Even businesses making big sales can end up cash-strapped if the proceeds from those transactions don’t reach their bank accounts in time to meet monthly obligations. In fact, a business can earn a net profit yet still have a negative cash flow and find itself unable to pay bills.
While this situation is relatively common for new businesses – and may be addressed with funding from investments and loans – it’s not a viable long-term solution.
Cash flow is the lifeblood of a business, essential not only to keeping the lights on, but also to investing in growth and expansion. That’s why having a solid understanding of cash flow and how to manage it is essential to a business's success. Below, we’ll provide a 101 guide to what cash flow is and isn’t, why it’s important, and how to manage it.
What Is Cash Flow?
Cash flow refers to the net balance of cash streaming in and out of a business over a specified period. Profit-generating activities bring cash in, while obligations like salaries, wages, supplier purchases, and loan payments move cash out. Cash flow is essentially a snapshot of a business's “bank account” over time.
Why is Cash Flow Important?
Cash flow is critical to the success of any business. It enables a company to meet its existing financial needs and also plan for the future.
Yet, cash flow is a common challenge, particularly among small businesses. Almost half of small businesses have cash flow problems, according to the2022 Intuit QuickBooks Small Business Insightssurvey, which surveyed over 2,800 small businesses in the U.S., U.K., and Canada. And three in five small business reported that they had unpaid invoices.
Staying on top of cash flow is essential to ensure smooth day-to-day business operations. At the same time, careful cash flow management helps companies build sufficient reserves to weather peaks and troughs in sales, late invoice payments, or unexpected expenses.
While both profit and cash flow are important, cash flow is king when it comes to tracking day-to-day financial health.
Ideally, it’s generally preferable to have positive cash flow, meaning more money comes into the business than goes out. Positive cash flow ensures that the company has enough cash (or cash equivalents) on hand to cover its bases and, ideally, reinvest in the business. Still, it’s not uncommon for a company to find itself in a negative cash flow state, with more money going out than in. While negative cash flow might reflect a money-losing situation, other times, it’s simply a result of poor timing, such as customers paying invoices late.
What’s the Difference Between Profit and Cash Flow?
Profit and cash flow are vital but distinct financial metrics for any business. Cash flow represents the money moving in and out of a business’s bank account. This flow is crucial to a company’s liquidity and its ability to meet financial obligations. Cash flow is reported in a company’scash flow statement.
Profit, on the other hand, is the money that remains after all expenses are paid in a given period. It’s reported in a company’s profit and loss (P&L) statement or income statement.
While both profit and cash flow are important, cash flow is king when it comes to tracking day-to-day financial health. A company can report profit and still find itself unable to sustain operations if it doesn’t have the cash flow to meet obligations, secure financing, attract investors, or invest in itself.
Is Cash Flow More Important Than Revenue?
Revenue is the money a business makes from the sale of its products or services. It shows how successful the company has been at selling its products or services.
While revenue is clearly an important financial metric, cash flow indicates how much money a business has on hand to keep operations running and invest in growth. Without that cash in the bank, increasing revenues may not do much good. After all, the business could land some big orders but be unable to fulfill them because it doesn’t have the cash reserves to pay its employees or suppliers.
Types of Cash Flow
To better manage and analyze its finances, businesses dividecash flow into three sources:
- Cash flow from operating activities:Operating activities are regular day-to-day business activities. Inflows include revenue from sales, interest, and dividends. Outflows include operating expenses like wages and office expenses.
- Cash flow from investment activities:Investment activities are monies made or lost as a result of short and long-term investments. Inflows include money made through the sale of assets such as land, buildings, or equipment. Outflows include payments for the purchase of land, buildings, or other investment assets.
- Cash flow from financing activities:Financing activities refer to any funding a company generates in a given time period, as well as the repayment of such funding. Inflows include money borrowed through a bank loan, while outflows include paying dividends or repaying debts.
What Is a Cash Flow Statement?
The three categories of cash flow are all reported by a company on its cash flow statement. This financial document records how much cash enters and leaves the business over a particular financial period.
A business cash flow statement illustrates the different areas where a company spent or received cash, reconciling the beginning and ending cash balances to arrive at a net cash flow balance for the period. The statement serves as a summary of cash flow movements over a reporting period and provides a snapshot view of how well a company is able to generate cash to pay ongoing operational expenses and obligations.
How to Calculate and Assess Cash Flow
To calculate net cash flow, a business adds up all cash inflows (from operating, investing, and financing activities) in a given period and then subtracts the total cash outflows from the same period.
Net cash flow = net cash inflows – total cash outflows
For example, if a retailer earns $300,000 from operations and $40,000 from financing, and then spends $60,000 on investments, the company’s net cash flow for the period is $280,000 ($300,000 + $40,000 – $60,000).
A company is generally considered financially healthy if it consistently has more cash inflows than outflows. However, a more nuanced assessment involves the operating cash flow ratio, which reflects a company’s ability to repay its debts.
Operating cash flow ratio = cash flow from operations / current liabilities
A ratio under one can suggest short-term cash flow challenges, while above one typically indicates good financial health.
