ComplianceLegalFinanceNovember 16, 2020

Managing cash flow peaks and valleys for a new business

When small business owners plan their cash flows, they usually assume that sales will occur on a regular basis. For example, if they estimate that they will have $120,000 in sales revenue, they typically presume that they will do roughly $10,000 per month in sales and plan accordingly.

Some businesses are seasonal, while some businesses endure ups and downs for a variety of other reasons. As a consequence, the business owner who has planned for $10,000 in sales revenue for a month and only receives $2,000 may experience a cash shortage due to poor planning.

To combat this problem, it is important to understand your cash flow cycle. To start, all new businesses need to forecast the inflow and outflow of cash. Next, a plan must be formulated to deal with unexpected results. A cash flow shortage may need to be covered. Many small businesses turn to third-party financing when unexpected shortages occur.

Forecasting cash flow within your new business

All new businesses should prepare a monthly cash flow forecast for the first year and an annual forecast for the first five years of the business.

The worksheet is set up to be used for forecasting your cash flow for each of the first six months for your new business. We've formatted the worksheet and put in most of the cash inflow (income) and outflow (expenses) categories for you. All you have to do is put in your numbers.You may need to add categories that are unique to your business

Let's take a look at a table of how those tools might be used to forecast your cash flow. Suppose the following:

Sales $287,000 Rounded.
Cost of sales - $143,500        Trade data shows that 50 percent of sales price is food cost.
Operating expenses - $104,664 Four times the 90 day's working capital.
Debt payments - $10,000 $50,000 note due over five years.
Net cash = $28,836 Approximate cash generated for one year.

What happens to this cash flow if sales are 10 percent less? If sales are only $258,300, then the net cash would only be $136 instead of $28,836. Would this affect your decision to open your new business?

Take this a step further. What if sales were down 10 percent and the cost of sales was 60 percent of sales instead of 50 percent ($258,300 x 60% = $154,980)? This would put you in a negative cash flow for your first year of operations by $1,732 ($258,300 - 154,980 - 104,664 - 10,000 = (11,344)).

Remember, this example does not provide any cash for the owner to live on. The example provides only the cash requirements for the business.

Enough gloom and doom. Switch all those what-ifs around and you will have a positive cash flow of $83,848 (sales $315,700, cost of sales $126,280).

Planning for cash flow ups and downs

Your actual cash flow results will probably be different from what you have forecasted. If you're fortunate, the variance will be on the positive side. For example, if your sales end up being 10 percent higher, or your expenses are 10 percent lower than budgeted, it's a nice situation to be in.

If your actual cash flow results are better than expected, ask yourself why. Is your new business making more money than you had anticipated? Go back to your original plans to see what is helping your cash flow. You will want to expand on the items that are having a positive effect.

For example, suppose that every time you advertised in the newspaper, your sales increased by 10 percent the following week. In this case, you may want to gradually increase your advertising budget until you see that sales are not increasing proportionately to the amount spent on advertising.

It's imperative to plan for when actual cash flow results are lower than the expected results before it happens. You should not plan your cash flow forecast so tightly that a small variation in actual results can have a significant effect on your ability to keep your business going.

Before you sink a lot of money into your new business, we suggest you perform a sensitivity analysis on your cash flow forecast. This will illustrate what will happen to your expected cash flow when your actual cash flow results are different from what you had originally budgeted.

Financing cash flow shortages in your startup company

Most businesses, especially new businesses, have cash flow peaks and valleys. As your business matures and you learn the ropes of operating your business, hopefully, the peaks will greatly outnumber the valleys! However, in the first few months and years, that's unlikely to be the case.

Some cash flow gaps are created intentionally. That is, a business will sometimes purposefully spend more cash to achieve a particular financial result. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerate cash outflows to take advantage of significant trade discounts, or spend extra cash to expand its line of business.

For other businesses, cash flow shortages are unavoidable such as with a business that experiences seasonal fluctuations. This business may normally have cash flow gaps during its slow season and then later fill the shortages with cash surpluses from the peak part of its season.

Cash flow shortages are often filled by external financing sources. Revolving lines of credit, bank loans, and trade credit are just a few of the external financing options available.

  • Revolving lines of credit: A revolving line of credit is usually obtained from a bank. This type of financing is when a bank allows you to borrow up to a specific amount and you are continually allowed to draw down and pay off that amount of debt. As an example, you might have a line of credit of $5,000. You borrow $4,000 and then pay off $2,000 and then borrow another $3,000; this process can be continually repeated when you have the revolving line of $5,000. The revolving line of credit must be backed by easily liquidated assets, such as inventory and receivables, along with personal guarantees to the bank. Typically, the bank will value the line at 50 percent of inventory book value, and 60-80 percent of receivables, depending upon the industry and quality of companies involved.
  • Bank loans: The cost of taking out a small business loan will vary by the lending institution. Call around for the best rates, and ask your friends and acquaintances for their recommendations. You'll need the same type of documentation regardless of which institution you choose.
  • Trade credit: Your major suppliers and vendors will normally provide you with trade credit. The supplier will allow you an extended amount of time to pay your bill, which may be a significant source of financing if inventory will be large in your new business. However, small businesses should even plan on C.O.D. or prepayment terms with some or all vendors until credit is established (especially retail businesses) unless the new business owner is able to negotiate credit terms or personally guarantee payment. The length of trade credit may be as short as 10 days or as long as 90. Payment terms beyond 30 days net are unusual from suppliers for most small businesses and retailers in the U.S. However it is possible to negotiate longer terms, often with the payment of additional interest points for each 15-day period over 30 days, with a cap of 60 or 90 days. Overseas suppliers who are anxious to establish and grow their business in the U.S. may provide 90-day or occasionally even 180-day terms without interest penalties.
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