When should your small business choose cash versus credit?

by Reed Richardson


The statistics staring at budding entrepreneurs are ugly-nearly two out of three new businesses won't survive past six years. A lack of a rigorous business plan, insufficient marketing, and poor product quality can, among numerous other problems, contribute to this sobering reality, but foremost among the reasons for early failure is a rather mundane and oft overlooked difficulty-poor cash flow management.


"Consumers are not stupid about banking issues, but they often are ignorant about the most efficient choices for themselves," noted E. Thomas Graham in a lengthy article on the FDIC Consumer News website that discusses using cash versus credit (click here to read more). Graham, who is president of the non-profit Personal Finance Employee Education Foundation as well as professor emeritus of consumer economics at Virginia Tech University, argues that many Americans-including many small business owners-are poorly educated about their own finances and, as a result, the choices they make on a daily basis often lead to long-term trouble.




Despite our economy's perceived obsession with credit, most transactions within our economy-from straightforward purchases like buying a soda at a vending machine to complex transactions like a massive cash-for-stock corporate takeover-still rely on good old cash. The most compelling reason for cash's continued dominance is its immediacy-"I want something now and I want to pay for it now." The buyer and the seller are both satisfied at the same time. This immediacy brings with it no extra transaction costs either, as FDIC Associate Director for Consumer Protection Kathleen Nagle explained in that same Consumer News article. "Cash is usually the cheapest way to go," Nagle noted. "No fees, no service charges, no interest payments."


Cash, of course, is (almost) universally accepted as well, making it the last and best form of payment no matter who is involved in the transaction or what's being purchased. Likewise, the primary hurdle for using cash-its availability-has been eliminated thanks to the vast network of 24-hour accessible ATMs now standing at practically every street corner. For small business owners that might be struggling to keep their head above water, using cash to pay bills and settle debts can offer a welcome oasis of simplicity and acceptance in an otherwise complicated and rejection-happy world. And no business ever fell into too much debt from just using cash on hand. Indeed, perhaps the most effective spending limit around involves looking into one's wallet or purse to see how much cash is left and to plan accordingly.


But cash as a payment method has its limitations and drawbacks as well. Unless you're an established customer or dealing with a public utility, cash won't be of much help when trying to execute most online or phone transactions. Nevertheless, cash is still considered the most liquid of all assets and, as such, it can therefore be the hardest to track in terms of how quickly it flows in and out of your business. Unless you are an inveterate receipt saver, a heavy reliance on cash can therefore easily mask where and how you're spending your money, which could lead to a cash flow disaster that shuts down your business if left unchecked. In addition, cash simply isn't well suited to large transactions or big-ticket capital investments and it offers the least in the way of consumer protections after the point of purchase-there's no way to stop payment or dispute a cash purchase after the fact.




By contrast, small businesses that rely more on credit get the benefit of time. In fact, credit cards are best thought of as short-term, roughly 30-day, interest-free loans. Putting off these payments for just one month can mean holding onto extra cash-and therefore earning more interest-which can be a boon to a small business's bottom line. But for this plan to work, a small business owner has to be diligent about paying off the entire amount spent at the end of their billing period. As countless examples have shown, if you fail to follow this rule or let spending with credit far exceed your small business's incoming revenue, you're in danger of adding extra costs to your purchases as well as over-leveraging your business. "After adding in the finance charges," the FDIC's Nagle explains, "you have done the opposite of buying on sale." Instead, she notes that not paying off your credit cards each month is "like marking up your purchases."


Still, credit and credit cards are only gaining in popularity because they increasingly offer many of the advantages of cash, yet with added consumer protections and built-in tracking mechanisms. Rare is the business that still refuses to accept some kind of credit card or, if you have a steady buyer-vendor relationship, delayed invoicing system, making the acceptance of credit for payment almost as ubiquitous as cash in today's economy. Plus, the Fair Credit Billing Act ensures that a small business can rely upon the consumer protection features of most major credit cards to ensure that the products or services it purchases match up with the quality promised by the seller. And for entrepreneurs looking to closely monitor all their outgoing expenses-no matter how small-over the course of a month, using a business credit card instead of cash is a simple way to ensure all those nickel-and-dime transactions get captured for later review.


Finally, as mentioned previously, credit remains the most popular method for making big-ticket purchases and for financing major capital investments, as it lets a small business spread its payments over time (while simultaneously depreciating those investments, in many cases). Still, using credit requires that someone be willing to lend that money to your small business and as many entrepreneurs have discovered, that can often be a more difficult task than expected. And trying to swear off credit purchases altogether is of little use as even those small business owners with the most modest of aspirations will one day require some kind of credit or lending for a purchase, so starting early and building up a reliable track record for borrowing and paying back is still a wise move.

Striking a balance
For an overwhelmingly majority of small businesses, a mix of cash and credit purchasing will end up being the right solution. Convenience at point of purchase is always a big driver in choosing between cash and credit, but many budding entrepreneurs fail to also consider the convenience factor when it comes to accounting for this spending later on. As managing cash flow is a critical part of a successful start-up, it's important to understand which spending preferences work (or don't work) well with the two main accounting methods. For example, the accrual method of accounting, which counts both debts and revenues on the books as soon the purchase or sale is made, provides a more accurate view of a company's current debt obligations, but can make it hard to judge just how much cash is currently available. A company using accrual accounting, then, might be better off using credit for more of its purchases. Conversely, a small business that follows a cash-based accounting method, where revenues and debts are only recorded once money actually changes hands, might be better suited to use cash or a debit card for most its daily expenses.


In fact, employing a debit card is perhaps the best compromise measure, one that builds in the immediacy and restraint of cash purchases, yet offers the flexibility as well as access to the often-generous rewards programs of a credit card. Linked to your small business's checking or money market account, your debit card, which effectively works as an electronic check, can become a quick and efficient way to combine many of the best features of both cash and credit purchases. For larger purchases you'll still likely need an actual credit card, but if your bank offers online access, a small business owner could then consolidate much of their company's spending within this account, which would allow for monitoring of spending going out, revenues coming in, and remaining cash flow on almost a real-time basis. And anything that gives you a better sense of your small business's cash flow is always a good thing.

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