February 28, 2024

The Three Sources of Cash Flow for a Business

Business owners typically can't manage what they can't measure. Better cash-flow managementcan start with examining three primary sources: operations, investing, and financing. These three sources align with the main sections in a company's cash-flow statement, an essential document for understanding a business's financial health.

Your cash flow statement reveals changes in cash flow over time. It can help business owners determine their ability to meet upcoming expenses like wages and rent. Lenders look closely at your business cash flow statement to decide whether to make a loan.

By understanding these three cash flow sources, business owners can create a precise and informative cash-flow statement.

What is Cash Flow?

Cash flow represents the total amount of money moving in and out of a business. It's the financial lifeblood of a business and shows its health.

Cash flow can originate from various sources, each playing a crucial role in maintaining a business's financial stability. Effective cash flow management is essential for a company's survival.

A business might be profitable on paper, but without adequate cash flow, it can face challenges in meeting its short-term obligations. So, understanding the nuances of cash flow, such as its timing and predictability, can be essential.

For instance, seasonal businesses might experience significant cash inflows during peak seasons and primarily cash outflows during off-peak times. By forecasting these patterns, businesses can better manage their finances, ensuring they have enough cash reserves during lean periods.

Cash flow is the financial lifeblood of a business and shows its health.

Cash from Operating Activities

Cash from operations is the net cash generated from the core business activities. It's derived from sales revenue after deducting expenses like the cost of goods and interest on loans.

It's crucial to note that cash flow from operations isn't synonymous with profit. A company might show profit on its income statement, but if customer payments are delayed while supplier payments are immediate, your business might experience a cash shortage.

Factors like changes in inventory, accounts receivable, and accounts payable also can influence business cash flow. For instance, a decrease in inventory or accounts receivable can boost business cash flow. Conversely, with payables, higher amounts can indicate more cash, while reductions may represent the opposite.

Lenders can often prioritize cash flow from operations when considering loan applications, since it reflects the business's operational strength. Strong cash flow also suggests a business can make payments on time and repay the loan.

Cash from Investing Activities 

This represents cash generated from selling business assets, which could range from obsolete equipment to real estate or investment securities. Conversely, cash used to purchase these assets is considered a cash outflow in this section of the company’s cash-flow statement.

Investments in intangible assets, like brand recognition or intellectual property acquisitions, can also appear on your cash flow statement as cash outflows.

Investing in long-term assets and later profiting from their sale can stabilize cash flow, ensuring it neither directly generates profit nor drains the cash flow.

Cash from Financing Activities

For most businesses, cash from financing primarily can come from loans or drawing down credit lines. Another source of cash flow from financing activities can be selling company stock, ownership in the company, or issuing bonds to investors.

Principal payments on loans, mortgages, or credit lines are cash outflows in this section of your cash flow statement – and so are dividends paid to company owners.

Business owners can enhance their cash flow from financing by getting new loans or refinancing existing ones. Refinancing loans with high monthly payments with loans offering lower payments may improve cash flow.

Business Cash Flow Caveats

While the sources above are typical for most businesses, their significance can vary. Young businesses generating minimal cash from operations might rely more on financing or equity investments initially.

For established businesses, substantial operational cash flow can be an indicator of robust health. However, a business is surviving by selling off assets may appear riskier. Occasionally, other cash sources, like lawsuit settlements or insurance claims, can become important.

Some lenders, like those for SBA loans, may merge a company's cash flow statements with the owners' personal ones to make lending decisions.

By focusing on these areas, business owners can enhance their cash flow statements, ensuring they meet their financial obligations and can secure loans when they need them.

The Takeaway

It can be important to monitor each cash flow type consistently, since they each provide insights into different aspects of a business's financial health.

Photo: Getty Images