What is cash flow and why is it important to know about before starting your own business?
Cash flow is the net amount of cash or cash equivalent moving in and out of your business. Another way to look at it is as the amount of money you make minus the amount of money you spend. So, why is this important for a small business, isn’t cash flow just for large corporations? I’m projecting to be profitable so does this matter?
Monitoring cash flow is critical for all business of all sizes to learn because it determines if you will be able to pay your bills and build a reserve, or not. Many people confuse the term cash flow with the term profitability. Profitability is the difference between the cost of your product and service and what you sell it for. You can sell all the products you have and make a profit and still go out of business because you have a negative cash flow. How can that be?
Here is an example. If you sell all your product at a price of $1,000 and you purchased all the materials at $300 you would be making a $700 profit. This simple calculation shows that your company is projected to be profitable. However, if you purchased the product on January 1st with a credit due in 60 days, you would owe the amount of the materials on March 1st. If you sell your product on a credit on February 16th, with a credit due in 30 days, you will not have the money from the sale in time to make the payment on the materials. This means you have a negative cash flow, you have to spend money before you make it. A negative cash flow may mean you have to liquidate some of your assets to make your payment, or it could lead to bankruptcy or the liquidation of your entire business.*
Cash flow works the same in business as it does in personal finances. Cash flow is the same as making sure your bills are due after you paycheck comes in. For example, if you start a new job and rent a new apartment in anticipation of your new salary, you might run into cash flow issues. Say you begin working at the company and discover that at your new salary you get paid once a month on the 10th. However, because you didn’t know this you have to scramble for your first month’s rent due on the 1st. If you had used all your savings for the deposit, then you could be late on your first payment. This can cause you to have to pay late fees or possibly sell off some of the things you own to cover the difference. Say your pay gets delayed another month for a clerical error, this issue can continue to snowball. The same goes for running a business. Even though you make enough to afford the apartment, until you get your paycheck you can be a bind.*
A positive cash flow on the other hand, shows that your liquid assets are increasing over time. This means that you are saving more money in a reserve to use if needed in the future. This can allow you to make large growth spurts, or allow you purchase new equipment to expand or replace something that broke.
You can manage and monitor cash flow by ensuring that you have enough, or more, cash on hand when you need it to pay debts. As a larger company you might have past reserves to lean on if you need to have a negative cash flow in the short term to drive long term revenue. However, for smaller companies with less reserve you need to know how much you expect to receive in revenue each month, how much you will owe for debts, and that they overlap properly. Some small businesses use a commercial line of credit, or loan from a bank, to manage fluctuations in accounts payable (debts) vs accounts receivable (revenue not paid). This is very common in seasonal companies like landscaping companies or pool companies where the majority of their revenue is gained in the summer, but they need to purchase materials in the spring in anticipation of the work to come.
It is important to not only know what your cash flow looks like, but to keep a record of that information. This can be very important if you decide to apply for a commercial loan in the future. Many banks use cash flow in the qualifying process to ensure that your business can make enough profits to cover the repayments for the money borrowed. Cash flow can be recorded in month-to-month measurements or quarterly measurements, depending on what your business needs.
Having all your documentation together on your cash flow and other financial information can help you when making business decisions and for many other financial needs. It can allow you to know if you can do the expansion you were thinking of, either with your own cash flow or through a loan. It can allow you to see that your business is struggling, and you need to reduce your credit terms or ask for longer debt terms. By monitoring the health of your company often, it not only helps you grow but also helps you maintain your business and stay away from debt.
Best of luck with your new business!
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* These numbers are used for illustrative purposes only.