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11 min read · Dec 8, 2022
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What is cash flow?
In any business, cash flow keeps the business running — no cash = no business! Understanding the cash flow movements of your business means measuring the amount of cash that goes in and out, and when these flows occur..
Looking at your cash flow allows you to identify whether you can cover the working capital (ability to cover short term operating costs) requirements of your business in the short term, or whether the company has enough finances to operate and perform all its service commitments over the long term. Aside from these two requirements, you are ultimately in business to generate enough cash to return to yourself as a decent return on investment. If your business isn’t doing that, then it’s not worth being in.
Understanding the Basic Terms
In measuring cash flow, it is important to understand how it works and its basic terms. Below are some of the most commonly used terminologies in working with cash flow analysis.
- Cash flow: As mentioned above, cash flow is the amount of cash that the business generates and spends within an identified period of time. It’s simply the movements in and out of your bank account.
- Revenue: This is an accounting concept. It’s income earned during a specified period. It generates cash inflows, but is not the same. The moment you invoice a customer for goods or services performed or provided, that’s revenue. It’s not a cash inflow until the cash from that revenue is in your bank account.
- Expense: The accounting concept that’s the opposite of revenue. Expenses are incurred in earning revenue — cost of goods sold / services provided and operating expenses such as payroll, rent etc.
- Profit or Net Income: Revenue less expense..
- Liquidity: The ability of an asset to be converted into cash. The most liquid assets are cash itself,, bonds, and securities, while the least liquid are properties such as land, buildings, and other real estate investments.
- Depreciation: The accounting recognition as an expense of the useful life of a tangible asset (equipment for example) progressively over its useful life as an expense
- Amortisation: This is depreciation for intangible assets, such as patents.
- Working Capital: As stated above, this cash required to cover short term (up to 1 months) commitments. A quick test of this is to deduct current liabilities from current assets; the latter should cover the former. This can be expressed as a ration of current assets / current liabilities. If it’s > 1, then the business would appear to be healthy.
- Capital expenditure: This looks at the cash spent or funding taken out on fixed assets such as equipment, land, or real estate. — non current assets, those with a life of greater than 12 months. These are the assets that are depreciated or amortised.
- Cash flow statement: This is generated after conducting a cash flow analysis. A cash flow statement shows you the movement of cash within your business — between the opening and closing bank balances for a specified period. It is part of the financial statements that a business must disclose to its shareholders and investors, along with a profit and loss statement (showing revenue, expenses and profit) and a balance sheet (statement of assets, liabilities and equity — owners’ stake plus net profit earned to date)
- Cash flow analysis: This is measuring the movement of cash within a business, using different tools and strategies. To conduct a cash flow analysis, one must look at the cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. These three cash flow categories are discussed in the next section.
- Cash flow forecasting software: These tools are used to predict and plan future cash flow. An example of a cash flow software is CashFlowMapper.
Types of cash flow
Cash flow operating activities cover the cash movement in relation to the business’s services. It is acquired by deducting the overall operational costs of the business from its overall sales. It covers standard operational expenses that are recurring regularly, such as utilities, rent, supplies, and salaries.
On the other hand, cash flow investing is the amount spent and gained on acquiring assets for the business, including properties, equipment, securities, and stocks. Cash flow investing looks at long-term, fixed assets, and capital investments.
As for cash flow financing, this refers to the cash provided to the business by founders, creditors, lenders, and investors. It also includes financing transactions with third-party suppliers, including equity, dividends, loan, credit lines, and debt.
What makes up a cash flow statement?
The cash flow statement is an historical analysis of cash flow over a period of time. It starts with opening cash, then adds operating, investment, and financing cash flows to arrive at closing cash.
How is cash flow calculated?
There are three (3) ways to calculate cash flow — the free cash flow formula, the operating cash flow formula, and the cash flow forecast formula.
To generate free cash flow, combine your total net income and non-cash expenses (including asset amortisation or depreciation), then deduct the working capital and capital expenditure. The free cash flow formula is ideal for getting an overview of the business cash flow but does not provide an accurate representation as it does not account for irregular investments, earnings, or spending.
