Cash flow has a simple definition: it is the flow of cash and cash equivalents in and out of a business. Though the definition is straightforward, cash flow is a powerful metric that business owners can use to assess the health of their business and enhance future successes.
More About Cash Flow
Although not perfectly analogous, you can think of cash flow as money going into and out of a checking account. Cash comes in when you get paid, and cash goes out when you make payments. If your bank account holds a balance, you have more cash coming in than going out. If your account is overdrawn, you have more cash going out than coming in.
Cash flow for businesses reports movement of both cash and cash equivalents. Cash equivalents are highly liquid assets like money market accounts, treasury bills, and marketable securities. In a pinch, these assets can be converted into cash and used to meet business obligations, so they are included in the cash flow metric.
To analyze cash flow, businesses should take stock of all changes to their cash balances over a certain time period. Some activities that can affect cash flow are:
- Receiving customer payments
- Purchasing office supplies
- Making debt payments
- Compensating vendors
- Depositing refunds
- Receiving (or paying) dividends
- Paying taxes
Cash is often referred to as the lifeblood of a business because without it, your business cannot operate – at least not for very long. You can use your cash flow reports to assess how well you are able to stay on top of your financial obligations. For example, you may be able to float a negative cash balance for a month or two, but holding a negative balance for three or four months may be too difficult to recover from. Run your cash flow reports monthly, quarterly, and annually so you can recognize patterns and promptly address issues that arise.
One important caveat to remember is that cash flows are different than income. While cash flow affects performance, a positive cash flow does not always correlate with income, and positive net income doesn’t always correlate with positive cash flow.
Cash Flow vs. Income
Income and cash flow are similar in that they both report performance metrics over a specified time period, but the income statement is more conceptual. The income statement relies on accounting concepts that deal with both cash and non-cash items, whereas cash flow reports show cash and nothing else. For example, depreciation is a non-cash expense that would show up on the income statement but be left off cash flow reports, and a payment on an accounts receivable balance would not affect the income statement but would increase cash. Both reports are important, and when they are used together, they can help you better understand your business.
How Cash Flow Can Help Business Owners
By keeping an eye on cash flows, you will be able to:
- Assess liquidity. You can see how quickly you’re able to pay your financial obligations.
- Know when you’ll have cash. By comparing your cash flow statement to sales, you can see how quickly your sales convert into usable cash.
- Withstand business ebbs and flows. Having positive cash flow can give you the buffer you need to withstand seasonal downturns or dips in the market.
- Gain the trust of investors. When you have positive cash flows, you’re showing your investors that your organization is stable and can weather the ups and downs of your industry.
- Invest in new property or equipment. Having consistently positive cash reserves allows you to invest in new property or equipment that may be necessary to ensure future profitability.
- Compare your performance to others. You can compare your cash flow reports (or ratios that rely on cash flow) to industry benchmarks to assess your performance.
- Create budgets. With knowledge of your actual cash inflows and outflows, you can create more accurate budgets.
- Predict future cash flows. Looking at your cash flows over time will reveal patterns that can be projected months or years into the future.
- Identify problems. Once you develop expectations about cash inflows and outflows, variances from those expectations may indicate problems requiring increased attention, such as a customer who isn’t able to pay, an unanticipated increasing cost of supplies, or even employee theft.
If you need help setting up your first cash flow report or would like to learn more about how cash flows can be anaylzed to assess the health of your company, contact us today.