Even if you’re taking in lots of sales, you can still find yourself cash-strapped if the money from those sales doesn’t reach your bank account in time to meet your monthly obligations. Understanding your cash flow and its importance will help you manage your accounts and ensure you always have enough funds available to pay your bills and grow your business.
In this article, we explain why cash flow is the essence of any business.
Cash flow definition
Cash flow refers to the incomings and outgoings of cash that represent the operating activities of your business. Think of cash flow as a picture of your bank account over time. If more money comes into your account than goes out, your cash flow is positive. If more goes out than in, it’s negative.
Why is cash flow important?
Cash flow is important because it enables you to meet your existing financial obligations as well as plan for the future.
Yet, cash flow is a common challenge among small businesses. Around 60% of small business owners say that cash flow has been a problem for their business and with 89% of them saying these problems have had a negative impact on their business[1].
By balancing your inflows and outflows of cash, you can ensure the smooth day-to-day running of your business, at the same time as building sufficient reserves to weather peaks and troughs in sales, late invoice payments, or unexpected expenses.
What is the difference between profit and cash flow?
Cash flow is the money that moves into and out of your business bank account over time, while profit is the amount of cash that remains in your account from your sales revenue, after all costs and expenses have been deducted.
Is cash flow more important than profit?
While profit is an important metric to track, it doesn’t show you the net amount of money moving into and out of your bank account, which is crucial to keeping your business running. This means that cash flow is more important to track on a day-to-day basis, as it's cash flow that ensures your business can keep going.
Is cash flow more important than revenue?
Revenue is the money your business makes from the sale of its products or services and, as we now know, cash flow is the movement of money into and out of your business's bank account.
In this way, revenue tells you how successful you are at selling your products or services. But cash flow shows you how much money you have available to keep your business running and invest in expansion. Without cash in the bank, you could land big orders that you can’t fulfill because you don’t have the cash reserves to pay your employees or suppliers.
Analysing your cash flow
Analysing your cash flow will help you to spot trends in cash management, such as invoices that are regularly paid late. This can help to reduce the risk of negative cash flow. Your cash flow statement should form the heart of this analysis.
What is a cash flow statement?
A cash flow statement is a financial statement that shows how much cash enters and leaves your business over a given period of time. It helps you identify profitable parts of the business, spot any areas of waste, and understand when and if it might be the right time to scale.
Types of cash flow
A statement of cash flow covers three main activities of your business:
- Operating activities: These are regular business activities. Inflows of cash include revenue from sales, interest and any dividends you receive. Outflows include operating expenses like wages and office costs.
- Investment activities: This refers to monies made or lost through short and long-term investments. For example, money made through the sale of assets such as land, buildings, or equipment and payments for the purchase of land, buildings, or other investment assets.
- Financing activities: This refers to raising money from debt or shares and repaying that debt. For example, inflows might be money you’ve borrowed, and outflows can be dividend payments or servicing debt.
What is a cash flow forecast?
A cash flow forecast estimates the cash position of your business in the future. It includes your projected net income, expected costs and expenses, and estimated outgoings. This reveals whether you need to cut expenses or fight hard for extra sales to maintain positive cash flow. You’ll also be able to see if delayed payments from clients often cause cash shortfalls. You can learn more and create your own forecast with our cash flow forecast template.
Why are cash flow forecasts important for a business?
Cash flow forecasts predict your future incomings and outgoings, based on your known costs and historical revenue data. You can use a cash flow forecast to understand whether you might experience a shortfall or surplus of cash in the future and use this in your decision-making.
For example, if you predict a shortfall you might consider cost-trimming whereas if you predict a surplus, you can consider expansion into other markets. You can learn more about how to create a cash flow forecast here.
How to calculate cash flow
The net cash flow calculation of your business is the total cash received minus the total amount spent over a given time period. It includes cash received from all your business activities, including operating activities, investing activities and financial activities.
Net cash flow = net cash inflows - total cash outflows
For example, imagine a business earns £50,000 from operating activities and £10,000 from financing activities. It lost £20,000 from investments. The company’s net cash flow for the period is: £50,000 + £10,000 - £20,000 = £40,000.
What is a good cash flow?
A company is generally considered to be financially healthy if it consistently brings in more cash than it spends.
One way to gauge how strong your cash flow is, is to calculate the operating cash flow ratio. This reveals a company’s ability to repay its debts and interest. The operating cash flow ratio formula is:
Operating cash flow ratio = cash flow from operations / current liabilities
Your cash flow from operations can be found on your cash flow statement. Current liabilities include short-term debts and accounts payable. A ratio of less than 1 can indicate short-term cash flow issues and a ratio higher than 1 suggests good financial health.
How to improve cash flow
Some easy ways to improve your cash flow include negotiating shorter payment periods with clients, automating reminders for late invoice payments, and cutting back on unnecessary expenses.
Maintaining a steady flow of cash into and out of your business ensures you always have enough money available to pay your expenses and reinvest for growth. With an American Express® Business Gold Card, you get up to 54 days to clear your balance. This helps you to better balance your incomings and outgoings. Plus, you can earn Membership Rewards® points – and use them to reinvest into your business – every time you make these payments.¹
1. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
Sources:
[1] Quickbooks
