What is cash flow in business, and why is it important?

What is the difference between cash flow and profit?

When it comes to cash flow vs profit:

Profit is what’s left of the business’s revenue after all operating expenses, production costs, taxes, bills, payroll, and other expenses are paid. In other words, profit is revenue minus expenses.

Cash flow, on the other hand, measures all the incoming money (for example sales and investments) and outgoing money (expenses, loan payments, etc.) of a business in a given period. It reflects the business’s liquidity and ability to meet its financial obligations and reinvest in the company. As we’ll see in the next section, cash flow and profit are not always aligned.

Can your business be profitable and have negative cash flow?

Yes. It’s 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. If you are asking, what is negative cash flow, this is what it looks like, even while the business is profitable. Keep in mind though, that this scenario is quite rare.

Why is cash flow so important?

Not having enough money to pay vendors or cover payroll is incredibly stressful. That’s the true negative cash flow meaning. However, there is more going on than just immediate expenses and it’s important to consider how much cash a business should have on hand at any given time.

Here are several reasons why cash flow is so important to a business’s short and long-term survival:

• Operational stability: Positive cash flow means the business can cover day-to-day expenses like payroll, rent, and supplies, without disrupting ongoing operations.
• Paying off debts: Lack of cash flow increases the risk of a business defaulting on loans or making late repayments, which come with penalties and fees.
• Investment and growth: Having enough cash on hand enables the business to invest in new equipment, innovate new products, and expand to new markets.
• Unexpected expenses: Positive cash flow helps keeping the business safe in the event of a market downturn or unplanned crisis.
• Credit score: Strong cash flow improves credit ratings, making it easier for a business to receive loan approvals.
• Avoiding insolvency: Even profitable businesses can fail without adequate cash flow to keep operations running.

How can negative cash flow affect a business?

Having sufficient liquid cash on hand to pay vendors and meet financial obligations is absolutely essential. Businesses that fall into negative cash flow and cannot cover expenses and payments are in a very tough spot.

It’s no surprise then that 82% of small businesses that close down say that cash flow issues were the reason. Having a negative cash flow also makes it harder to forecast expenses and prepare for slow months.

Profit alone is not enough, you need positive cash flow to ensure you are keeping your business healthy.

How to calculate cash flow

There are two different types of cash flow that you’ll need to calculate in order to assess your business’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.

Operating cash flow

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

How to prepare a cash flow statement

There are several types of financial statements every business should regularly review to understand its health. A cash flow statement is a financial report that shows how much money is moving in and out of your business during a given period. Using this report, you’ll be able to see how much cash is available to your business.

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, such as 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: This represents 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 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. You can also use a cash flow app to automate the process and reduce manual errors.

If you aren’t using accounting software, here’s what you need to do: 

• 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, whatever you prefer.
• Add up your income: List all the cash 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.
• 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.
• Calculate your cash flow: For each week or month, subtract your total expenses from your total income.

Imagine a restaurant business that also provides catering services, and check out the example of a cash flow statement below. Note that while the first three months of the year are predicted to be slow, last year’s profit and investments keep the business at positive cash flow.

Inflation

When inflation is high, businesses with existing loans suddenly find themselves making larger installments. Higher loan payments mean that businesses may have predicted a certain cash flow, but are now dealing with less available cash on hand.

Supply chain issues

Ongoing disruptions in the supply chain—whether from lack of working hands or price increases across all industries—are leading to a rising cost of goods. This means that downstream businesses have less free cash, making it harder to forecast cash flow.

Growing labor expenses

Labor shortage leads to higher wages and less efficiency. As a result, businesses sometimes fail 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 larger your inventory, the less cash you have. Forgotten stock can also lead to cash flow issues down the road. You cannot sell it until you find it, and uncounted stock will continue to burden your cash flow until you do.

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

It makes sense that when you lack cash and are wondering how to increase cash flow, the first thing you might 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, an accountant 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. These simple changes act as cash hacks—tactical shifts that can help you free up working capital quickly. 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. While reducing hires can be a short-term solution, rehiring new employees later may cost more in the long run.

Streamline your payment terms

One of the main causes of negative cash flow is the time gap between delivering a product and getting paid for it. Consider using an online bookkeeping tool to track your accounts receivable more closely, so you make sure to get paid on time. Learning how to manage business money well ensures your receivables process supports—not sabotages—your cash flow.

If customers are late with their payments, an online tool can automatically send them a reminder. This automated approach frees up your time as a business owner 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.

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 the payment type (ie. 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 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:

Make sure you pay on time

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

To make paying on time a regular habit, it is recommended to: