Back to Blog
Published at | Updated:

What is cash flow and why is it important?

A man working out of his kitchen reviews a cash flow statement for his small business.
Erez Shoshany Corporate Controller
Published at | Updated:

In the world of business, only one thing is certain–cash is king. To keep a business going, you need cash on hand. And when you have no cash, your business is likely struggling.

Common concerns business owners have include making payroll, distributing profits, and not having enough cash to pay vendors or taxes–all of which can be solved by making sure you have positive cash flow.

Being more proactive and systematic helps the financial health of your business. In this guide, we’ll share everything you need to know about cash flow management and how to approach all the issues that come along with it.

What is cash flow?

Cash flow is exactly what it sounds like: a measurement of the flow of cash (or cash equivalents) in and out of your business over a set period of time. When more cash is coming in than going out, it’s known as positive cash flow. When the outgoing cash exceeds the incoming cash, it’s called negative cash flow.

What is the difference between cash flow and profit?

Your company’s profitProfitProfit is the earnings that remain after you deduct expenses from revenues. Net profit is what’s left when all types of expenses are deducted from sales. Gross profit is what’s left after deducting the costs associated with making and selling the products, or the costs associated with providing services. is what’s left when all the bills are paid and expenses are deducted from sales. Cash flow, on the other hand, takes into account not just earnings, but also loans or investments. So, you can have positive cash flow, even if you’re spending more than you’re earning.

Can your business be profitable and have negative cash flow?

Yes. It’s entirely possible to have negative cash flow while being a profitable business, and vice versa. Let’s look at some real-life examples of how this works.

Imagine you’re opening a coffee shop. You take a small business loan from a local bank for $50,000. That loan represents money flowing into the business, producing a positive cash flow. But if you don’t have any customers in your first two months, you’re not generating revenue, which means your profitability is nil. Positive cash flow, without being profitable.

The reverse is also true. Let’s say you sell musical instruments, and most of your customers use the “buy now, pay later” option. You pay $3,000 for a piano, then resell it for $5,000, with the customer paying $2,000 now and $3,000 due in six months. Your cash reserves have actually gone down by $1,000 even though you netted a profit from the sale. Negative cash flow, while being profitable. Keep in mind though, that this scenario is quite rare.

Why is cash flow so important?

Having positive cash flow means you have enough money to pay for supplies, vendors, taxes, subcontractors, etc. while still having extra cash for unexpected expenses or for growing your business. Maintaining positive cash flow gives your business more resilience during uncertain times.

How can negative cash flow affect a business?

82% of shuttered small businesses cite cash flow issues as the reason for their failure. Having negative cash flow makes it harder to forecast expenses or prepare for slow months. You’ll also need positive cash flow to better adjust your prices, gain clarity on your spending, and pay your vendors on time.

Negative cash flow puts business owners in a real bind. It’s essential to have sufficient liquid cash on hand to pay your vendors and meet your financial obligations. Meaning profit alone isn’t enough. Positive cash flow is a must for keeping your business healthy and in a position to grow.

Cash flow management basics

Let’s go over a few important terms that will help us moving forward:

Capital expenditure: This includes money your business spends on fixed assets, like land, leasehold Improvement, or equipment.

Depreciation/Amortization: Many business assets lose value over time. Depreciation refers to tangible assets such as computers, desks, etc. while amortization refers to intangible assets such as domains and trademarks.

Net income: This is the total income left after deducting business expenses from the total revenue. A good way to calculate this is: sales – cost of goods soldCost of goods soldAll costs involved in the product or service your business is selling are called cost of goods sold, or COGS. The cost of materials and the cost of labor would all be summed up and called COGS., general expenses, taxes, and interest.

Working capital: Working capital is the difference between your assets and liabilities. It represents the capital used in the day-to-day operation of your business.

How to calculate cash flow

There are two different types of cash flow that you’ll need to calculate in order to assess the company’s financial health: free cash flow and operating cash flow.

Free cash flow
This represents the money that remains after paying for things like payroll, rent, and taxes. This is the cash a company can use as it pleases.

The formula to calculate free cash flow

Operating cash flow
Operating cash flow indicates whether or not a company can generate sufficient positive cash flow to maintain and grow its operations.

The formula to calculate operating cash flow

How to prepare a cash flow statement

Cash flow statements show how much money is moving in and out of your business. Using this report, you’ll be able to see how much free cash is available to your business at any given time.

The main components of a cash flow statement are:

  1. Cash flow from operating activities: This is how much cash is generated from a company’s ongoing operating expenses like its products or services.
  2. Cash flow from investing activities: These include any sources and uses of cash from investments made by the company for the company. These include purchases or sales of assets like computers or desks for example.
  3. Cash flow from financing activities: The sources of cash from investors and banks, as well as the way cash is paid to shareholders. 

