What is Cash Flow and How Does it Affect Me?

by Craig Anthony

4 min read

Your business needs a steady supply of cash to operate successfully. It’s quite easy to lose track of the amount of cash coming into your business and flowing out of your business. If you don’t have a system in place to monitor cash flow, there may come a day when you’re completely caught off guard by a sudden lack of operating cash. That spells trouble for the health of your business.

Businesses of all sizes have failed due to chronic cash flow problems. You can avoid their fate by familiarizing yourself with positive and negative cash flow issues, and set up a reliable cash flow management system.

What Is Cash Flow?

Cash flow is the amount of money flowing in and out of your business. For a more practical cash flow definition, consider each time you make a bank deposit. Your business receives an injection of funds that may increase the amount of cash you have on hand to spend on business necessities. Negative cash flow occurs when you dip into your budget to pay bills or vendors, or when you need to purchase equipment, supplies, and property.

Positive vs. Negative Cash Flow

Every transaction results in positive cash flow or negative cash flow. Both types of cash flow affect how your business operates and whether you have enough money to buy adequate supplies and pay employees.

Positive cash flow typically comes from direct sales of goods and services, accounts receivables, loans, or investors. Your business needs these funds to achieve its goals.

Negative cash flow happens when your business spends more money than it takes in during a fiscal period. If this situation isn’t corrected quickly, your business may end up sinking.

Don’t Rely on Your Bank Balance

One of the biggest mistakes you can make is to look at your business bank statement and assume it accurately reflects cash flow. Your bank statement only tells part of the financial story. It doesn’t show outstanding cheques or credit card payments waiting to go through. It doesn’t show funds tied up in research and development, or next week’s payroll. Don’t put too much faith in it.

Profits Don’t Equal Cash Flow

Don’t confuse profits with cash flow. The number in the profits column of your accounting statement may seem impressive, but a good portion of those funds may already be allocated for critical expenditures. You wouldn’t want to upset your employees by spending a portion of next month’s payroll on a new vehicle. While sales equal revenues on your balance sheet, that doesn’t mean all monies are sitting in the bank, ready for use.

Keeping Track of Cash Flow

The best way to ensure your business doesn’t fall prey to a negative cash flow problem is by tracking the numbers constantly. A standard cash flow statement helps you track where to money comes from and where it goes. The statement includes six categories: cash balance, operations, investing, finance, new cash balance, and forecasting.

Operations, investing, and finance include sub-categories for keeping track of cash received or spent on specific items. The operations category is usually the largest, and involves the most updating. Breaking cash expenditures down into bite-sized chunks makes it easier to see if you’re spending too much and too quickly – or whether you can afford to spend more in certain areas.

Analyzing Your Cash Flow Cycle

Every business has a natural cash flow cycle. Funds ebb and flow at certain times. By reviewing monthly cash flow statements, you can recognize cyclical patterns, which you can analyze to make financial forecasts.

Understanding and analyzing these monetary cycles can help you make wiser decisions. For instance, you can better determine when to make a major purchase or when it’s time to seek additional capital from investors.

Direct vs. Indirect Cash Flow Methods

Businesses use either the direct or indirect method when creating cash flow statements. Only the operating section of the statement is affected when you choose a method. The direct method is more detailed, categorizing items such as cash receipts as major operational activities. For example, you could keep track of operational costs for employees, supply vendors, and miscellaneous expenses. Line item cash disbursements for each category shows a direct link to cash amounts.

Most businesses prefer the indirect method because of its simplicity. Your company’s net income is the starting point for all calculations. Continuing adjustments are made for any non-cash items, such as earnings losses and depreciation of assets. Regardless of what method you choose, the important thing is to keep an eye on total operational expenses.

Methods to Improve Cash Flow

If you’re not satisfied with your company’s operational cash flow, there are steps you can take to increase the amount of cash you have on hand.

  • Encourage customers to buy more. You can begin incorporating sales strategies such as cross selling and upselling. As customers are shopping, present customers with related items and add-ons that make their purchase more valuable.
  • Invoice quickly. Set up a streamlined invoicing system, and issue invoices in a timely manner.
  • Ask for payment up front. Don’t deliver goods until you receive a bulk of the payment.
  • Offer incentives. Give customers a discount or special deal for paying early.

Monitoring cash flow is vital to your business. Analyzing your cash flow with the help of cash flow statements is an essential part of maintaining a healthy balance sheet.

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