Cash flow is the lifeblood of any business, and tracking it is important for survival and growth. While profits may look good on paper, the actual movement of money in and out of your business determines your ability to pay bills, invest in opportunities, and weather any unexpected storms.
Over half of small business failures are due to a shortage of cash, yet up to a third of business owners say they are too busy to track their business's financial health.
By monitoring cash flow, you will gain insights into your business's financial health, identify potential issues before they become critical, and make informed decisions about everything from day-to-day operations to long-term strategy.
You can have a profitable business, yet still fail
Even though your business may look profitable on paper, Profit and Loss statements and Balance Sheets do not focus on cash; they are records of what has happened in your business. Understanding your cash flow enables you to examine the flows of money in and out of your business and to plan ahead.
Having enough cash available to pay your bills and suppliers each month is important. Your business might not last long if all your cash is tied up in assets or stock.
Profit and liquidity are not directly related, and even if a business is making reasonable profits, it is possible to run out of cash.
Let’s use a personal example:
If you’re employed, your salary is paid into your bank account each month; your bills and expenses are paid throughout the month, and you aim to have enough money to last you until the next payday without reaching zero or going overdrawn.
You feel you're doing well if you have enough left each month to save towards a big purchase or holiday. But if you regularly have to dip into an overdraft, things don’t feel so positive, and you may be thinking about getting a better-paying job.
Unexpected expenses like car repairs or household appliances needing replacement can throw things off quite quickly if you can’t access cash. You may need to turn to credit cards or loans; even if you have savings, they might be held in an account requiring notice to withdraw funds without a penalty.
Business cash flow is very similar. It’s about how much money moves in and out of your business over time as revenue is earned and expenses are paid. Like any personal savings you hold in an account that requires notice, assets or stock are illiquid - they can’t be sold or exchanged for cash without incurring a loss in value.
Cash Flow Forecasting
A Cash Flow Statement (or Statement of Cash Flows) analyses where cash has come from and what it’s been used for in previous years.
Operating structures and accounting standards affect how these statements must be calculated, but things can quickly get complicated unless you are a finance professional.
These statements can be used to forecast (or project) how much money will move in and out of your business in the future, which can help with budgeting and planning your spending.
Below is a simplified version of a cash flow statement based on an example used in Frank Wood’s Business Accounting [1]. It doesn’t include adjustments for items that don’t involve the actual movement of cash in and out of the bank during a financial period. It’s
By taking the bank balance at the beginning of a financial period and tracking the movement of cash in and out of the business during that period, you should be able to see how you’ve reached the bank balance at the end of that period.
Notes
Profits bring cash into the business; Losses take cash out of it.
The cash received from the Sale of a non-current asset, such as Property, enters the business, while a Purchase removes it.
Reducing Inventory, i.e. stock in the normal course of business, means turning it into cash; increasing Inventory ties up cash.
A reduction in Accounts Receivable i.e. invoices due for payment, means more cash is paid into the business, whereas an increase means less cash is coming into the business.
An increase in Capital brings cash in through additional funds or shares sold. Drawings or Dividends take cash out of the business.
Loans taken out bring in cash, but Loans repaid remove cash.
An increase in Accounts Payable, i.e. bills to be paid, keeps cash in the business, whereas a decrease means more cash is being paid out.
Cash flow forecasts are typically used for short-term planning up to 90 days, whereas cash flow projections can be useful for longer-term budgeting for things like new product launches or deciding to hire an employee.
For the businesses I’m involved with, I tend to create a 12-month projection using a spreadsheet, with a row for each accounting category and a column for each month. At the end of each month, I update this projection with actual numbers from my accounting software and update the projections for future months where necessary.
Popular Cash Flow Metrics
Cash flow metrics are key indicators that will help you understand and manage your business's financial health over the short, medium and longer term.
Net Cash Flow: this is the most basic cash flow metric. It is calculated by using the total amount of cash coming in minus the total amount going out of your business.
Operating Cash Flow: Operating activities are your business's main income-generating or revenue-producing activities, i.e., selling goods or services. The net cash flow from these operating activities considers how much it costs you (expenses) to provide those goods or services.
Free Cash Flow: How much cash is available after allowing for capital expenditures (Capex) i.e. buying or maintaining physical assets like property, machinery, equipment or technology.
The Cash Flow to Debt Ratio answers the question: Can you pay off your debts from your Operating Cash Flow? It is calculated by dividing the Operating Cash Flow by the Total Debt.
Whether you're using accounting software or a spreadsheet, the key is to make cash flow forecasting a consistent habit. Mastering cash flow management is a fundamental skill that can make the difference between the success or failure of your business.
[1]. Wood. F & Sangster. A (2012). Business Accounting (12th Ed.). Pearson.