Running a small or medium-sized enterprise (SME) can be compared to piloting an aircraft. In the achievement of your objectives, you keep your eye on certain controls. As velocity and altitude are typically the two most important gauges for a pilot, for the owner of an SME, it is usually profitability and cash flow. Too often, SME owners will neglect cash flow. This may result in the business equivalent of crashing an aircraft into a mountainside.

So why is cash flow so important?

First, cash is like the gasoline in an aircraft or automobile. You run out, you crash. New companies, particularly in the hi-tech business, talk of a “burn rate”: the higher your overheads, the faster your gasoline is being depleted, the faster you must either reach cash break-even or get a cash infusion, failing which, you crash.

Second, many businesses are seasonal. Even though they may be highly profitable, they may require huge amounts of cash at certain times of year (like when inventories and receivables are building up), and throw off huge amounts of cash at other times of the year, (like when inventory and receivables might be declining). The cash flow in seasonally positive months may easily give a false sense of security. Like a predator in the jungle that must ensure it has enough energy to make it to the next “kill,” the SME owner must ensure that there is enough cash even in the good months to make it through the entire cycle.

Third, cash is also a buffer that protects a business in any down cycle. If the bottom falls out of the economy – and your company’s sales – your cash buffer will determine how long you can survive and whether you will survive until your sales pick up again. Deceptively, many businesses with cyclically declining sales are cash-flow positive; as receivables diminish, they are turned into cash. Such businesses survive downturns very well, only to hit a wall when they are recovering, where receivables once again begin to accumulate.

Fourth, cash flow may be strained whenever there is a capital investment program. Will your business have enough gasoline to take it not only through the capital investment program, but also the increase in sales required to pay off any bank loans, etc., associated with the investment? One of my clients entered into a €10 million investment and expansion program, only to find out that the expected revenues from the expansion did not materialize due to the recent recession. It helps to do the analysis beforehand.

Finally, banks usually monitor cash flow, and will often prescribe cash flow coverage ratios (such as cash flow during any given period must be a minimum of X times interest, or Y times principal and interest).

One of the most important exercises that the CFO or financial manager should do is a Profit & Loss / Cash Flow Statement. This is vastly superior to the “back of the envelope” liquidity calculations that most SME’s employ. Generally, an excel spreadsheet will suffice, and it is generally not difficult to create a spreadsheet that will give you both P&L and cash flow statements. Make the statement as “granular” as you require the information—weekly, monthly, or quarterly, and for as far out as you need it: a minimum of one year, but could be for multiple years.

This type of forecast should not be performed annually and then forgotten until the following year. Rather, it should be a “living” document, updated periodically to reflect up-to-date information. It may also be used for sensitivity analysis: “what if” decisions. What if the company were to engage in a new investment? What if the company were to open a new office? What if the company were to take on a new product line? Or open a new warehouse? All of these “what if” decisions may be quantified. And not only will the owners and management of the business be able to ascertain whether or not such decisions will crash the business from a cash flow perspective, if one uses the cash flow forecast to calculate Net Present Value, one may also ascertain whether the decision is accretive to the value of the business, or diminishes its value.

Performing this type of analysis regularly is an important step forward in the corporate governance of a company. The vast majority of investors will require this type of information. You might say that it is the business equivalent of moving from Visual Flight Rules to Instrument Flight Rules, which allows pilots to fly also through fog or through the night. It may be an important step in leaving behind “crisis management,” to building a real company.