For the operating cash flow formula, combine your operating income and the depreciation value of assets, subtract taxes, and then add the change in working capital.
When looking at long-term business performance and potential expansion, a cash flow forecast formula is necessary. This gives you insights into how sustainable the business is.
Methods of generating cash flow statements
There are two ways to generate a cash flow statement for your business — the direct and indirect method. The direct method notes all its income and expenses on a set duration and identifies which ones are paid with actual cash. The indirect method looks at the net income of the business for a set duration and conducts an analysis to determine the actual cash on hand.
The direct method is commonly used by big businesses with established processes and dedicated teams working on their finances. Small and medium-sized businesses, on the other hand, typically use the indirect method as its process is simpler and more straightforward.
All of these can be done in-house or outsourced to a third-party specialist. There are also tools that you can use to generate and manage your business cash flow. These tools vary from standard spreadsheets to more advanced platforms with features designed not just for the present, but also for the future. Some of these features are rolling forecasts, scenario mapping, team collaborations, and quick report generation with visuals that are easy to understand.
Example of cash flow
To provide the context of cash flow, here is an example: The owner of Gravity Art Gallery, Glen Beach, was able to sell $5000 worth of her paintings for the month of July 2022. From this revenue, the buyers paid only $3000 in cash, while the remaining $2000 was settled in instalments payable up to six months.
For the month of August, Glen is looking at renting a new studio near her house. This will require a $4000 security deposit. While the $5000 income from the previous month may easily cover this expense, the entire amount will not be fully available in cash until the customers have completed the instalment payment.
To manage this, a friend suggested that Glen find a faster way of generating cash and spend more time understanding the cash flow of her business. Committing to providing the deposit for the studio without the actual cash on hand is an example of a cash flow problem.
How to manage cash flow?
Commit to accurate and up-to-date bookkeeping
Numbers in business are everything. A minor variation in numbers can determine success or failure in a business. Therefore, being committed to updated and accurate bookkeeping is essential in managing cash flow. Record all the transactions regardless of their value. Without the correct numbers, you cannot ensure effective cash flow management.
Conduct regular cash flow analysis
To effectively manage your cash flow, a regular cash flow analysis must be conducted. The output of this analysis is a cash flow statement that informs you of the capacity of your business to operate both in the present and in the long term. A positive cash flow signifies a promising future for the business, while a continuous negative cash flow means an urgent recalibration of the business operations, finances, and investments is required.
Determine areas to speed up cash flow
With a clear perspective on the strong and weak points of your business cash flow, you can choose strategies that will speed up your generated income. This includes putting more resources on profit-generating parts of the business or cutting costs in the areas that slow down the cash flow.
Ensure cash availability
To ensure a stream of positive cash flow, ensure that a good amount of cash is always available. Using the similar example above, Glen might think that the revenue from her paintings would cover her expected costs for the month. However, the actual cash on hand is short of what her expenses require. By successfully managing the cash flow of her business, she can avoid potential financial problems.
Monitor business profitability
As in any business, working on profitability is important for a continuous positive cash flow. Regularly conduct an audit on which aspects of your business are generating a profit and note those that are incurring more expenses than revenue. With this data, you can also be more strategic in the sales process, including what items or services to prioritise and which ones will generate more profit. A business might be running but if it is operating on a loss, this must be urgently addressed.
Follow where the money goes
Another way to manage cash flow is by monitoring where cash is spent. Small purchases might be overlooked but over time, they can balloon into enormous expenses. Be mindful of both small and large purchases and ensure that these are all accounted for. Reviewing your expenses regularly can also provide you with information on where most of your cash is being spent. This is beneficial when revisiting your operational and investment costs to increase savings.
Invest in creating timely forecasts and speed up cash flow
Cash flow projection and timely forecasts of account payables and instalments are also crucial in managing cash flow. A common pitfall among business owners is assuming the expected receivables are already part of the cash flow. This is not the case.
