Cash Flow. What is it? Why is it Important?

As I work with businesses and get to know them, one of the most common issues or areas of concern is around cash flow. The problem is that a majority of small businesses don’t fully understand cash flow, understand the importance of it, or understand how to manage it. I hope to solve some of that mystery with this post.

Why Cash Flow is So Important?
Lack of cash is one of the biggest reasons small businesses fail. The Small Business Administration says that “inadequate cash reserves” are a top reason startup don’t succeed. It’s called “running out of money,” and it will shut you down faster than anything else.

At the most basic level, cash flow is the money that is moving (flowing) in and out of your business during a given period of time. Although it does seem sometimes that cash flow only goes one way – out of the business – it does flow both ways.

Cash is coming in from customers or clients who are buying your products or services. If customers don’t pay at the time of purchase, some of your cash flow is coming from collections of accounts receivable. Cash is going out of your business in the form of payments for expenses, payroll, rent, insurance, inventory purchases, monthly loan payments, and in payments for taxes and other accounts payable.

Think of ‘cash flow’ as a picture of your business checking account over time. If more money is coming in than is going out, you are in a “positive cash flow” situation and you have enough to pay your bills. If more cash is going out than coming in, you are in danger of being overdrawn, and you will need to find money to cover your overdrafts. More often than not this does not result in an overdraft, but rather it appears as late payments to vendors, and a growing accounts payable report.

Here are some scenarios where cash flow is even more critical:

Are you just Starting a Business? Dealing with cash flow issues is most difficult when you are starting a business. You have many expenses and money is going out fast. And you may have no sales or customers who are paying you. You will need some other temporary sources of cash, like through a temporary line of credit, to get you going and on to a positive cash flow situation.

Do you have a Seasonal Business: Cash flow is particularly important for seasonal businesses – those that have a large fluctuation of business at different times of the year, like holiday businesses and summer businesses. Managing cash flow in this type of business is tricky, but it can be done, with diligence.

My Income statement says I’m Profitable: It’s possible for your business to make a profit but have no cash. How can that happen? The short answer is that profit is an accounting concept, while cash is only the amount in the checking account. You can have assets, like accounts receivable but if you can’t collect on what’s owed, you won’t have cash. Your accounting system may also show a difference between cash and profits. If your business runs on accrual accounting, you recognize income when the invoice is sent, even though the customer hasn’t paid. In this case, you might show a profit but not have the cash.

How do I Analyze Cash Flow?
The best way to keep track of cash flow in your business is to run a cash flow report.

A cash flow statement looks at the change to cash (in this case, your business checking account), from different business activities and increases or decreases in other accounts on the business balance sheet.

For example:

What happens to cash if a customer pays a bill?
What happens to cash if your business purchases supplies?
What happens to cash if you buy a computer?
What happens to cash if you pay an employee or an independent contractor?
At times, you may need to keep track of cash flow on a weekly, maybe even a daily basis.

A quick and easy way to perform a cash flow analysis is to compare your total unpaid purchases to the total sales due at the end of each month. If the total unpaid purchases are greater than the total sales due, you’ll need to spend more cash than you receive in the next month, indicating a potential cash-flow problem.

The best way to deal with cash flow and remove the element of surprise is to use a cash flow forecast. While rearview mirror is great for understanding why you don’t have the cash to pay your obligations, a cash flow forecast is forward looking, and becomes a tool to help you manage cash and your obligations. A Fractional CFO can help with developing a cash flow forecast and help you understand the impact on cash that decisions you make have.

Hopefully this helps answer some questions around cash flow and its importance. For help with this and other financial issues please reach out to A Fractional CFO today.