In the vast majority of cases, businesses exist to turn a profit for their owners and, depending on the corporate structure, their shareholders. This is not a destination at the end of a journey, though. Making money is an ongoing process, and to keep your business accounts in the black, you need to understand the importance of cash flow.
Your cash flow is directly affected by your money management skills, and as a small business owner, those skills can be critical in ensuring the survival of your enterprise. Therefore, it's vital that you know how cash flow management works and what it can mean for your organisation.
These are the key points that you should aim to understand:
What Exactly is Cash Flow?
You may often hear the saying that cash is the lifeblood of all entrepreneurial ventures, or, to put it more succinctly, that "cash is king". This concept cannot be overstated in the business world. If your finances are out of order and you don't have enough cash to spend, then your company is likely to run into some big problems.
Cash flow is a crucial metric in business management. It measures the net change in the amount of cash held by your company over a specific period, be it monthly, quarterly, or yearly. But what does that mean?
In any business organisation, there is a multitude of ongoing costs (usually referred to as expenditure), such as salaries, utility bills, supply costs, and other miscellaneous expenses. As a result, the amount of cash in your checking account is always fluctuating.
Of course, to offset this, there is an inflow of cash, too, such as bills paid by your customers and clients, other sales income, and capital injections. A portion of this cash gets spent on the various expenses mentioned above, resulting in an outflow of money.
Your cash flow statement, therefore, is a measure of this net change as a result of inflows and outflows. To put it simply, if you bring in more cash than is going out, then you have a positive cash flow. Alternatively, if the outflow on expenses exceeds the inflow, you have a negative cash flow.
The Difference Between Profit and Cash Flow
This might sound the same as profit, but it’s important to differentiate between the two. Indeed, this is a common mistake of new entrepreneurs and business owners, who often ignore their cash flow statements as a result.
This can cause significant difficulties for your business in the medium to long-term. As we all know, profit is your net income – the result of deducting all expenses from your revenues. The money you earn as profit is always an asset to your business and never a liability.
But positive cash flow can result in liabilities. Take the example of a loan you take; it results in an increase of cash in your accounts. While the effect is positive and you have money to spend on necessary expenses, you will have to be mindful of the interest you will be forced to pay in future.
Aside from this, there is another critical aspect that many rookie entrepreneurs forget when it comes to profits: what is shown as profit on your accounts may not have an impact on your cash flow until much later.
For example, take a business that makes sales worth $5,000 in the month of July, over expenses of $4,000. The profit here is $1,000. But remember: clients often don't pay the bills receivable until a month or two later. This means that the $1,000 inflow will only happen in your cash flow statement after one month, or two.
This is vital to consider, as nearly 69% of all small business owners encounter cash flow issues due to this reason. If you are not mindful of this disconnect between your profit and your cash flow, you could end up in serious financial trouble.
Why Positive Cash Flow is Important
No business can continually function without cash; unavailability of money is often the most significant red flag of a failing business. If you have consistently negative cash flow statements for an extended period, then it's highly likely that you will find yourself in this situation.
The only way to avoid this fate is by maintaining a positive cash flow – plain and simple. If you can do this over an extended period, then your business will have a healthy surplus of cash reserves. This is crucial for the following reasons:
Dealing with Debt
Taking on debt in the form of various types of loans is an integral part of running a business. But you also have to be incredibly careful about paying your dues on time. Defaulting on loan repayments can have severe consequences for your business – both in terms of financial stability and reputation.
Having a positive cash flow is key to repaying your debts on time. If you have a negative cash flow, those monthly payments will soon chip away at your cash reserves
Planning Future Growth
Growing your business is not an easy task. Whether you want to open a new office, develop a new product, or increase your existing production capacity, you will need cash. The ideal pathway to growth in business is using the surplus cash owned by the company.
However, this is not always possible due to the magnitude of expenses involved, and, as a result, most businesses tend to opt for a business loan. Either way, both of these paths are much easier to take when you have positive cash flow. The surplus cash in your accounts lends you an air of confidence about the future.
Risk Management
There is a clear reason why small businesses are often the first to fail during a recession or an economic downturn: they lack the cash reserves required to tide them over during lean periods. Firms with extra cash lying around have a better chance at weathering such unexpected storms.
Positive cash flow helps your organisation maintain a surplus war chest that is bound to come in handy while dealing with unexpected and adverse events. You can create emergency funds to handle unexpected expenses, making your business more resilient and flexible in the face of trouble.
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As mentioned, positive cash flow is often an indicator of the financial strength and stability of an enterprise. It means that your business is able to generate surplus cash over its expenses. This is a good sign in almost every instance.
Imagine a situation where you are taking loans every month; the immediate effect on the cash flow statement will be positive. But in the long-term, it is only adding to your expenses in the form of debt repayments.
Therefore, if loans are all you have keeping your cash flow statement in the green, then your business is headed for trouble – and fast. On the other hand, if you have a balanced mix of cash sources, with sales, ROI, loans, tax cuts and refunds, then it is a far healthier state of affairs for your business to be in. This is why cash flow is so important in business, and why it’s vital that you understand and monitor it appropriately.
In the meantime, to learn how to forecast your projected cash flow, don't forget to take a look at our comprehensive guide.
Why else are cash flows so crucial to businesses? Especially small ones? Let us know your thoughts and experiences in the comment section below.