Manage my business

What is cash flow and how does it affect your small business?

All small businesses need to understand the importance of cash flow. In the grand scheme of things, cash flow is an indicator of your business’ health. Namely, it’s one of the most decisive metrics in all of finance and accounting.

What is cash flow?

Cash flow is the movement of cash in and out of your business. Consider the “cash” in cash flow as actual physical cash and any equivalent. In other words, it’s the amount of cash (currency) that is generated or consumed in a given period.

What are your liquid assets?

Cash or cash equivalents are liquid assets. They pour from one “container” to another, without resistance. Liquid assets can be used to make purchases at any time. Cash, money in checking and savings accounts, and money market accounts are part of your cash flow.

What are your non-liquid assets?

Non-liquid assets have value but aren’t easy to access. Money owed to you by a vendor or customer is not part of your cash flow. Physical assets like real estate or a tractor are also not part of your cash flow. Receivables are not spent until your customer pays you. You must sell physical assets to convert them to cash.

Items like real estate and vehicles aren’t liquid and may involve complicated sales processes. Real estate has an escrow process, and vehicles require registration and title transfers.

How do you calculate cash flow?

Calculate net cash flow over a set period. For example, calculate a month’s cash flow as you would a bank balance.

How much cash came into the business in a month and how much went out? You get your cash flow by subtracting your month’s ending cash balance from your months beginning cash balance.

If you look at a month’s cash flow, is the number in your favor? Did you have cash left over at the end of the month? If you did, you have a positive cash flow. If more money went out, then you have a negative cash flow.

If your cash flow is negative, look for ways to improve your cash flow.

What impacts cash flow?

Some companies have limited cash flow because they spend all incoming cash. They may put the majority of their expenditures toward paying bills. Large companies may tie up their cash in real estate or maintaining extensive inventories.

Businesses may also have a large amount of money owed to them at some point in the distant future.

How small business operations are affected

As an illustration, a company agrees to landscape a public park. The city will pay for the project when it’s complete. The project will take six to ten months, depending on other contractors and the weather.

The company looks forward to receiving $50,000 from the city at year-end. Yet, until then, they may not be able to afford to fix their lawnmower.

Another company focuses on a seasonal market. They are a mail-order business that makes English toffee. The confectioner makes thousands of pounds of toffee that sells between October and January.

In mid-January, they are sitting on a large cash flow. However, they may have to pay off debts accrued in slow months. They may also need to carefully budget to make sure they can survive until the next holiday season.

The landscaping business and the candy business have poor cash flow. They are not consistently liquid.

Why do you need a positive cash flow?

A company with positive cash flow can react to opportunities. The candy makers could respond to a drop in sugar prices and stock up on sugar. The landscaping company could purchase additional equipment when it’s on sale.

A company with positive cash flow is better able to react to opportunities and challenges. They can manage a crisis immediately and pay for what they need. They can also invest in their business and pay down debts.

Cash flow matters to banks and investors

The ability to react to threats and opportunities instills confidence in investors and loan officers. It also shows that the business is stable and more likely to pay back loans or pay dividends.

Steps to improve your cash flow:

1) Start with a solid bookkeeping system. A serious business documents its strengths and weaknesses. It can tell you at any moment, the state of its assets and debts.

Basic bookkeeping only requires a pen and paper or a dynamic spreadsheet program like Microsoft Excel. There are many complex bookkeeping-specific software programs as well.

2) Balance cash on hand with inventory on hand. It’s tempting to try to have everything a customer might need in stock. Then again, flexibility is necessary too. Don’t tie up all your cash in goods.

3) Sell old inventory. Once you determine it’s not selling at full price, sell the items at a loss. It’s unlikely to increase in value. Better to transform it into cash on hand.

4) If you provide services, manage your purchase orders and billing. Instead of agreeing to a lump sum payment at the end of a project, consider scheduling payments by milestones. When possible, begin with a deposit.

5) If you provide goods to other businesses, demand payment of your invoices in 30-90 days. Don’t extend payment options beyond a quarter.

6) Offer your services as monthly subscriptions. Have clients and customers pay you on a regular monthly schedule.

7) Expand your business model beyond seasonal spikes. A candy company can appeal to many gift-giving situations and celebrations year-round. Think about ways to expand your business model.

8) Stick to your budget and budget for cash flow. It’s not exciting to save cash. Learn that cash-in-the-bank can be your most precious asset.

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The Growth Center does not constitute professional tax or financial advice. You should contact your own tax or financial professional to discuss your situation.