When creating the cash flow statement, here are the steps you need to take: 

  1. Determine the starting balance of cash at the beginning of the reporting period.
  2. Calculate cash flow from operating activities. 
  3. Calculate cash flow from investing activities. 
  4. Calculate cash flow from financing activities.
  5. Determine the closing balance. Take the sum of cash flow from operating, investing, and financing activities to see your change in net cash for a given period.

Forecast expenses and earnings

A cash flow forecast is an estimate of your future sales and expenses. It shows you how much money will come in and go out of your business over a particular period. It will also help you understand if you’re going to run out of cash or if you are looking at a cash surplus.

You can use accounting software, like QuickBooks or Xero, to create a cash flow example. If you aren’t using accounting software, here’s what you need to do: 

  1. Decide on your forecasting period: Choose a reporting timeframe that’s easy to predict and that’s correlated with what you want to know. It can be a week, a month or a year–doesn’t matter.
  2. Add up your income: List all the cash you’ve got coming into your bank account during the forecasting period. This includes sales, tax refunds, interest earned, investments from shareholders or owners, grants, and miscellaneous cash payments.
  3. Add up your expenses: List everything you’ll need to pay for during the forecasting period. That includes rent, wages, inventory, loans, fees and charges, marketing and advertising, and tax.
  4. Calculate your cash flow: For each week or month, subtract your total expenses from your total income.

Let’s say you own a restaurant that also provides catering services. Here’s an example of a cash flow statement. You can see that the first three months of the year are predicted to be slow, but last year’s profit and investments keep the business at positive cash flow.

An example of a cash flow forecast

Main reasons for cash flow issues

Different industries have different ways of doing things, and thus, different reasons cash flow issues surface. In this section, we’ll cover some of the main issues that affect most of the small businesses in the U.S. right now.


When inflation is high, as we saw in the second half of 2022, businesses with existing loans suddenly find themselves making larger installments. Higher loan payments mean businesses may have predicted a certain cash flow, but are dealing with less free cash on hand.

Supply chain issues

Covid-related shutdowns, lack of working hands, and other factors created material shortages and price increases across all industries. The rising price of goods means less free cash and it’s thus harder to forecast cash flow.

Growing labor expenses

Most, if not all industries are currently facing staff shortages. This issue started with the pandemic but the issue has worsened over time.

Because of this country-wide issue, businesses sometimes aren’t able to deliver products and services to their customers, which can hurt revenue. Meeting those demands comes at a cost–hiring temporary staff or investing in upskilling existing employees.

Inventory Management Issues

Having too much stock is a problem. The bigger your stock, the less available cash you have. Plus, if you forget to count a part of your stock, you end up with money issues without even knowing it. Not only will you not be able to sell it until you find it, but this forgotten stock will continue to burden your cash flow until you do.

What to do when cash flow is negative

There are many more reasons your cash flow may be negative but no matter the “why”, we’ll now focus on the “what”. What should you do when you already have a negative cash flow? Keep on reading to find out.

Should I take a loan if my cash flow is negative?

It makes sense that when you lack cash, the first thing you think of is taking a loan. And this is definitely one possible solution. However, there are safer steps to take before you resort to that. First, find out why your cash flow is negative. Once you have the answer to that question, the solution will be clearer.

Seek professional advice

Before you make any big decisions, consult a professional expert. An accountant will be able to help you decide how to solve your current issues and how to move forward. Plus, if you do end up taking a loan, they can help you manage the whole process and get the best terms possible.

Cut down your expenses

Reducing expenses is one of the quickest ways to improve cash flow. When you spend less on payroll, rent, production, supplies and other common expenses, the more cash you will have on hand.

This is an immediate step you can take, however, be very careful when cutting down staff. Hiring new employees will be difficult and teaching them the job could end up costing more in the long run.

Streamline your payment terms

One of the main causes of negative cash flow is the big time gap between delivering a product and getting paid for it. You should consider tracking your accounts receivable more closely in order to make sure you get paid on time. Using an online tool to do exactly this is the most efficient way to go. You have a lot going on, and chasing customers to make sure they pay you shouldn’t be a concern. Your customer is late on a payment? An online tool can automatically send them a reminder, leaving you to focus on other things.

Line of credit

A line of credit is a preset borrowing limit that can be used at any time, paid back, and borrowed again. A loan is based on the borrower’s specific need while credit lines can be used for any purpose.

In short, a line of credit gives you access to money that you can spend on your business expenses.

Lines of credit vary by industry, but most commercial banks have pretty consistent practices. Businesses can typically borrow up to 75% of their accounts receivable balances that are current. 

