What is cash flow? An in-depth guide

Cash flow is the movement of money in and out of your business and your business bank account. Think of cash flow like your car’s fuel tank: you fill up the tank with petrol, and it empties as you drive. The goal, however, is to have enough fuel in your tank so that you never run on empty.

In the same way, cash flow is the movement of cash in and out of your business account. Cash inflows are your sources of income. Cash outflows are your business expenses. Naturally, positive cash flow is better than negative cash flow.

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Why being cash-flow positive is important to your business

Positive cash flow should be the goal for all small business owners. You want to generate more money than you’re spending. That sounds simple, but plenty of profitable businesses run into cash flow problems. It can be challenging to balance regular business expenses—salaries, rent, technology updates, etc.—with things that you have less control over.

Think of sporadic revenue and periods of negative cash flow from seasonal patterns or investments in growth. To achieve and maintain a positive cash flow, you should understand where your cash goes and how to get more when you need it.

Four tips for cash flow management

There are a number of tips for managing cash flow for your small business. Here are four to consider.

1. Practice calculating it yourself: calculating cash flow is fairly simple if you know your operating expenses and your revenue. First, identify the period you want to calculate for. Then, subtract the business’s operating expenses for that period from the business’s revenue for the same period.

2. Maintain some cash reserves: as a business owner, it’s not your job to anticipate every speed hump on your journey, but it does help to have a rainy-day fund to pay for any damage you take as a result. Having enough savings to help cover a month or two of expenses will help ensure you never fall behind when business is slow.

3. Focus on cash flow management, not profits: if your business invoices customers, you know what it means to wait (and wait) to get paid. Consider offering discounts to customers who pay early and charging a late fee for those who miss their deadline. You might also adjust your contract with customers so that invoice due dates are more airtight. Otherwise, you might invest in an invoicing software that can remind customers to pay on your behalf.

4. Operating activities:  you’ll soon learn it’s possible to be profitable while still experiencing slow or negative cash flow. For instance, say you’ve sent out 10 invoices for $100 each based on work you did amounting to $50 per job. You’ve made a profit of $500. Alas, until your customers pay those invoices (your accounts receivable), you’re in debt (cash-flow negative) by $500—the amount you invested in those jobs. That’s why it’s important to pay more attention to your cash flow than your profits. Focusing on profits might give you an inaccurate picture of how your business is performing.

Types of cash flow

There are a few different kinds of cash flow, depending on who you ask. Some might list operating cash flow, finance cash flow and investing cash flow. Others might list past cash flow, discounted cash flow, future cash flow and net cash flow. Either way, cash flow “types” are metrics. There are two common types of cash flow metrics: operating and free.

What is operating cash flow?

Operating cash flow measures cash that’s generated by the company’s business operations. Business owners like it as a metric. It can tell them if they have enough funds coming in to pay the business’s bills or operating expenses. Investors will also be interested in your business’s operating cash flow. It can help them determine if your business is financially viable in the long term.

What is free cash flow?

Free cash flow measures the cash a company generates from business operations after they subtract capital expenditures. You may have heard the terms “levered free cash flow” and “unlevered free cash flow”. To understand the difference, it may help to imagine a cake. Unlevered cash flow is the cake when it’s whole. It’s all the money the business has before it’s paid off any financial obligations. But then, the business pays off some debts, operating expenses, interest payments, etc. Each one takes a slice out of the cake. Levered free cash flow is what’s left over. It’s the amount of money a business has after meeting its financial obligations.

What is a cash flow statement?

A cash flow statement tracks money coming in and money going out of your company. It shows how much cash your company has on hand and provides insight into your company’s liquidity. It’s also known as a statement of cash flows. Publicly traded companies are required to release cash flow statements each quarter.

Income statement versus cash flow statement

Cash flow statements, along with balance sheets and income statements, help provide insights into a company’s finances, but business owners aren’t always sure how they connect.

The balance sheet gives you an overall view of your company’s finances. It’s split into assets, liabilities and equity. The cash balance from the company’s cash flow statement appears on the balance sheet in the asset section. The income statement shows a company’s revenue, expenses, and profit and losses. It offers insights into a company’s profitability.

The bottom line of your income statement is net income. You can use your net income to calculate cash flow from operating your business. Any non-cash income from the income statement, such as depreciation and non-cash expenses, flows into the cash flow statement and affects net income.

Each accounting statement can help you understand your company’s performance from all angles. The balance sheet and cash flow statement focus on the financial management of your company in terms of its structure and assets. The income statement shows you which core operating activities generate the most income for your company.

Cash inflow versus cash outflow

Poor cash flow management is among the leading reasons businesses fail, according to a 2019 study from CB Insights. Understanding the cash inflows and outflows on your cash flow statement is critical if you want to keep your business up and running. Cash inflow is the money going into your company. It may be from investments and finance or sales. Cash inflow is the opposite of cash outflow, which is money leaving your business for things like payments to suppliers and disbursements. For your company to be healthy financially, your cash inflow must be greater than your cash outflow.

On your cash flow statement, you will find operating activity, investing activity and finance activity, in that order. Add the total cash gained from or used by each of the three activities to see the change in cash for the period. Then add that to the opening cash balance to reach your cash flow statement’s bottom line, also known as the closing cash balance.

Revenue versus cash flow

Revenue is the total income generated by sales related to your company’s primary operations. In other words, it’s always cash inflow. On the other hand, cash flow is the total amount of money moving in and out of a business at a given time.

