If you have been running a business for a while, you may have noticed experts say how vital cash flow is for your business.
But like many entrepreneurs, are you confused and never clear about cash flow?
Let’s start with the basics.
Why Is Cash Flow Important to an Entrepreneur?
Do you run a business that makes money?
Do you want more cash to come into your business?
And, do you know that your business can go bust even when you sell a lot?
If yes, you must understand what cash flow is.
So, what is cash flow?
Cash flow is simply the flow of cash coming in and going out of your business.
When your customers pay you and money comes into your business, it is called cash inflow.
When the opposite happens, it’s called cash outflow.
So when you pay your suppliers to buy what you need to provide the product or service, and money goes OUT of your business, it is called cash outflow.
This combination of cash inflow and outflow is called Cash flow.
Here are some examples of cash inflow:
- Government grants
- Cash from customers
- Financing loans
- Business owner loan
And, are some examples of cash outflow:
- Payment to direct suppliers, and paying costs towards sales (also known as variable costs)
- Payment towards indirect suppliers, and fixed expenses)
- Taxes to pay like social security, sales tax, and corporate tax
- Loan repayments
- Shareholder payment
Is It Business Cash Flow or Cash Flow?
Entrepreneurs often get confused with the terms cash flow and business cash flow.
Both are the same.
Similarly, people use both cash flow and cash flow. I stick with cash flow.
What Is Not Included in Cash Flow?
Here are some non-cash expenses that are not included in cash flow.
- Depreciation expense
- Stock write-downs
To learn more about non-cash expenses, check out this article by Freshbooks.
Still, confused about other accounting jargon?
Don’t worry. Look it up in this glossary whenever you are confused about different accounting-related terms.
Now you know what cash flow is, time to learn about what cash flow tells you.
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What Does Cash Flow Tell About Financial Health?
Cash flow tells if the company can take care of expenses in the business without any problems.
When a business can cover expenses with the cash flow it generates, the business continues to run smoothly.
The usual expenses covered by cash flow are rent, rates, salaries, marketing, professional fees, and office expenses.
This may leave you wondering about the next question.
What Is a Good Cash Flow?
A business has good cash flow when cash inflow is greater than cash flow outflow.
It’s ok if cash inflow is not higher than cash outflow. But if it consistently covers all expenses without needing external funds from the owner or banks, you have good cash flow.
To have a good cash flow, sometimes, you may not have the liquid cash to cover pay the bills, but you may have assets that you can convert into cash. They are called cash equivalents. You also need to consider the cash equivalent when calculating cash flow.
Let’s take a closer look at cash equivalents.
You might be wondering why cash equivalents are relevant to your cash flow?
Before talking about what they are, know that anything that can bring cash into a business and take it out is relevant for understanding cash flow.
So cash equivalents are the assets like stock and debtors that a business owner can easily convert into cash.
You can sell physical stock and convert it into cash. You can also follow up with your debtors – clients who owe you money – to convert debt into cash.
Have you heard about a business suffering from poor cash flow or having a lack of cash flow and wondered what this means for a business? I’ll share it with you one by one.
What Is Poor Cash Flow?
A business has poor cash flow when cash inflow is continuously less than cash outflow every week, month, and quarter. Consistent poor cash flow can lead to serious cash flow problems and bankruptcy.
What Is the Lack of Cash Flow?
Think of the moment when the bills are due. You get a reminder from your suppliers and don’t have the cash to pay the bills. I won’t wish this situation on anyone. But this inability to pay bills because you don’t have cash means your business lacks cash flow.
Lack of cash flow could be for different reasons. I have listed some of these reasons below.
It could be due to a lack of sales that will result in less cash inflow.
You may have good sales and cash inflow, but cash outflow may be higher.
You may have a profitable business, but the cash may be tied up in debtors.
Now, you have the basics covered. Take your understanding of cash flow to the next level, by understanding how cash flows in the business.
With this understanding, you’ll know how to manage cash flow so that there is enough of it always.
I’ll show you more, with a cash flow diagram.
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How Does Cash Flow in the Business?
Cash flow in your business goes through five steps.
Similar to how it happens when I go to Manchester from London, and the train goes through five stops before reaching my destination
In the same way, cash flow has to go through FIVE stops in your business before it reaches the ultimate destination, your pocket.
Let me take you through each of these 5 stops.
The first step comes when you make the sale, and collect the payment from your customer.
Then you pay suppliers who supplied what went into making the product or service you sold. At this point, you arrive at the second stop, called Gross Profit. It is the cash left after the costs of fulfillment.
Then you pay for fixed costs like rent, salaries, and office expenses. You pay for these costs whether you make a sale or not. After paying for fixed costs, you arrive at the third stop in the cash flow journey, called profit before tax.
Next, you pay business tax to arrive at the fourth stop in your cash flow journey.
After that, you pay personal tax to arrive at the fifth and final stop in your cash flow journey.
This is when cash flows to your pocket as INCOME or MONEY in your bank account.
Now you know, the stop cash goes through before it arrives in your pocket.
By knowing these steps, you have an opportunity to fix the cash flow problems at the exact stop that needs attention to avoid a situation of lack of cash flow.
In addition to understanding how cash flows in the business, you also need to know whether the business you have is a cash flow business or not.
If you have multiple businesses, one of them will generate the highest amount of cash. Such a business is a cash flow business or a cash cow.
Cash Flow Businesses Operate on a Cash Basis Rather Than on Credit.
If you are in the hospitality industry or retail or dental business, you receive cash as soon as the sale happens. So it’s a cash flow business.
If you are a coach or consultant, you might not get paid for 30 days from your invoice date. It works on a credit basis, so it is not a cash flow business. Yes, some coaches would charge upfront cash. But most of them send their invoices after they have done the work and their clients pay them in the standard 30 days. Such a business is a credit business, not a cash flow business.
Another example of a cash flow business is one that collects cash first and pays later.
One of my clients sells luxury sofas. He collects the payments from the customers first and then pays suppliers who make the sofa later. So this business is a cash flow business.
In my opinion, it is one of the best cash flow business models as it reduces the risk of cash flow crunch because the business only has to pay vendors if they have a business from customers. They use future cash inflow to cover future cash outflow. This leaves the current cash flow in business intact available to re-invest.
In this section, we looked at what cash flow is, why cash flow is important, how cash flows in business and some nuances around cash flow that you need to know to understand cash flow.
I know the term cash flow can be heavy for some of us when we start small, especially for those who have been riding a cash flow rollercoaster for a long time.
My goal is to help you understand cash flow from basics to advance level so that you are not left behind.