How to avoid having negative cash flow

Whether you’re a new or growing business, cash flow is something that should always be managed and taken into account. There are many ways to make sure your company has positive cash flow, and in this section, we’ll cover some of them. For starters, we recommend that you:

Hire an accountant

Accountants are professionals who handle bookkeeping and manage the financial documents you need to run your business. They evaluate financial operations, identify issues, and strategize solutions. They also offer guidance on cost reduction, revenue increase, and maximizing profit and cash flow.

One of an accountant’s main responsibilities is making sure you have enough cash on hand to run your business. And while you focus on other aspects of the business, they will help with the nitty gritty financial details that you probably don’t have a sufficient understanding of.

Improve inventory management

Effective inventory management lies somewhere between having too much inventory and not enough. There are technical tools to manage your inventory, including some accounting software you may already be using. The first step to better inventory management includes tracking everything coming in and out, alongside their invoice statuses.

Ensure customers pay on time

Most businesses are able to dramatically improve cash flow by focusing on a more proactive and streamlined approach to their customer payment process. No matter what payment type (invoicing, credit card, cash, check, etc.) making sure you get paid on time can be exhausting and time-consuming.

All too often, you unintentionally damage your own cash flow system by poorly managing your revenue cycle and by making it difficult for customers to pay you. Here are a few tips that will guarantee you put cash back into your bank account faster and more efficiently:

Set up a quick, but regular invoicing schedule

While you want to limit the amount of time between delivering your product/service and invoicing for it, you still want to perform this function at a regularly scheduled time. Schedule a set time each day, week, or month that works best for your business’s billing cycle.

Use an automated billing tool

You may be able to implement an automated recurring billing system to gather recurring payments from customers. This helps automate the payment process by automatically charging customer credit or debit cards (or via ACH) each month. This is highly efficient and helps ensure you get paid on-time every month.

Ask customers to pay electronically

The pandemic pushed people business owners to start receiving online payments. If you haven’t yet jumped on that bandwagon, we recommend you establish a billing system that allows customers to pay digitally. From credit cards to PayPal/Venmo and from ACH to wire, there are a number of modalities that can speed up receipt of cash. Most of the billing tools now support multiple options.

Establish an escalation process

It occasionally happens that a customer drags their feet when paying their invoices. You need a plan for dealing with these uncomfortable situations. 

One of the biggest mistakes you can make is waiting too long to communicate and then doing so in an overly aggressive manner. Start early by being friendly, helpful, and seeking to understand (honestly) why your customer is slow to pay. 

Get paid by ACH bank transfer

You can receive payment directly into your bank account when using Melio to get paid by your business customers. Instead of dealing with cash or paper checks–and potentially facing fraud–you get peace of mind knowing the payment will go where it needs to. You can also track every invoice from the minute it’s generated.

Have a credit policy

A credit policy is a document that sets payment terms for customers. In industries where a lot of the payment is done in different stages, like construction for example, a credit policy can be as important as insurance.

It’s wise to create incentives for early payments, limit the amount and time for payments on specific accounts, and create a procedure for dealing with delayed payments.

Use contracts

Always work with written contracts. Make sure the payment terms you give clients are shorter than the terms you have with your vendors. Add a clause for materials’ price increases and certain delays.

Make sure you pay on time

Oftentimes, late payments carry late fees. To avoid them, make sure you pay on time. Some vendors even give discounts for early payments.

To make this reality, we suggest you:

Use an online bill pay tool

With an online bill pay solution, you can reduce the time spent paying the bills and be sure all payments go out right on time.

Things to consider when choosing a bill pay tool:

  1. Customer interface: You’ll want the ability to just take a photo of an invoice, upload a file, or enter details directly.
  2. Ability to select a payment method: You’ll want the ability to pay with ACH bank transfer, debit, or credit card.
  3. Group or split invoices: Can the platform facilitate combining multiple bills into one or splitting bills into installments? 
  4. International payments: Does the platform support payments to foreign countries your vendors work from?
  5. Workflow capabilities: It should include user roles and permissions.

Pay upfront

It can come in handy if you are able to leverage your vendors for better pricing when you pay upfront.

Pay with a credit card

This allows you to defer payments and buy more time. Your vendors get paid on time, while the payment is deducted at the end of your next billing cycle. If your vendors want a check or bank transfer, with Melio they still get it their way and you can still pay with a credit card. 

Buy now, pay later

Some vendors allow you to buy products now and pay for them later. It’s a common practice in the industry and it’s recommended if you want to keep the most cash on hand possible.

Cash flow health = your business health

Once you understand your cash flow weak spots, it’ll be easier to figure out how to solve those issues, and how to avoid them. The key is to stay on top of your cash flow status at all times.

Want to find out more about how Melio can help maximize your cash flow?Learn more

*This guide is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.