Why is cash flow important to your business?For small business owners, positive cash flow is the goal. You want to generate more money than you’re spending. This sounds simple, but plenty of profitable businesses run into cash flow problems. It can be challenging to balance regular business expenses — like salaries, rent, and technology updates — with the sporadic revenue and periods of negative cash flow that can come from seasonal patterns or investments in growth.Achieving and maintaining positive cash flow is essential in a small business. In practical terms, understanding where your cash goes every month and how you can get more cash when you need it are the bare necessities to running a successful company. Understanding those parts helps you see how to manage cash flow and create a cash flow forecast.To grasp the idea of cash flow, let’s take a look at a cash flow statement, how to read it, why it’s important, and what problems to avoid so you don’t find yourself and your business in a tight spot.
What is a cash flow statement?A cash flow statement — also known as a statement of cash flows — tracks money in and money out of your company. It will show how much cash a company has on hand and provide insight into a company’s liquidity. Public companies are required to release cash flow statements each quarter. You can see examples of cash flow statements from Nordstrom, Meta Financial Group,Inc., and Ford on Yahoo! Finance.A better option for your company may be to download your free cash flow statement template from QuickBooks.
What goes into your 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 a company’s finances. It’s split into assets, liabilities, and equity. The cash balance from a 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 (P&L). It will offer insights into a company’s profitability. The bottom line of your income statement is net income. Net income is used to calculate cash flow from operating your business. Also, any non-cash income from the income statement, such as depreciation, and non-cash expenses flow into the cash flow statement and affect net income.Long story short, each accounting statement is important for understanding 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 both structure and assets. Whereas, the income statement shows you which core operating activities generate the most income for your company.Profits and cash flow are both essential aspects of a business. After all, for your business to be prosperous long term, you need to make a profit while also operating with positive cash flow. Keep in mind, however, that profit and cash flow are very different.
Cash inflows and outflows on your cash flow statementNot understanding cash flow and poor cash flow management are among the leading reasons why businesses fail. That’s why understanding the cash inflows and outflows on your cash flow statement is so important 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 financing or from sales. Cash inflow is the opposite of cash outflow, which is money going out of your business from things like payments to vendor or disbursements. For your company to be considered healthy, your cash inflow must be greater than your cash outflow.On your cash flow statement, you will find operating activity, investing activity, and financing activity, in that order. Add together the total cash gained from or used by each of the three activities to come up with the overall change in cash for the period. Then add this to the opening cash balance to reach your cash flow statement’s bottom line, also known as the closing cash balance.
The difference between cash flow and profitAlthough cash flow and profit are related, they’re quite different when it comes to accounting. You can see it most clearly when you compare an income statement to a cash flow statement.The most significant difference between the two is that the income statement may be based on accrual accounting, whereas the cash flow statement is based on cash basis accounting.But, even if you don’t handle your own financial reporting, it’s still important to know how both accrual accounting and cash basis accounting work so you can choose the best reporting method for your business. It’s also important to know that as long as your sales are less than $25 million per year, you’re free to use either.
Cash basis accountingCash basis accounting identifies revenue when it’s received and expenses when they’re paid. It does not recognize either accounts receivables or accounts payables. Many small businesses use cash basis accounting because it’s simpler to maintain. It’s easy to see when a transaction has been made or how much cash your business actually has at any given time by looking at your bank balance.
Accrual accountingAccrual accounting, on the other hand, 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 will show a cash outflow of $240 immediately. On the other hand, your income statement will break down the $240 into each individual 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 receivables 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 simply because you couldn’t manage your company’s cash outflow or cash 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.In other words, cash flow is the total amount of money moving in and out of a business at a given time. Whereas profit is the amount of money left over after all expenses are subtracted or paid.
How to calculate cash flow and read a cash flow statementYou can break down a cash flow statement into a simple equation:
- Operating activities:Also called operating cash flow, operating costs show how much you’ve spent or made on a daily basis. It’s the amount of money your company brings in from any ongoing regular business activities, such as selling products, manufacturing, or providing a service. 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.
- Financing activities: Financing is cash received from or paid to lenders, other creditors, and investors (if you have them). For publicly-traded companies, this is where cash flow from the sale of stocks and bonds, payment of dividends, or repayment of debt capital is reported.