How to manage cash flow in SMEs
The other day i had a chat with a financial advisor who happens to be an expert in SMEs, on how to manage cash in and outflows. He told me that one of the most important issues for small businesses is their ability to manage cash flow. Most firms usually finds a lack of sales, cash flow management and profitability are amongst the top concerns. Given the importance of this subject it seems worthwhile to examine the academic literature to see what the findings from recent research studies might suggest for the owner-managers of small firms.Despite its importance, the number of research published on the subject of cash flow management within small business, has been relatively limited. However, several studies were found that offer some potentially useful findings. The expert shared about his experiences on management of cash flow and working capital where he said the first thing is for owners or managers to understand the relationship between the cash conversion cycle and levels of liquidity, invested capital and performance.This is because some firms with shorter cash conversion cycles require less invested capital and enjoy superior financial performance and are more liquid that firms that had longer cash conversion cycles. In his work, he has found that firms with shorter cash conversion cycles maintain lower levels of invested capital. In comparison, firms with longer cash conversion cycles were forced to take on more debt seek equity partners or invest more of their own capital to maintain liquidity. He has also over the years found that firms with shorter cash conversion cycles also enjoyed enhanced financial performance. Such firms he said had superior asset turnover and return on investment figures than those with longer cash conversion cycles. He also believes that liquidity levels are higher amongst firms with shorter cash conversion cycles.In his advice to your blogger, he noted that it is easy for a busy owner-manager to ignore cash flow cycles. When sales are strong it is also likely that owner-managers will become less concerned over the collection of receivables. It is only when sales start to slow down that cash becomes tight and the cash conversion cycle becomes of interest.
The expert did however highlight the importance of the cash conversion cycle as a tool for small business owners to employ. Also, he pointed out that understanding cash flow management and monitoring creditors, debtors and working capital requirements within the business are critical. Overall, how short or long the cash conversion cycle is can impact on the firm’s inventory levels, discount policies and need to maintain over draught facilities.When it comes to working capital management and profitability, he says cash conversion cycle is a measure of a firm’s working capital management. In his own words, cash conversion cycle includes the firm’s management of accounts receivable, inventories and trade credit. In addition, shorter cash conversion cycles indicate a more aggressive approach to working capital management. Over the years, he has found a relationship between working capital levels and firm profitability. He suggests that SMEs may have an optimal level of working capital that maximises their profitability. Once a firm moves away from this optimal level profitability is likely to decrease. He does highlight the need for small business owners to focus on finding an optimal level of working capital and seeking to maintain it.His advise to your blogger addressed the issues of cash flow management and liquidity amongst small firms and his views point to the importance to small firms of effective cash flow and working capital management. If I were to summarise his opinion into lessons for small business owners, i should point out that monitoring cash conversion cycle by tracking debtors and creditors and setting measures of how long it should take to receive payment from customers and make payments to suppliers is hugely important. It is also important to recognise that cash flow management is an integral part of a firm’s financial system and will impact on its working capital requirements and overall financial performance.Also, there is a potential relationship between the firm’s profitability and its working capital requirement and each firm may have an optimal level of working capital.Importantly, each industry may have different factors influencing liquidity levels.What I learned from him in a nutshell is that managing firm’s cash flow and working capital requirements towards a future in which debt financing isn’t needed, is the key to success in SMEs.