Cash flow is one of the most important things when it comes to running a business. It dictates how much money you can spend, how much money you have in savings, and whether or not your company will be able to keep operating.
If cash doesn't come in as quickly as it goes out, then there's no way for a business to survive. In this article, we'll go over what cash flow is and why it matters so much for small businesses.
What is Cashflow?
Cashflow is the movement of money in and out of a business. It refers to the amount of cash that comes in (revenue) and goes out (expenses).
It is a complicated concept for many entrepreneurs to master, but understanding cash flow is crucial for small businesses.
Cashflow is different from profit. Profit is the total revenue of a business minus its total expenses, but this doesn't necessarily mean that you have money in your bank account to spend or save right away.
You've got to consider cash flow when it comes to managing your small business' finances.
Why Does Cashflow Matter?
You may notice that while your company is profitable (revenue > expenses), your bank account doesn't necessarily reflect that.
It's because cash flow tells you how much money is coming into and going out of a business on a regular basis, not just once or twice per year.
Cash goes in as sales revenue and comes out as expenses like payroll costs, rent, and marketing.
If your business is profitable but you don't have the cash to pay for those expenses as they come up, then you'll find yourself in a difficult situation quickly
Different types of Cashflow
Cash flow can be positive or negative, and each has different implications for your business.
- Positive Cash Flow
Positive cash flow means that the money coming in is greater than the amount going out. This doesn't necessarily mean you have a lot of extra money at hand to spend on anything you want you may still have expenses over time that need to be paid.
However, positive cash flow gives you the opportunity to save for future expenses or make an investment that will help your business grow
- Negative Cash Flow
Negative cash flow is when money going out exceeds what's coming in. This means that whatever extra money you have left over after paying off all of your monthly bills isn't enough to cover expenses. Negative cash flow can lead you into debt and eventually bankruptcy.
How to Manage your Cashflow
Cash flow is difficult for many entrepreneurs because they must manage their money on a day-to-day basis, unlike other business owners who only have to think about it once or twice per year when filing taxes.
To keep positive cash flow, you need to manage your expenses and stay on top of every little thing that's going out.
1. Solid Payment terms
Payment terms are the amount of time that clients are willing to wait for their invoices to be paid. Most entrepreneurs ask for 100% payment upfront, but some larger businesses may request Net 30, 60, or even 90-day terms.
My biggest advice is to always try and negotiate your payment term with a client. If they're asking for net 30 payment terms, ask for something smaller like a net 15.
You might also be able to offer them a small percentage discount in exchange for shorter terms
2. Cost of Goods
The cost of goods sold is the amount that it costs you to produce or purchase your product. If your company makes and sells its own products, then this number probably looks pretty low it's just the materials used plus a little extra for overhead like equipment rental fees.
However, if you're selling something else (like tech support) rather than producing it, you'll have to factor in the costs associated with providing that service.
Buy supplies and packaging in bulk or source inexpensive alternatives. You can also try to purchase any common cost of goods sold items when you have the most cash on hand.
3. Invoice Cycle
The invoicing cycle is the number of days between when you send an invoice to your client and pay yourself. This can vary depending on how often you get paid because it's good practice to stay ahead of the game.
If you're reliable about getting paid on time, then it's okay to invoice your client a little more frequently.
In this case, 30-day invoices would be appropriate. Make sure to set a reminder in your calendar to check up on invoices every 30-60 days, or else you might find yourself getting paid at less frequent intervals.
4. Delayed Payments
Delayed Payments can be a real pain for business owners. It's difficult to track down the source of late payments, and sometimes it can be hard to even get in touch with your client.
Don't let this discourage you—you should always do everything within your power and ability (and ethics) to collect that money owed as soon as possible.
If you can't get in touch with the client yourself, you might need to hire a third-party collections company.
This is important because if your debt goes into collection status it will be listed on your credit report and affect other areas of your financial life such as applying for mortgages or car loans down the line
Refunds are a tricky part of running a business. It's important to get things right because refunding money can really affect your cash flow.
If you are over-promised and under-delivered, take the hit on that one transaction rather than giving in to customer demands for a full or partial refund every time something goes wrong
If you do have to issue a refund, that money could be spent on something else. Or if you're able to resell the product in question, at least there's some potential for profit.
Cash flow is difficult, but it's one of the most important aspects of running your business.
By understanding how cash flow works and what positive or negative means you can keep track of your company's money and make sure you have enough to pay your expenses.
Cash Flow Metrics
Cash flow is typically measured using different metrics. These include:
- Liquidity – Liquidity looks at the amount of cash that a company has on hand and whether or not it can cover its short-term financial obligations.
- Cash Flow Yield – The Cash Flow Yield (CFY) measures what percentage of investment return accrues as actual, real money in your pocket after a year.
- Cash Flow Per Share (CFPS) – Cash from operating activities divided by the number of shares outstanding. The CFPS is a measure of how much cash flows through to each share per period.
- Price Earnings Ratio – Also called as P/E ratio, it is found by dividing the stock price per share by earnings per share (EPS). It shows how much investors are willing to pay for each dollar of a company's earning.
Benefits of Cashflow
Cashflow is the lifeblood of a company. It starts with cash inflow from sales and ends when money flows out as payments to suppliers, wages, taxes, etc. A business can survive without profit but cannot continue without sufficient cash flow.
- Identifies Problem at Initial Stage
Cashflow identifies the problem at the initial stage itself and thus gives time to rectify it before causing damage. As poor cash flow is linked with a lack of sales, it can be observed that there are fewer or no new customers coming in.
- Increase Cash Reserves
Cashflow helps to create a buffer that can be used when the times are not good for business. This way businesses survive the bad phase and come out even stronger after facing competition from bigger players.
- Analysis of Cashflow Statement
Cashflow statement is critical as it reveals information about a company's ability to generate cash from its operations, capital resources, and financial flexibility.
It also provides insight into how much money is needed for growth opportunities. A strong cash flow statement indicates the company's ability to meet its debt obligations in all circumstances.
- Short-term vs Long-term Impacts
Cashflow shows the short-term and long-term impact of an event on business. It makes it easy for management to take decisions regarding financing, expansion, working capital, etc. Cash is king in this scenario as liquidity determines whether a business can run or not.
- Retains Cash Balance
Cash flow is important to ensure that a business has enough money for its day-to-day expenses.
It also helps in maintaining the right amount of cash balance. While this can be managed by increasing sales, it does not always mean more profits as there are other costs associated with them too. The invoice cycle time plays an important role in raising cash through invoice discounting.
- Financial Security
Cash flow plays a pivotal role in determining financial security. It helps to build wealth by investing in the right places.
A strong cash position not only gives peace of mind but also acts as collateral for borrowing money at lower interest rates, thus saving the cost of finance.
It is important to monitor and manage cash flow so that it supports business needs without compromising on growth opportunities. Overall, a strong cash position helps in building financial security.
It provides the necessary liquidity for day-to-day expenses and capital requirements too. Thus, cash flow is the lifeblood of a company, which needs to be managed carefully.