Cash flow is often described as the lifeblood of a business. Managing cash flow properly is what keeps your company going, essentially giving it “life” to grow and prosper. In this article, we’ll go over why cash flow is important, how to calculate and project cash flow, and explain what the difference is between cash flow and profit. We also go over some cash flow management strategies that could be useful to your small business.
What is cash flow and why is it important?
Cash flow is how money moves in and out of a business. The inflows come from business revenue. Outflows are classified as expenses or costs. For a business to be successful, the sum of the inflows needs to be higher than the sum of the outflows. There’s also a timing element involved because cash needs to be in the bank to cover expenses when they become due.
How to calculate and project cash flow
There are two different types of cash flow calculations. The first is operating cash flow, which is based purely on incoming sales revenue and expenses. Total business cash flow incorporates other sources of income and expenses, such as interest earned, legal settlements, and income taxes paid. Both numbers have their place in small business accounting.
To calculate cash flow, begin by adding up your cash inflows. It’s important to note here that we’re not talking about the sales revenue you record on the income statement. Cash inflows are money that has already been paid to you. Once you have that number, subtract the expenses for the reporting period to get your operating cash flow number.
Projecting cash flow can be done by adding up accounts receivables that are due to come in before the end of the reporting period and subtracting expenses that will come due during that same time frame. To be on the safe side, assume that 10% to 15% of your accounts receivable will come in late. Factoring that in will give you a “cushion” to make sure you remain solvent.
Cash flow vs. profit
The best way to remember the difference is that cash flow is money that has flowed in or out of your bank account, while gross profit is a number on your income statement. Profit is the total of net sales minus the total cost of sales. Cash flow tells a business owner how much money they have on hand. Profit is the amount of money a company will make after all income and expenses have been settled.
To understand this better, consider the invoicing process. A company makes a sale and invoices the client to pay in 30 days. The sale counts as revenue when it’s made because the company is required to do accrual accounting. Subtract the costs of making that sale (costs of goods sold, or COGS) and you have a profit number. Cash flow doesn’t increase until the client pays the invoice.
Cash flow management strategies
The difference between cash flow and profit is the reason why they show up on two different financial reports. The cash flow statement is a useful tool for optimizing cash flow because it shows what you have coming in and what you’re paying out each reporting period. If the numbers aren’t working, there are a few ways you can adjust them.
Pay business bills strategically
Paying bills as soon as they come in might feel good, but it’s not necessarily the right thing to do for your business. Waiting until the bill is due can increase working cash flow in the present, allowing for additional revenue to come in before that outflow needs to happen. This is called strategic bill paying. Speak with your accounts payable department about implementing it.
Try to negotiate bill payments with vendors
If you’re invoicing your clients with net-30 or net-60 terms and your vendors and suppliers are billing you with 10-day terms, you will have a cash flow problem. Negotiating vendor terms can help solve that. Most vendors have similar conversations every day, so there’s a good chance they’ll be willing to work with you. Don’t wait until you’re forced to pay them late.
Use online bill pay to schedule payments
Paying bills when they’re due and avoiding late fees can be accomplished by using the automation functions of online bill pay. This feature also has a mobile component, giving business owners and accounts payable managers the ability to pay anywhere at any time. That convenience can help you keep an eye on cash flow even when you’re away from the office.
Pay bills with your business credit card
Another way to manage cash flow is to use a business credit card to pay bills. This can be extremely helpful in months when cash flow slows down. You can use your card to cover bills until cash flow increases again, at which point the company can pay off the full balance if it’s available. You can also use your business credit card to make sure you don’t miss due dates.
Consider applying for a line of credit
Borrowing money before you need it can be beneficial to cash flow. Applying for a business line of credit is one way to do this. A line of credit can give your company additional purchasing power and can act as an “insurance policy” if your cash flow can’t cover that month’s expenses. Seasonal businesses often use lines of credit to get them through their off-season.
