For SMEs, cash flow management is critical to ensuring the business can sustain operations and grow. This becomes particularly important for non-profitable businesses, such as startups or high-growth companies, where the focus is on investing in expansion rather than immediate profitability. Such businesses are often reliant on their cash reserves and external funding. And improving your understanding of the underlying dynamics behind your cash flow is essential for effective management and business growth.

Key Metrics for Managing Cash flow

Four essential metrics form the foundation for understanding cash flow for growing SMEs:

Net Income

• Net income is the profit (or loss) a company earns after all expenses, including taxes, interest, and operating costs, have been deducted from total revenue. It is often referred to as the "bottom line" and can be found at the end of a company’s income statement.

• Net income serves as a key indicator of a company’s profitability, reflecting how efficiently it operates relative to its costs. 

Net Working Capital (NWC)

• Net Working capital or just working capital refers to the difference between a company’s current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and short-term debts).

• It is a measure of a company’s liquidity, operational efficiency, and short-term financial health. The working capital calculation is:

  NWC = Current Assets - Current Liabilities

  
  

• Changes in working capital directly affect a company's cash flow. For instance, if accounts receivable increase, it ties up cash in unpaid invoices, reducing available cash. Similarly, rising inventory levels mean more cash is locked in unsold products. On the other hand, an increase in accounts payable allows a company to delay payments to suppliers, conserving cash in the short term

Operating Cash Flow (OCF)

• Operating Cash Flow (OCF) measures the cash generated by a company’s core operating activities, excluding cash from financing and investing activities. It provides insight into the company’s ability to generate cash from its primary operations, which is crucial for covering ongoing expenses without relying on external funding.

• OCF ties both Net income and changes in working capital together in a single metric, and can be calculated as:

  OCF = Net Income + NonCash Expenses + Changes in NWC

  
  

• OCF is used to assess the overall efficiency of cash management within a company, giving a more holistic overview of a company's cash flow.

Cash Burn Rate

• Cash burn rate represents the net cash outflow a business incurs over a set period (usually monthly). It shows how much cash the business is spending compared to the inflows from operations or revenue. Burn rate is critical for understanding how quickly a company is depleting its cash reserves and, by extension, how much runway it has left. The cash burn rate calculation is:

  Cash Burn Rate = Cash Outflows - Cash Inflows

  
  

• Cash Burn Rate is a simplified calculation focused more on the actual cash movement. It can however be tricky to calculate as cash usually moves between many different accounts within a business. Over a period, cash burn rate and OCF will roughly align, but there might be differences too.

Calculating a Business Runway

Runway refers to the length of time a business can continue operating before it runs out of cash. The simple formula for calculating runway is:

Runway (months) = Current Cash Balance / Current Burn Rate

For a conservative approach, one could also use the Gross Burn Rate, which only takes into account expenses, and leaves out incoming cash. This would give an estimate how long the business could operate without any additional revenue coming in.

An improved approach to understanding when a company would run out of cash, would be to align it more towards the viewpoint of OCF. The proposed formula would be:

Runway (months) = (Current Cash Balance - changes in NWC) / -(Net Income + NonCash Expenses)

I.e. assuming a business has a net income of -£55,000 a month, with 5,000 of depreciation as the only non-cash expense. And a cash balance of £500,000. Growth is expected, and as such, the business is projecting that they need to tie an additional £200,000 in working capital over the next 6 months. The runway then becomes 6 months ((500 - 200)/(- (-55+5)))

If the business on the other hand is instead able to free up £100,000 in the next 6 months. Runway would instead become 12 months ((500+100)/(- -55+5)). 

The formula above can further be extended with things such as Capital Expenditure (such as investment in assets) and Net Cash from Financing Activities (such as additional loans) to ensure a more accurate representation.

Strategies to Optimize Cash Flow

To manage cash flow effectively, SMEs can adopt the following strategies:

Optimize Cash Burn

• Prioritize growth-focused spending: Only invest in initiatives with a clear return on investment (ROI), such as marketing campaigns or product development.

• Cut unnecessary expenses: Reassess subscriptions, office space, and other fixed costs that don’t contribute directly to growth.

• Stagger capital expenditures: Spread out large expenditures like equipment purchases to avoid high cash burn in a single period.

Manage Working Capital Effectively

• Shorten AR cycles: Encourage customers to pay more quickly by offering early payment discounts or implementing stricter payment terms.

• Extend AP cycles: Negotiate longer payment terms with suppliers, giving the business more time to hold onto cash before paying out.

• Better manage inventory: Avoid bulk purchases that tie up cash unnecessarily. Implement just-in-time (JIT) inventory practices to align purchases with demand.

Improve Operating Cash Flow (OCF)

• Increase revenue-generating activities: Focus on core business operations that generate positive cash inflows.

• Enhance operational efficiency: Streamline processes to reduce operational costs, which can positively impact OCF.

• Reduce cash leakage: Identify and eliminate unnecessary outflows that drain cash from daily operations.

Accurate Cash Flow Forecasting

• Create detailed cash flow forecasts that account for burn rate, working capital needs, and OCF. Regularly update these forecasts to reflect changes in revenue, expenses, and market conditions. Accurate forecasting allows businesses to anticipate cash shortages and adjust strategies accordingly.

Conclusion

Cash flow management is critical for SMEs, particularly for non-profitable businesses that are investing in growth. By understanding how cash burn, working capital needs, and operating cash flow (OCF) interact, businesses can better manage liquidity, optimize their runway, and make more informed financial decisions. Effective strategies, such as improving AR/AP cycles and controlling expenses, will not only extend the runway but also position businesses for long-term sustainability and profitability.

With the right tools and proactive cash flow management, SMEs can maintain the financial flexibility needed to navigate growth phases and emerge as successful, profitable ventures.