts, like 2% off if paid within 10 days, can incentivize faster payments and improve your cash flow. Make sure to communicate these benefits to your customers clearly.
Lastly, regular follow-up is essential—send reminders a few days before and immediately after the due date if payment hasn’t been received. Its amazing how this one tactic alone can improve collection times. For larger accounts, personalized follow-up calls or emails can make a significant difference. Additionally, having a clear escalation process for overdue accounts ensures that you address delays professionally and effectively.
Issue #2: Too Much Inventory on Hand
How Excess Inventory Increases Cash Burn
Just like accounts receivable, a useful metric for inventory is “Inventory Days.” This metric tells you, on average, how many days’ worth of sales your current inventory represents. For instance, if you have 50 days of inventory on hand, it will take you 50 days to sell through all of it.
Typically, you must finance the holding period for inventory. If you take advantage of your vendor’s terms, you often get to finance your inventory for 30 days at zero percent interest. However, any day over 30, you need to finance.
Additionally, having cash tied up in excess inventory means you lack available cash for other needs.
The Cost of Holding Excess Inventory
Beyond financing costs, holding too much inventory can lead to additional storage and spoilage costs.
Storage costs are straightforward: if a business has a lot of inventory, it needs space to store it. For example, e-commerce clients who hold 90 days of inventory need significantly more physical space than those holding just 30 days. This increase in inventory leads to higher rent, utilities, and payroll costs.
The longer you hold inventory, the more it ages, increasing the risk of spoilage. Even without spoilage, inventory can become obsolete. E-commerce companies often find themselves with older versions of products after a vendor introduces a new version, reducing the value of the older stock.
Identifying the Right Inventory Levels and Strategies to Reduce
Finding the right balance in inventory levels is key to minimizing cash burn. Start by understanding your inventory turnover ratio, which measures how often your inventory is sold and replaced over a period. A high turnover ratio indicates efficient inventory management, while a low ratio suggests excess stock that ties up cash. Pair this with demand forecasting to predict future sales based on historical data, market trends, and seasonality. Accurate forecasting helps you maintain optimal inventory levels, ensuring you have enough stock to meet demand without overstocking.
To keep your inventory lean, consider implementing Just-in-Time (JIT) inventory. JIT is often hard (maybe impossible) for small business owners to implement. But the concepts can be adhered to. JIT aims to align your inventory orders with production schedules so that materials arrive just as they are needed, reducing storage costs and minimizing waste.
These strategies not only help reduce excess inventory but also free up cash that can be better utilized elsewhere in your business.
Issue #3: Bad Pricing Practices
The Role of Pricing in Cash Burn
Pricing plays a critical role in determining your business’s cash flow and profitability. Poor pricing practices can quickly lead to increased cash burn and financial instability.
Small businesses are often overly conservative when it comes to pricing. They are much more concerned then larger businesses about relationships with customers and the impact pricing will have on them. As a result, small businesses are constantly pricing their products and services too low.
Common Pricing Mistakes
Businesses often don’t understand their full cost of selling a product. While a product you sell for $10 may have only cost you $6, there are often other items that impact the true cost of selling the item. For example, marketing expenses, shipping costs, and transaction fees can significantly add to the overall cost. Additionally, overhead costs such as salaries, rent, and utilities must be factored in to get an accurate picture of profitability. Without accounting for these hidden costs, businesses may inadvertently underprice their products, leading to reduced profit margins and increased cash burn.
Impact of Poor Pricing on Cash Flow
When pricing is not optimized and products are sold too cheaply, the immediate consequence is reduced profit margins. Underpricing means you’re not covering costs effectively, which can quickly erode your bottom line. This practice can lead to a constant struggle to maintain a healthy cash flow as revenue fails to meet the necessary expenses. Moreover, consistently low prices can devalue your products in the eyes of customers, creating a perception of lower quality and undermining your brand’s reputation.
Effective Pricing Strategies
Pricing effectively often means taking a multi-pronged approach. No one methodology will often lead to the correct price to set for your goods and services.
Start with thorough market research and competitive analysis. Understanding what competitors charge and what customers are willing to pay helps set a realistic price point.
Next, truly understand your numbers and what your total cost for selling a product is. Understand your overhead an how to adequately cover that in your pricing strategy.
Lastly, you must have a detailed forecast that will show the results on cash burn of pricing at different levels. Only then will you be able to see the full effect of specific pricing levels.
Conclusion
Effective cash flow management is not just a good practice; it’s essential for the survival and growth of any business. As mentioned, studies show that 82% of small businesses fail due to poor cash flow management, and 60% face cash flow issues annually.
Over my years of managing finances for numerous businesses, I’ve observed that cash flow management is a universal challenge. By concentrating on improving collections, maintaining optimal inventory levels, and setting effective pricing strategies, businesses can significantly enhance their financial health.
The practical steps outlined in this article are not just theoretical; they are proven methods that have led to dramatic improvements in cash flow and overall business performance. By adopting these strategies, businesses can move from merely surviving to truly thriving.
Krieger Analytics Can Help
Krieger Analytics has several small business owners who rely on them as their outsourced CFO. These businesses range in size ($1M to $15M in sales) and industries. We are an expert in servicing small businesses because we have been entrepreneurs. Our expertise doesn’t just come from theory, it comes from practice.
Contact us now if you want to learn what a CFO can do for your small business. We’d love to see if we are a good fit and can help you accomplish your goals.