If you have been an entrepreneur for any length of time, you probably have learned this lesson already—cash is king. When I say cash, I don’t mean actual $$$…I mean cash flow. Let me give an example. If you have $3,000 of income every month on 30-day terms and $2,000 of expenses but that invoice doesn’t get paid till 60 days and you have no cash in the bank to pay that $2,000, you essentially have a cash flow problem. To put it bluntly, it doesn’t matter how much money you have coming in if you don’t have enough money to pay your expenses now your business will eventually go bust.
It will be slow. The recurring payments will stop at first. The people who give you credit will no longer offer you terms and buying products you need to make more money to get out of this cycle will start to dry up. Then there’s rent, utilities, etc. And as a business owner, do you really want to make your employees wait to get paid? You get the picture. The situation can look grim.
What is cash flow, net cash flow and what are the benefits
Cash flow is the net amount of cash or cash equivalents that are transferred into and out of the business. At its most basic, a company’s responsibility and its success are measured by its ability to generate positive cash flow. To break it down even further, success can be measured by the ability to maintain a long-term surplus of cash. Too much surplus without reinvesting it, however, can also viewed negatively as the money is sitting in a bank rather than being used to further the company’s goals
Cash flow is one of the most important and basic objectives of financial reporting. Understanding the cash flow statement which is a report on the operating cash of the business (income, COGS, and expenses), investing (buying plant property and equipment) and financing (debt, equity, and dividends). Net cash is the sum of all cash flow from operations, investing, and cash flow from financing
Positive cash flow indicates that an entity’s assets are increasing which allows them to settle debts (loans, repayments, etc.), buy back shares from its shareholders, pay out dividends, reinvest in itself to provide a platform for growth, pay for its expenses without incurring more debt, and provide a buffer against future financial challenges such as downturns or recessions
Major cash flow pitfalls
There are 4 major reasons that businesses fail due to cash flow than lack of profit
- Business owners often overestimate their income and underestimate their expenses. This happens frequently, and it can be a huge issue when predicting your cash flow.
- Smaller business owners see the amount of money in the bank account and start to draw on those funds for personal wages more than was allocated for their personal payroll which causes cash flow to sharply decline.
- Business owners are forced to suspend or cease operations since they failed to anticipate a cash shortage. This means they did not hold enough cash reserves to be able to pay debts even though they have active customers.
- Customers not paying their invoices on time.
There is a large difference between cash flow and net profit. Let’s look at those.
Cost of goods sold – expenses = net profit (or net income)
Income depending on the accounting method can be recognized the moment the sale is recorded. The same can be said for expenses. They are recorded at the time of the purchase rather than at the time of the payment.
Cash flow is the difference between the net incoming funds vs what is going out. Income/expenses are not counted until the money hits the bank or leaves it. Cash flow also includes investor contributions or loans from debtors.
Why is cash flow better than profit?
Profit and cash flow truly go hand in hand. However, focusing on cash flow as we have stated before shows the liquidity of the business as well as ensures that your bills, employees, and you get paid. There are other reasons to focus on your cash flow over profits. Focusing on profit identifies sales related issues such as actually getting new clients or repeat business. Cash flow, however, can identify operational related issues such as increased COGS or expenses. ‘Growth is planned for.
Of course the goal of the business is to make profit, but keeping an eye on your cash flow enables the business to increase repayments to pay off debt faster or take on that new employee that you know you need but you don’t know whether or not you can afford it. Debts become more expensive if you don’t pay them on time—over drafts, late fees, or extra interest that you didn’t need to pay (credit cards I am looking at you). With a steady cash flow, it allows the business owner to plan better for debt repayments, decreases stress, and allows the owner to make decisions on how much debt to take on.
Risks of not maximizing cash flow
Even profitable companies that fail to maintain their cash flow correctly and do not generate enough cash to stay liquid run the risk of failure. This can happen if cash is tied up in assets such as inventory or accounts receivables. It can also happen if the business owner takes an owner draw from the business or excessive withdrawals for personal expenses. Investors and creditors generally want to know if the company has enough liquidity (cash, cash equivalents, and current assets) to settle current liabilities (any liability that is paid within a 12-month time period). It is good for investors and creditors to see the company meet short term liabilities with the cash it generates from operations.
Liquidity isn’t a fail-safe, however. A company might have a lot of cash because it is liquidating long term assets to keep itself afloat or taking on unsustainable levels of debt which would over state liquidity.
To check a company’s cash liquidity, the following ratios need to be computed.
- Quick Test Ratio = Total Current Assets – Inventory – Prepaid Expenses/ Currently Liabilities
- Current Ratio = Current Assets / Current Liabilities
There are many ways to maximize cash flow.
Basic cash flow forecast
This is beneficial to break out weekly and have both the inflows and outflows dated so that you can ensure you know exactly where every bit of cash is going at any given time.
Start with actual money you have on hand. Your bank balance and potentially petty cash.
Next, determine what your inflow is—customer payments, money not in accounts receivables, actual payments, investment earnings, interest, and any bad debts that you have sold off any inflows.
Then look at your outflows of cash—cost of goods sold, bills you are going to pay, payroll, taxes, utilities, and really anything with money going out of the company. Consider any unexpected outflows you may have. If you aren’t sure, take historical data from the year before.
See below for a basic idea on how to build a forecast. Build yours over a 12-month period or speak with your accountant or us about building one for you. As a rule of thumb, be conservative with your inflowing money—estimate lower and longer. Estimate that your outflow will be expected to be paid sooner and at a higher cost. It is better to have additional cash flow rather than be scrambling for cash to pay a bill last minute. If you do have any months that are in the negative, you have a potential problem; however, due to this forecast, you will know well in advance so you can put money away to ensure that there is sufficient cash to pay your obligations.
Cash on hand + inflows - outflows - average unexpected costs = Total remaining cash
Track your Actual cash flow vs against your forecast
Every month go back into your spreadsheet and put beside your forecasted cash flow what went in and out. Comparing the two will give you an idea moving forward where you are going wrong vs where you are going right. That way you can improve as time progresses.