Business cash flow is an essential metric that needs to be watched like a hawk. New business owners and managers tend to misunderstand the importance of cash flow in an organization which can have serious consequences.
You may be generating a lot of business, in absolute terms, and be profitable on paper, but if cash flow isn’t optimized, the business can still go under.
In this guide, you’ll learn what cash flow is, the different types, and ways to make sure you always have enough to run your business.
Keep in mind that we may receive commissions when you click our links and make purchases. However, this does not impact our comparisons and recommendations. We try our best to keep things fair and balanced, in order to help you make the best choice for you.
What is cash flow
In simple terms, cash flow is the net amount of real cash moving in and out of an organization at any time. Cash flow is important because businesses have many monetary obligations in order to keep the lights on.
For example, if a customer signs a contract to pay you for a product in monthly installments over the course of a year, the monthly payment is part of your cash flow. The total sale of the product (depending on the kind of accounting you’re doing) may be recognized immediately but cash enters your hand once a month.
While you’re waiting for the customer to complete the payment for their purchase, you’ll still be obligated to pay salaries, vendors, rent, etc. This is why cash flow is important – so you can continue to meet obligations irrespective of the situation you find yourself in.
When you have more money moving into the business then it’s called positive cash flow while more money moving out of the business is called negative cash flow.
Cash flow vs profit
Cash flow is not to be confused with profit. Even if you have positive cash flow over a period, that doesn’t necessarily mean your business is profitable.
Profit is when all of your expenses have been subtracted from total revenue in a given period. You can calculate profit monthly, quarterly, or yearly. Profit can be taken out of the business without having a negative effect on regular operations.
For example, it can be withdrawn by the owners or paid as a dividend to shareholders. It can also be reinvested in the business to aid future growth.
If, on the other hand, money is taken out from cash flow before profit and loss are determined, it can have a negative impact on the business.
Profit is always positive but if there is no profit in a business and it’s using more money than it earns then this is known as a loss. Businesses can lose money and not fail because of profitable periods where money was saved or through outside investments.
Types of cash flow
Cash is cash but it can be produced from different methods or channels and should be planned for and considered differently. The cash flow from selling goods and services should be treated differently from the cash flow associated with dividends or another source.
Operating cash flow
The operating cash flow is what most people think of when considering how a business pays its staff, vendors, and for its other debts. This is the cash generated through the course of normal business operations. For example, selling a product or service will generate operating cash flow.
For the vast majority of businesses, this is where the bulk of the money it produces and uses comes from.
Investment cash flow
This type of cash flow is realized from investments businesses have made. Of course, stocks (securities) are the major areas people think of when it comes to investments but it’s not the only one. It could be from equipment that the business bought for its own use but also rents out when it’s not needed.
This type of cash flow is more common in mature businesses. Growing businesses tend to reinvest most of their proceeds into the company so investment cash flow is negative.
Financing cash flow
This is a type of cash flow that refers to the flow of cash between the owners of a business, the investors, and creditors. It’s the cash used to finance the business. For example, a loan used to purchase equipment or money invested by the owners. It also takes dividend payouts to shareholders into consideration.
The three types of cash flow have different uses and businesses at different stages will utilize each one accordingly. Operating cash flow is essential for growing businesses while investment cash flow is more apparent with mature businesses. Financing cash flow is used at all stages but it’s usually owner or investor inflows at the beginning and outflows to the same people when the business matures.
How to optimize cash flow
Choose an accounting method and stick with it
There are two core types of accounting. One is accrual accounting and the other is cash accounting. Accrual accounting recognizes money that may not have been received yet but is promised like an invoice you’ve sent out. Cash accounting only recognizes the money that’s in your hand (or bank account).
Neither one is right or wrong. It’s important that you choose a single method and stick with it. You can’t do cash accounting for some things and accrual accounting for others.
Stay on top of your books
This one should be obvious but, unfortunately, it’s not. Bookkeeping can be exhausting – especially if you have no formal training for it. With that being said, it’s essential because it’ll give you an accurate snapshot of your finances at any given time.
With current books, you’re able to perform analysis, figure out where to cut spending, understand the overall health of your business, and make strategic investments. If you have no idea how much is coming in and going out then you’ll be in a tough position.
A cash flow statement – created from your books – will help you with the next step. You can generate a cash flow statement as often as you need and it can quickly answer questions such as:
- How much money do we have right now?
- What did we spend money on?
- How much did we get paid through operating income
Audit your cash flow
Once you have up-to-date books, you can start the task of auditing your cash flow. How much is coming in, how much is going out, and what are the sources of that cash. Depending on the size of your company, there may be ghost subscriptions that someone signed up for, left, and no one ever canceled.
You may be overpaying certain vendors, under collecting in other areas, and so on. You may also discover that you’re paying for too many things with a line of credit and not real revenue generated which is a sign that things need to change.
No matter the business, there are ways to slash operating expenses and improve your cash flow position. Of course, mileage will vary depending on how optimized your cash flow is.
Do you need a full-time employee for a specific set of tasks or can it be outsourced? Do you need all of the software you’re currently paying for? Can you renegotiate with vendors based on volume (this is more possible than most people think)?
There are many ways to effectively manage cash flow but it’s necessary to think outside the box in some cases.
Accelerate outstanding payments (accounts receivable)
Another powerful tool in your arsenal is to simply get paid faster. If you have a monthly subscription product, try to push for the yearly payment. If you give clients and vendors net 60 terms, consider reducing that to net 45 or net 30.
Properly managing business cash flow is essential no matter what stage your organization is in. You could be making less than $100,000 a year or millions a year. The only thing that changes is the complexity. The goal is to always have positive cash flow.
This guide has gone through what cash flow is, why it’s important, and a few strategies to optimize it. Let me know what you think in the comments and the strategies you’re using.