What is Cash Flow, and How Does it Affect Your Business?

If you’re running a small business or planning to start one, you must have come across the term, cash flow. In this article, we’ll discuss what cash flow is, its types, and why it matters.

What is Cash Flow?

Cash flow measures the total amount of money that comes into your business as well as goes out of a company monthly. There are two parts to a company’s cash flow. One part is the incoming cash, and the other is the outgoing cash. 

Incoming cash refers to all money that the business makes within the month. It could come from different sources, but the most common source of incoming cash is from customers and clients who pay for services. 

Outgoing cash refers to all money spent by the business in a month. The standard categories under outgoing cash include employee salaries, operational costs, and utility bills. 

Both sides of the cash flow equation are not meant to be equal. In some instances, they are, and it’s a sign that the company is barely managing to break even. One of the signs of a thriving company is that it maintains a higher incoming cash to outgoing cash ratio. If your business has more expenses than incoming cash, it’s bound to fold. 

As explained above, incoming and outgoing cash don’t originate from one pipeline. With so many streams of cash going and leaving the business, tracking cash flow is essential each month. The process of balancing your cash flow is cash flow analysis, and it helps businesses make informed decisions. Each month, businesses should carry out a cash flow analysis and draft a cash flow statement (a document showing a complete analysis of a business’s cash flow for a specific period).

Why is Cash Flow Important?

Cash flow is vital for any business because cash makes the world of businesses go round. For every business to survive, they need to not only have good cash management policies, but they also need to know and understand their cash flow. It helps them make better decisions and even predict the financial future.

Investors use some of the metrics derived from studying businesses’ cash flow to determine if they should invest.

Types of Cash Flow

There are three types of cash flows that businesses need to monitor closely.

Cash Flow Financing

Cash flow financing refers to all money that moves between a business and other parties (creditors, shareholders, and owners). The financial activities in this type of cash flow are transactions around dividends, equity and debt.

Cash Flow from Investments

Cash flow from Investments is all the money spent on or generated from the investments made by the business. 

The data on this category doesn’t immediately affect the business as operating cash flow. However, the information obtained here is used to analyse the companies’ investments to determine a loss or gain, as either could affect the business’s ability to get loans and credit.

Cash Flow from Operations

Operating cash flow refers to all money flows tied directly to producing and selling goods or services. It involves everything from procuring raw materials to the production process to marketing and delivery. 

The operational cash flow is very important because it determines if a business can still operate. It also helps businesses know if they are generating enough cash to fund an expansion, if they have to take out a loan, and how much they’ll need to borrow. 

For a company to comfortably handle operational cash flow, it means that the operational cash inflow should be higher than the operating cash outflow.

Operating cash flow is calculated for a specific period, usually monthly. It is determined by subtracting operating cash outflow from the amount received from sales. Note that this sales amount isn’t the total sales made in a month but the amount already paid. This distinction is why businesses should use credit control software to improve their debt collection.

Positive and Negative Cash Flow Explained

Positive cash flow is when a business has more cash coming in than going out in a specified period. This means a business could have a positive cash flow this month and a negative cash flow the next. It all depends on how much money the business can bring in each month. An annual positive cash flow is a better indicator of net growth. 

Businesses aspire to stay in a state of positive cash flow because this means they have a positive operating cash flow and can afford to keep money aside for investment and expansion purposes. 

At the same time, negative cash flow is the opposite of positive cash flow, and businesses that register a negative cash flow record more outgoing cash than incoming. Just as positive cash flow, negative cash flow is calculated over a specified period. It is also subject to change from month to month. 

Long-term negative cash flow has dangerous effects on businesses. This means depleted savings as the business uses its cash reserves to run operational costs. If the tide doesn’t turn around and the business exhausts its cash reserves, it’ll fold. 

Small businesses and businesses undergoing an expansion usually record negative cash flow. In these two instances, negative cash flow is to be expected and can be handled to prevent the business from folding. 

Small businesses run a tight ship when it comes to cash flow. Lack of steady customers and too many negative cash flow months is why most new businesses don’t make it past a few years.

The first six months would often record negative cash flow, but even within this timeframe, no business should record recurrent negative cash flows. To improve the balance, businesses may consider running a lean ship by cutting all expenses except for the necessary ones. 

For businesses undergoing an expansion, there might be a few moments of recording negative cash flow. You can control this by drafting a budget and plans to follow through with the budget. Also, keep a timeline for when your business is supposed to start showing positive cash flow. 

The concepts of positive and Negative cash flow help businesses manage their capital pipeline and plan accordingly. It also has another advantage. Understanding the cash flow of your business helps you map out the best cash flow management strategies to use.

Bottom Line

Cash is King. Every business owner already knows this. But it goes one more step, cash flow is essential to keep the kingdom running. Understanding your company’s cash flow is vital to making informed decisions.