What is cash flow? An in-depth guide for business owners

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 gas tank. You fill up the tank with gas, and it empties as you drive. The goal, however, is to have enough gas 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 while cash outflows are your business expenses. As you might guess, positive cash flow is better than negative cash flow.

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, and more—with things less under your control, like sporadic revenue and periods of negative cash flow from seasonal patterns or investments in growth.

To achieve and maintain positive cash flow, you should understand where your cash goes and how to get more when you need it.

4 tips for cash flow management

Managing cash flow for your small business is a constant learning process. Here are four tips to help you get started (and avoid searching your couch cushions when you realize you’re out of money):

• 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. Subtract the business’s operating expenses for that period from the business’s revenue of the same period. That’s your cash flow.
• Maintain some cash reserves: As a business owner, it’s not your job to anticipate every speed bump 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 cover a month or two of expenses will help ensure you never fall behind when business is slow.
• Focus on cash flow management, not profits: 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, you’re in the hole (cash flow negative) by $500—the amount you invested in those jobs. That’s why it’s important to put more stock into your cash flow than your profits. Focusing on profits might give you an inaccurate picture of how your business is performing.
• Get ahead of late payments: 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 invoice due dates are more air-tight. You can invest in invoicing software that can spare you the awkward conversations and automatically remind customers to pay.

Types of cash flow

There are a few different kinds of cash flow, depending on who you ask. Some might list operating cash flow, financing cash flow, and investing cash flow. Others might list past 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, as it can tell them if they have enough funds coming in to pay the business’ bills or operating expenses. Investors will also be interested in your business’ operating cash flow, as it can help them determine if your business is financially viable 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 in and money 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. You can create a cash flow statement on your own, or you can download a free cash flow statement template from QuickBooks.

Understanding common accounting terms

Income statements, revenue, accrual accounting…as you get an understanding of your business’ cash flow, you’re bound to run across a number of other terms that make your eyes glaze over.

Accounting jargon can be intimidating, but it doesn’t need to be that complicated. Here’s what you need to know about several common accounting concepts.

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 financing or sales. Cash inflow is the opposite of cash outflow, which is money leaving your business for things like payments to vendors 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 financing 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. As long as your sales are less than $25 million per year, you can use either.

Cash basis accounting versus accrual accounting

Cash basis accounting identifies revenue when it’s received and expenses when they’re paid. It does not recognize 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, regardless of when the money is received or paid out.

For example, if you paid $240 upfront 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

You don’t need to be an accountant to read and understand your cash flow statement, especially once you understand the basics. This statement adds operating activities, investing activities, and financing activities to determine available cash. The formula follows:

Operating activities + investing activities + financing 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.

Financing activities

Financing 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?

As a concept, cash flow isn’t that difficult. But in reality, it can be difficult to manage in your business.

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 store are reserved. You know that inventory will be paid for soon, and you don’t want empty space in your store. 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 upfront.

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—and now you know a cash flow statement is created by adding up your business’s operating activities, investing activities, and financing 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 familiarize yourself with your business’ finances. Here are four things to check on as you go through the numbers.

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

Maintaining healthy cash flow is crucial for any business owner, and that all starts with knowing what to look for and how to use that information to calculate your own cash flow.

With that knowledge under your belt, you’re ready to keep a close eye on your cash flow and prevent your business from running on empty.

Disclaimer:

**1. The #1 accounting software for small businesses: #1 Accounting Software for Small Business based on PCMag, as of October 2020.