You can explore different ways to receive your payables faster, such as by cutting the payment period from 60 to 30 days or providing a discount for those who can complete the full payment ahead of time.
Another way to speed up the cash flow is by sending out invoices quickly and providing customers with channels to pay electronically. To encourage faster turnaround time in completing payments, you can also charge a higher interest rate for longer payment terms.
Experiencing a roadblock?
Blockages in cash flow can happen. Running a business comes with its own challenges and sometimes, you must be able to speed up the income-generating part of it. Some ways to quickly manage this situation include asking your bank for financial help, looking at loans or lenders, discussing possible payment extensions with suppliers or lenders, checking your inventory for assets that can be liquidated, and putting up sales or discounts to speed up revenue.
Why understanding cash flow is important
Cash allows any business to run. Spending time on understanding cash flow provides you with information necessary in deciding for the business.
Know your working capital
Cash flow also provides you with clear visibility of your current working capital. This is the amount of money that you have to fuel the operations of your business and complete its financial obligations. To calculate your working capital, identify your current assets and subtract the current liabilities. Consider as well when these expenses are due within the accounting period.
Makes your business attractive to investors
Investors always look at financial statements, and this includes the cash flow statement. The clearer you can show how streamlined and efficient cash moves within your business, the more attractive it will be for investors.
Determine performance against business goals
You can’t improve what you don’t measure. With a good grasp of your cash flow, you gain insights into the current financial health of your business. Being aware of this data will also provide founders, business owners, managers, executives, and department heads the opportunity to ensure the short and long-term financial goals of the business are being achieved.
Future-proof your business
Effective cash flow management allows you to future-proof your business. It looks at both the historical data and present performance to generate an accurate projection. It also identifies slow periods throughout the year, allowing you to prepare ahead of time.
There are tools as well, such as CashFlowMapper, that are equipped with the capacity to provide Rolling Forecasts for your business, effectively showing how your decisions made today can affect the cash flow of your business in the future. CashFlowMapper also features Scenario Mapping, allowing you to better visualise how each business decision will turn out and compare them accordingly.
These enable you to make better data-driven decisions that can surely bring further success to your business.
Conclusion
Cash flow looks at the circulation of cash throughout the entire business, divided into these three (3) key areas — cash flow from operations, investments, and financing activities.
There are also various ways to measure cash flow, depending on the information that you need. A quick overview can be done with free cash flow, while operating cash flow formulas provide you with a more detailed description. To determine the long-term financial performance of the business, you can use cash flow projection.
With effective cash flow management, you get a better grasp of the finances of your business. This allows you to make sound decisions on when and how to increase the cash flow in your company, how to generate it faster, and how to better manage your overall spending.
FAQs
What is cash flow?
Cash flow is the movement of cash, the most liquid asset, within a business, in a set period of time. This includes both cash generated and spent.
What are the three (3) types of cash flow?
Cash flow from operations, cash flow from investments, and cash flow from financing activities. Cash flow from operations is cash generated from the sales of the business minus its operating expenses, cash flow from investments in the amount of cash spent to secure equipment or other assets, while cash from financing activities considers third-party financing means, such as securities, bank deposits, and approved loans.
What is cash flow and how does it work?
Cash flow is a measure of how cash moves around within a business. It looks at when cash is received from sales and financing to how it is spent on operational costs and investments.
How is cash flow different from revenue?
Cash flow looks at the entire circulation of cash within the company on a set period, from generated income to expenses. Revenue measures only the cash generated from sales.
How is cash flow different from profit?
Cash flow fuels the business covering everything from financing, operations, investments, and expenditure costs. Business profit is calculated by subtracting the overall expenses from the overall revenue, within a set period of time.
What are the signs of early cash flow problems?
Some of the common signs of potential cash flow problems include slow movement or liquidation of assets with a hefty inventory, piling up of short-term debts, inconsistent income generation, increasing number of receivables with some not fulfilled on time, and being dependent on big sales transactions to be able to sustain the business.