Then there’s profit. Profit is the amount of money left over after a business pays and subtracts all expenses. And contrary to what you might think, it’s possible to be profitable but still have negative cash flow.

You can see this most clearly when you compare an income statement to a cash flow statement in accounting. The most significant difference between the two is that the income statement may be based on accrual accounting. The cash flow statement is based on cash basis accounting.

It’s critical to know how accrual accounting and cash basis accounting work so you can choose the best reporting method for your business.

Cash basis accounting versus accrual accounting

Cash basis accounting identifies revenue when it’s received and expenses when they’re paid. It does not recognise accounts receivable or accounts payable. Many small businesses use cash basis accounting because it’s simpler to maintain. You can look at your bank balance to see a transaction or how much cash your business has at any given time.

Accrual accounting records revenues and expenses when they are earned, irrespective of when the money is received or paid out.

For example, if you paid $240 up front for a two-year newspaper subscription, your cash flow statement would show a cash outflow of $240 immediately. On the other hand, your income statement would break down the $240 into each accounting period, usually monthly or quarterly.

Think of it this way: let’s say you started a company. After one year, you ran into cash flow issues, even though your business was profitable. As a small business, you relied on invoices to collect accounts receivable from customers.

As anyone who sends invoices knows, customers don’t always pay on time. Even though your company was profitable, according to your income statement, you were short on cash.

You may have had the best intentions but failed to make payment deadlines because you couldn’t manage your company’s cash outflow and inflow. The relationship between cash flow and profit will vary depending on the type of business. You can be profitable but have times of slow or inconsistent cash flow.

How to read a cash flow statement

A cash flow statement adds operating activities, investing activities and finance activities to determine available cash. The formula is as follows:

Operating activities + investing activities + finance activities = available cash

Following the equation should show you the changes in cash balances from one period to the next. That way, you can always stay on top of your company’s cash flow.

Operating activities

Also called operating cash flow, operating costs show how much you’ve spent or made each day. It’s the amount of money your company brings in from any ongoing, regular business activities, such as selling products, manufacturing, or providing services. It is the most accurate assessment of how much money you’ve generated from your core business.

Investment activities

Also called cash flow from investing activities, asset investments show cash used to buy or sell long-term capital assets for your business. These assets may be equipment, property, machinery, vehicles, furnishings or investment securities. Over time, you want to see that your business can pay for these investments with income generated from its operations.

Finance activities

Finance is cash received from or paid to lenders, other creditors and investors, if you have them. This is where publicly traded companies report cash flow from the sale of stocks and bonds, payment of dividends or repayment of debt capital.

What causes cash flow problems?

Cash flow problems occur when business owners don’t understand the difference between profits (sales) and cash flow. It’s easy to think that the key to positive cash flow is increased sales, but that’s not always the case. More often than not, cash flow is a challenge because income is sporadic while expenses are recurring. It may be possible to fix the problem with more or bigger sales, but if those efforts aren’t sustainable, cash flow problems will resurface.

Here’s an example: say you own a business that sells hot tubs. Sales are good—up year over year. You have several orders from customers, which means half the tubs in your shop are reserved. You know that inventory will be paid for soon, and you don’t want empty space in your shop. You anticipate a need for more inventory, so you purchase it. Unfortunately, until your customers pay for their reserved hot tubs, all your money is now tied up in inventory and accounts receivable. You might be having a great month sales-wise, but that doesn’t mean you have enough cash to pay your bills.

Controlling your accounts receivable is one of the best ways to increase cash flow, and there are plenty of ways to get paid faster. Even so, it’s not always easy. The best way to stop mounting past-due receivables is not to let them pile up in the first place. If a customer wants to reserve a hot tub, make them pay for it up front.

More than that, though, avoiding cash flow problems often comes down to awareness and making small changes before small problems build up. So, it helps to perform a cash flow analysis, regardless of how great sales are looking.

Performing a cash flow analysis

The first step to performing a cash flow analysis is to make a cash flow statement. We now know a cash flow statement is created by adding up your business’s operating activities, investing activities and finance activities. To conduct your analysis, you may need to take a hard look at your budget or banking history.

The second step to performing a cash flow analysis is to familiarise yourself with your business’s finances. Here are four things to check on as you go through the numbers.

1. Positive cash flow: as you look at business operations, there should be more money coming into your business (inflow) than going out (outflow).

2. Billing and collections: find out how long it takes the average customer to pay their invoice. If late payments are affecting your accounts receivable, consider making some changes to your collections process.

3. Loan amounts: if you’ve already maxed out your line of credit, you may find it challenging to try new initiatives that could grow your business. Maybe you’re right where you need to be, loan-wise. Or maybe it’s time to consider refinancing for a higher credit limit.

4. Savings: you should have some money tucked away, just in case.

Looking at your business from all angles, including savings and invoicing, may help you better understand its financial health.

Cash flow you can bank on

Typically, solving your company’s cash flow issues comes down to getting all of your accounting in order. As the business owner, it’s entirely within your power to solve many of your business’s cash flow problems. But that doesn’t mean you can’t ask for help.

For even more business insights, check out an automated accounting software like QuickBooks. Run cash flow reports as often as you’d like, and compare those to other reports that show profits and sales. Never be in the dark about your business’s financial wellbeing ever again.