Analyzing Cash Flow
Cash flow analysis involves more than just calculating cash flow and reviewing the cash flow statement. It’s about understanding what may be behind those figures and identifying trends over time. After all, negative cash flow is not always a bad sign; It could be due to strategic decisions like expanding into new markets or staffing up for a busy season – both of which may be positive moves for the business.
By analyzing cash flow across different periods, a company can get a clearer picture of its financial trajectory, uncover potential issues in cash management, or identify late payment patterns. Integrating this analysis with otherfinancial statements, like the P&L statement and balance sheet, can provide even deeper insight.
Effective cash flow analysis can help business owners make decisions about how to boost profitability, whether to liquidate certain assets, how to improve cash collections, or whether to secure additional funding. It can also guide in identifying areas for cost reduction or confirm the feasibility of investing in expansion.
What Is a Cash Flow Forecast and Why is It Important?
Cash flow forecasting is essential for future business planning. It involves estimating a business’s future cash position by projecting net income, as well as expected costs and expenses, using both current and historical data.
The resulting forecast can suggest, for example, whether a business might need to cut expenses or increase sales to maintain positive cash flow. It can also indicate potential cash shortfalls due to delayed payments, as well as guide decision-making for cost management or possible expansion.
As part of cash flow forecasting efforts, a business can also explore how different scenarios or decisions could impact its cash flow situation. What might happen if the sales team missed expectations by 25%? Or if the cost of raw materials jumped by 10%? This kind of exploration, called a “what-if analysis,” can be used to help businesses prepare and adapt to potential future financial changes.
How to Improve Cash Flow
When cash flow challenges emerge, there are steps a business can take. Some proven solutions to common cash flow problems include negotiating shorter payment terms with clients for quicker turnover, implementing automated reminders for overdue invoice payments, and cutting back on unnecessary expenses. Investing in robust cash flow management systems and processes can also help make sure businesses have the information and insights required to make the best financial decisions.
The Bottom Line
Managing cash flow is key to making sure you always have enough money available to pay expenses and reinvest in growth. Try to startby establishing a clear, comprehensive view of your business’s cash inflows and outflows. After that, regularcash flow analysisand reporting are essential. By closely monitoring cash flow statements and engaging in cash flow forecasting, businesses can stay informed about their financial health and adapt as needed through various stages and seasons.
A version of this article was originally published August 3, 2021.
Photo: Getty Images
I'm an expert in business finance, particularly in the critical area of cash flow management. My expertise stems from years of hands-on experience and in-depth knowledge of financial principles. Now, let's delve into the concepts discussed in the article.
1. Cash Flow Defined: Cash flow refers to the net balance of cash moving in and out of a business over a specified period. It's a snapshot of a business's "bank account" over time, depicting the inflow from profit-generating activities and outflow for obligations like salaries, wages, and loan payments.
2. Importance of Cash Flow: Cash flow is vital for a business's success, enabling it to meet financial needs, plan for the future, and maintain day-to-day operations. The article highlights that almost half of small businesses face cash flow problems, emphasizing the significance of staying on top of it.
3. Profit vs. Cash Flow: While profit is the money remaining after expenses, cash flow represents the movement of cash in and out of a business. The key distinction lies in the fact that a business can report profit but still face operational challenges if it lacks sufficient cash flow.
4. Cash Flow More Important Than Revenue: Revenue reflects sales success, but cash flow indicates the actual cash on hand to run operations and invest in growth. Without adequate cash reserves, increasing revenues may not benefit the business.
5. Types of Cash Flow: Businesses categorize cash flow into three sources:
- Cash flow from operating activities (day-to-day business activities)
- Cash flow from investment activities (resulting from investments)
- Cash flow from financing activities (funding and repayments)
6. Cash Flow Statement: A company reports all three cash flow categories in its cash flow statement. This document provides a summary of cash flow movements over a period, offering insights into the company's ability to generate cash for ongoing expenses.
7. Calculating and Assessing Cash Flow: Net cash flow is calculated by subtracting total cash outflows from total cash inflows. Financial health is assessed not only by positive cash flow but also by ratios, such as the operating cash flow ratio, indicating a company's ability to repay debts.
8. Cash Flow Analysis: Analyzing cash flow involves understanding the figures, identifying trends, and integrating this analysis with other financial statements to gain a comprehensive view. Negative cash flow may not always be detrimental and could result from strategic decisions.
9. Cash Flow Forecast: Cash flow forecasting is crucial for future planning. It involves estimating a business's future cash position, helping in decision-making for cost management, potential expansion, and preparing for various financial scenarios.
10. Improving Cash Flow: The article suggests practical solutions for businesses facing cash flow challenges, including negotiating payment terms, implementing automated reminders for overdue invoices, and investing in robust cash flow management systems.
In conclusion, managing cash flow is fundamental for a business's financial health and sustainability. Regular analysis, reporting, and forecasting are essential tools to adapt to different financial situations and ensure a business thrives in various stages and seasons.
