Posted: September 30, 2011

Ask any business owner about the status of his or her business and you will probably receive a reply telling you about the company's sales - "this year's sales figures are well above last year's," or "this year's sales figures are not as strong as we projected."

If not a discourse on sales, you might be told about the company's profits - "we have killer profits this quarter."

While there is no denying the importance of both sales and profits, all too often small business owners overlook the one thing that is the most critical measurement of business success or failure: its cash flow.

What exactly is cash flow? It is the ebb and flow of cash, both into and out of the business. A readily understood example is making bank deposits and writing checks to cover expenditures.

Cash flow is not profitability. That is what occurs on an income statement when the business sells a product.

Cash flow is the lifeblood of the business. Without it, the business will cease to exist. If the money is not coming into the business, then the owner will have to resort to using his working capital - usually a line of credit with his or her bank or financial institution - to cover the bills until the receivables are paid.

No business is exempt from the perils of low or negative cash flow. Retailers need to purchase inventory to sell, and those purchases are not done on a contingency basis.

Manufacturers need raw materials and packing materials to make and ship their products prior to selling them. Rarely, if ever, are service-based companies paid in advance for their services, unless it is a legal firm that collects retainers.

What business owners need to do is avoid what Ron Collier of the Collier Consulting Group refers to as the "cash trap," or the lag between the time a product is sold and the time that the cash is actually collected. He postulates that any outstanding accounts receivable that is over 30 days will have lost 8 to 10 percent of its value due to inflation, administrative processing and collection fees. Those receivables that are 60 days or older will probably be completely written off as they are, usually, uncollectible.

A simple formula to measure this important indicator is to calculate the business's working capital turnover. Simply divide the amount of sales by the amount of available working capital and you get a number. Anywhere between 1 and 9 and the business is probably over-capitalized, which could lead to poor business practices due to no sense of urgency to sell product because the is "money in the bank."

A number greater than 12 indicates that the business is under-capitalized and there is a real risk of failure if invoices are not paid in a timely manner. Indicators that a business may be under-capitalized include: the owner not taking a paycheck; balancing invoices and determining what can and cannot be paid and when; and stalking the mailbox looking for checks that can immediately be deposited in order to avoid overdrafts.

In order to succeed in this arena, a small business needs enough working capital to match its sales requirements, a budget and cash flow projection based on realistic assumptions, and a clearly written and consistent collection policy.

Without them, business owners will find themselves extremely busy, making little, if any, money and find out there is no value to the business when it comes time to sell.

Jim Carroll is the executive director for the Small Business Development Center of Hampton Roads and the vice president for small business for the Hampton Roads Chamber of Commerce. He can be reached via email at JCarroll@hrccva.com.