Cash flow is the net amount of cash and cash-equivalents moving into and out of a business from one period to the next. Positive cash flow means that a company’s liquid assets (cash on hand or assets that can be converted to cash) are increasing. For example, if a company is projecting $5 million in revenue but $2 million in expenses next year, then projected cash flow would be $3 million.
Why Is Cash Flow Important?
Quite simply, cash flow is important because your business won’t run without it. One of the main reasons some businesses fail is due to lack of cash.
The most challenging time for managing cash flow is right when you’re starting your businesses. There are many expenses to start a business, and cash can run out fast. Because of this, many businesses decide to take out a line of credit, get a loan or look into alternative lending options to help them get going and create a positive cash flow situation.
Although it may seem simple, there is a lot that goes into understanding cash flow and why it’s important to your business. First, let’s start with the two ways cash flow can be expressed: nominal and real.
Nominal Cash vs. Real Cash
There are two ways money moves in and out of a business, and they are both useful for different reasons.
Nominal cash flow refers to the actual dollar amount of money a company anticipates bringing in and paying out, without any adjustment for inflation. Nominal cash flow is useful for projecting future revenue and expenses. An example of nominal cash flow would be a lease payment or rent: your payments will stay same through the agreed-upon term.
Real cash flow is adjusted to take inflation into consideration and reflect changes in the value of money over time. Inflation affects the purchasing power of a unit of currency From year-to-year, inflation can fluctuate. If the inflation rate increases, goods and services require more money to purchase, and the value of that money falls. Real cash flow can be useful for analyzing a business’ current cash flow in relation to the previous year’s cash flow.
Cash Flow vs. Profit
Did you know it’s actually possible for your business to make a profit but have no cash? This is because “making a profit” references any positive financial gain your business makes after you’ve subtracted all your expenses. A business can’t survive long unless it’s profitable. However, the successful product you’re marketing may be the culprit of insufficient cash flow.
For example, perhaps your business’ product goes through a very long sales cycle, and your customers aren’t paying invoices for 90 or 120 days. Even though your sales are increasing and your business is profitable, you’re not getting paid by your customers in time to pay your suppliers and employees. This leaves a gap, creating a cash flow issue that could force creditors to push your business into bankruptcy at a period when sales are actually growing.
Here’s another interesting cash flow situation some businesses find themselves in. Consider what might happen if sales are increasing and profits are coming in, but you’ve borrowed money to solve a cash flow problem. Rising debt costs can increase the cost of your borrowing above the break-even point. If this happens, your cash flow will eventually dry up.
How Can You Analyze Your Business Cash Flow?
Understanding cash flow is critical to keeping your business running. The best way to analyze cash flow for your business is to run cash flow statements. A cash flow statement shows how changes in balance sheet accounts and income affect cash and cash equivalents. More specifically, cash flow statements provide important data to help run your business more successfully.
They identify where your business’ money went: Cash flow statements tell you where you spent your money. If you increased revenue, extended more credit to customers or bought capital equipment, you used cash. These types of transactions will not show up on profit and loss statements.
They help you focus on creating excess cash: Profits help create cash, so having profits is important. If you’re able to pay less for capital equipment (for example, purchasing in bulk), you’re creating cash while spending money and investing in your business. The more efficient your business becomes, the more cash you will create.
They provide better performance indicators: Identifying where and how you’ve created excess cash is a great way to continue to build on that pattern. Conversely, identifying where you’re losing cash means you can look to improve that aspect of your business. Perhaps you need less expensive capital or can make a process more efficient. Cash flow statements will help you identify these areas.
They help with financial decisions: Cash flow statements help you decide how to use your cash to better finance your business’ growth. Every aspect of building and growing your business uses cash: buying capital, increasing inventory, adding employees or acquiring customers. Cash flow statements will help you understand if you’re in a position to use cash, or if you need to work with a financial institution to get access to more.
Starting a business and keeping it going is challenging. A business can be profitable, but still not have adequate cash flow — so fully understanding your financial status is important to your success. Now that you know what cash flow is, continue to utilize that knowledge as you dive into your financial statements and improve your business.