The Fundamentals of Business Cash Flow

Business cash flow

Whether you own a small business or a large multinational, business cash flow is a critical measure to manage.

A U.S. Bank study found that cash flow management issues were responsible for 82% of businesses failures. Quite simply, it’s one of the most important aspects for running a business successfully.

Cash flow tends to be one of those things that seems like it should be obvious or intuitive, yet it trips up many businesses. A common issue is that business owners may not understand it properly. What does cash flow comprise of and how should it be managed for success?

Here are a few fundamentals of cash flow that every business owner should know:

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What is cash flow?

Cash flow will form the basis for your business’ financial reporting. It refers to the net amount of cash flowing into and out of your business during any given time period. That concept of “time period” is critical; to understand cash flow correctly, you need to look at it through the lens of time.

For most businesses, this means looking at it on a month-to-month basis. For some, however, it might make more sense to look either less or more frequently. Quarterly is another time period that is often used.

Your business bank account can be a good representation of your cash flow. When you have more than enough money coming in to cover your bills of costs of operating, this is known as a positive cash flow. When you fall short on money for covering those essential bills, this is known as a negative cash flow.

The difference between positive cash flow or negative cash flow is often a timing issue for a business. For example, what happens if you’re expecting a large influx of cash from sales very soon, but you have a number of bills due right now without the funds to pay them? This is one way businesses can find themselves in hot water, despite having an otherwise good outlook.

Business cash flow

Key terms in business cash flow

Here are a few key terms to understand around cash flow:

Accounts payable – This is a liability account. It tracks the money that leaves your business to pay bills. For example; operating costs, staff salary or wages, loans and any other business expenses.

Accounts receivable – This is an asset account. It tracks the money coming into your business from sales and business activities. Both accounts receivable and accounts payable are critical in calculating business profitability.

Cash inflows – Money received in a given period of time resulting from operating activities, investments or financing activities.

Cash outflows – Total outgoing funds in a given period of time.

Cash flow forecast – An estimate of your cash inflows and outflows for a given period of time.

Cash flow statement – A summary of your actual cash inflows and outflows for a given period of time.

Net cash flow – The difference between your cash inflows and outflows for a given period.

Working capital – The difference between your current assets (cash, accounts receivable and inventory) and your current liabilities.

Why is business cash flow important?

Cash flow is one of the primary indicators of the financial health of a business. Sometimes people mistakenly assume profit is the measure that should be used, but it’s really not helpful at all.

Profit is a poor indicator because it’s possible to show good profits on paper but have zero cash in the bank. You might make 200% profit on every item sold, but still have more expenses than income, or negative cash flow. You might have had a record month for sales and profits, but most of it is still tied up in accounts receivable, so you don’t have the cash to pay bills.

To boil it right down to a basic level, cash flow is important because it’s what keeps your business running. There are countless tales out there of businesses that had popular products and large sales volumes, yet couldn’t keep the doors open due to cash flow issues. If your premises is shut down because you don’t have the cash to pay the rent, it doesn’t take long to lose the business.

It’s important to understand that you can be profitable, yet cash flow negative; unprofitable, yet cash flow positive

It’s important to understand that you can be profitable, yet cash flow negative; unprofitable, yet cash flow positive. Click To Tweet

What are the most common cash flow mistakes?

The primary mistake leading to business cash flow problems is simply not managing cash flow well. At a more micro level, here are some common mistakes business owners make:

  1. Not using or monitoring the cash flow statement. This is a key document and should be regularly kept in check as a vital metric for the business, along with other financial statements.
  2. Not taking charge of accounts receivable. When customers owe you money and the account is left lingering, it can have a serious impact on your ability to pay the bills.
  3. Leniency with any line of credit. This follows on from that last point – if your business is in the habit of extending credit to customers that haven’t yet proven their creditworthiness, it can leave you in a bad position when they don’t pay up.
  4. Overspending too soon. Being overly optimistic about expected results can lead business owners to “counting their chickens before they’ve hatched.” Issues such as lines of credit or credit cards that are past due may be symptoms of this. Overestimating the sales forecast is relatively common – the best strategy is to take a conservative approach based on known data.
  5. Operating without cash reserves. That last issue can be somewhat mitigated if you’ve budgeted to have cash reserves. Even if your sales forecast is spot on, your cash flow forecast may not be. No one knows exactly when a debtor may fail to pay up, or when a creditor may have a change in circumstances that in turn changes yours.
  6. Waiting too long to get professional help. Many business owners (especially those of small businesses) try to manage everything themselves, particularly while the business is young. However, any cash flow problems are managed more easily if they’re picked up and dealt with early. Getting the help of an accounting professional early means you can get a cash flow management plan in place to take care of any issues.

Business cash flow

How is cash flow managed?

Cash flow management will look different for each unique business. However, it always begins with a firm grasp of the basic elements that make up your cash flow, primarily your accounts receivable and accounts payable.

Your accounts receivable should have very clear terms around them that make sense for your business. For example, you wouldn’t offer NET 60 terms if you need the money before 60 days. It might be better to offer NET 30 or less.

Some strategies businesses use to keep accounts receivable in-check include offering a discount for early payment, or adding a penalty for late payment. It’s common for people to drag out payment for as long as they can – that’s a cash flow management technique!

At the same time, ensure your accounts payable are set up with terms you can manage. For example, you might be able to negotiate a NET 30 contract with a supplier, even if they initially wanted payment on delivery.

Calculating cash flow projection and generally taking a proactive approach to financial management is crucial. You should be monitoring your cash flow statements, noting any difference with forecasts and taking appropriate action where needed.

For example:

  • Help manage accounts receivable by making it easy for customers to pay you. Offer common payment options that they can manage.
  • Beware of growing too quickly and try to do so when you calculate you will have positive cash flow throughout the process. For example, opening a new location uses a lot of resources; if you’re not going to see income from the new location for a few months, you don’t want the situation to be putting your core business at risk.
  • Implement a reliable inventory management program. This will help to ensure that you don’t have too much money tied up in inventory that is sitting on the shelf, or alternatively, that you’re not missing sales due to stock-outs.
  • Assess your marketing plan and check that you’re marketing in the best places to reach your target market. More customers is a great way to improve cash flow!
  • Aim to always have cash reserves. You never know when you might need them.
  • Look at ways of building more flexibility into your cash flow, such as by utilizing a line of credit or seeking investment funds.

These are just a few examples of what you might do to manage a positive cash flow. There are plenty of other actions you might take, depending on your own business’ situation. We recommend consulting with a qualified accountant to plan for your unique needs.

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Final thoughts

Cash flow is one of the most important indicators of the financial health of a business. In fact, poor cash flow management is one of the most common reasons for business failure.

It’s important for every business owner to have a good understanding of what cash flow means and what factors go into it. You might look like you have healthy profits on paper, but if you can’t pay your bills because you are cash flow negative, then your business will quickly be in trouble.

We have shared just a few basics on business cash flow here, but there is a lot more to know and learn about. Stay tuned for more from us in the future, and feel free to leave a comment below with any questions!

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