What Is Cash Flow?

Cash is the lifeline of every business and if you run out of it then your business can fail. Regardless of how many sales your business makes, if you do not have enough cash you will not be able to pay your bills and keep the business open.

This is why it is important that you understand the basics of cash flow and cash flow forecasting. Read on to learn more about cash flow.

Definition of Cash Flow

Cash flow measures how much money is moving into and out of your business during a specific time. Cash flowing into a business includes making money through sales, return on investments, and from loans and investments. Cash flowing out is what your business spends on expenses, supplies, services, bills, and more.

Cash flow is measured by how money flows into a business and how much flows out during a certain period of time over the course of a month or a quarter.

To calculate your cash flow, use the following formula:

  • Cash received – cash spent = net cash flow

If the number you calculate is positive, your business cash flow is positive and accumulating cash back in the bank. If the number you calculate is negative, your business cash flow is negative, and you are finishing the month with less cash than you started with.

The Difference Between Cash Flow and Profit

It is possible for your business to be profitable but still run out of cash because cash flow and profit are different. Profits include sales that you have made but have not been paid for yet. Cash is the amount of money you actually have in your bank account. If you cannot use it right now to pay your bills, it is not cash.

For example, you can make a lot of sales but if you invoice your customers and they pay you within 30 days of receiving the invoice, you can have a lot of revenue on paper but not a lot of cash in your bank account because your customers have not paid you yet. These sales will show up on your income statement.

If the money your customers owe you is not in your bank account, it will not appear on your cash flow statement until it does. It is still in the hands of your customer even though they have an invoice for it. You keep track of the money your customers ow you in accounts receivable.

You can only pay your bills with real cash in your bank account that is why keeping track of your cash flow is important. You need to have a sense of what is coming in and going out of your business and do what you can to be cash flow positive.

How to Forecast Your Cash Flow

A cash flow forecast is all about predicting your money needs in advance. Your cash flow statement takes inputs from your revenue projections, your expense projections, and your inventory purchase plans if your business keeps inventory at hand.

To build a cash flow statement can be built using two methods: the direct method and indirect method. They both will arrive at the same end-result and predict how much cash you will have in the future.

The direct method of forecasting cash flow provides a clear view of how cash moves in and out of a business. You add up the cash your business has received and then subtract the cash paid out to vendors, suppliers, employees, etc.

The indirect method starts with your net income from your Profit and Loss Statement and then makes adjustments to that number to account for non-cash expenses such as depreciation. From there you make adjustments to account for changes in inventory, accounts receivable, and accounts payable.

The indirect method is common for building cash flow statements and is a popular method for forecasting cash flow, even though the direct method is easier for people who are not as familiar with accounting.

If you are forecasting your cash flow using spreadsheets, the direct method is recommended because it is easier and more straightforward. You want to create future estimates of when you will receive money from customers and when you will pay your bills.

It is not critical to forecast every invoice and bill payment but forecasting will help you make strategic decisions about your business so making broad estimates in your forecast is okay.

How to Improve Your Cash Flow

When you calculate your cash flow and you find that it is negative, there are plenty of options you can improve your cash flow. The following are some examples:

  • Convince your customers to pay you faster
  • Pay your own bills a bit slower
  • Purchase less inventory and have less inventory on hand
  • Follow up on bad debts
  • Establish a line of credit or another business loan

The Bottom Line

Cash is the most important resource in any business, but it is frequently misunderstood. By understanding what type of cash flow that you have, you can make improvements in your business to be more successful. If your cash flow is poor, remember to follow the above steps to improve your cash flow.