Cash Flow: What It Is & How To Best Manage It

Cash flow is one of the most critical metrics for small businesses. Why? It directly impacts your business growth, profitability, and ultimately cash left in your business bank accounts. However, it can be challenging to know where to start when trying to save money on your company’s expenses. In this article, we’ll explain cash flow and how you can manage yours more efficiently. 

What is Cash Flow?

Cash flow is the amount of cash coming into a business in a given period, minus the amount of cash going out. It’s the money that keeps the doors open, pays the staff, and buys the raw materials. Without cash flow, you will be quickly forced to shut down.

Cash flow can be calculated on an individual basis (for example, your personal cash flow), or it can be done at a company level to determine whether a business is making a profit or not.

For example, if you’re an entrepreneur with several sources of income, such as an investment property, rental properties, and your own business, then you have multiple streams of cash flowing in and out of your life. You might also have some expenses that are recurring and some that aren’t.

It’s important to understand how each of these factors affects the overall picture of your cash flow situation, so you know when it’s time to make changes or take action.

Why Does Cash Flow Matter?

Understanding your cash flow is essential because it tells you how much money is coming in and going out of your business. It helps you see if you’re making enough money to cover your expenses and stay profitable. If you have good cash flow, then you know that there’s enough cash coming in to cover all your expenses and leave some left over for growth.

If you don’t have good cash flow, then there may not be enough coming in to cover all your expenses each month. This means that it will be hard for you to make payroll or pay vendors on time. In addition, if nothing is left over for growth after paying all the bills, then there won’t be any extra money available for new projects or hiring new employees—so your company could become stagnant over time and lose momentum. 

Cash flow is one of the most important concepts in business because it affects everything from your ability to pay employees to whether or not you can buy more inventory. The more cash you have flowing into your business, the better off you are.

Types of Cash Flow

Cash flow can be divided into three broad categories: operating cash flow, investing cash flow, and financing cash flow.

Operating Cash Flow

This is the amount of cash generated by a business’s everyday operations. It includes things like sales revenue minus the cost of goods sold (COGS), as well as other expenses such as wages paid to employees and rent paid for commercial space. 

Operating cash flow represents the largest component of total cash flow for most businesses, but it’s also the least predictable component because it depends on factors outside of management’s control, such as market conditions and consumer spending habits. Operating cash flow also fluctuates from year to year due to changes in COGS and other factors mentioned above.

Cash From Investing Activities

Investing cash flow is the money you get from selling investments. This includes the sale of stocks, bonds, mutual funds, and other securities. It also includes the sale of real estate (when you sell your primary residence) and any other non-business assets that produce income.

The amount of investment income you receive depends on what you sell and when you sell it. For example, if you sell stock that has gone up in value since you bought it, you will have a capital gain on which tax must be paid. If you hold stocks longer than 12 months before selling them, they are taxed at lower rates than stocks held for only one year or less.

Financing Cash Flow

Financing cash flow is the money that a business receives as a result of financing. This type of cash flow can come from debt, equity, or both. It can be used for investing activities in the business or paying off existing debt.

Interest payments are an example of financing cash flow. If a business borrows money to fund its operations, it must pay back those debts to its creditors with interest payments. Interest payments are considered part of financing cash flow because they are a form of debt repayment.

The Cash Flow Statement

The cash flow statement is one of the three primary financial statements (the other two are the balance sheet and the income statement) that provide an overview of a company’s financial health. It shows where the money came in and went out during a specific period, usually one year.

Cash flow statements are particularly useful for investors because they are not just concerned with current assets and liabilities, but also with long-term projects’ ability to generate positive cash flows over time.

The components of a cash flow statement include three major sections: operating cash flows, investing cash flows, and financing cash flows. Each section includes several smaller subcategories that break down exactly where the money went during a given period.

Limitations of the Cash Flow Statement

The cash flow statement does not include all factors that affect the profitability of a business. For example, it does not include changes in inventory levels or accrual-based revenue accounts such as receivables and payables. This means that accounts payable and receivable may rise or fall without any corresponding change in cash because they are accounted for as liabilities on the balance sheet rather than as assets that consume cash. 

The same is true for inventory items, which can increase significantly without impacting cash flows if they are financed through credit sales rather than cash receipts.

What is Profit?

Profit is the difference between total revenue and total costs. It’s calculated by taking the total revenue from a business and subtracting all the expenses associated with running that business.

The idea behind profit is that it represents how much money was left over after all the expenses had been paid. The profit can be used to pay back investors or owners with your cash balance, increase salaries for employees and improve working conditions, or pay dividends to stockholders.

Types of Profit

A business’ profit can be expressed in different ways depending on the type and size of the business. For example:

  • Gross profit: Gross profit is the amount of money left over after subtracting the cost of goods sold from sales revenue. This figure gives an indication of how much each item sold contributes toward covering overhead costs such as rent and payroll.
  • Operating profit: Operating profit is the gross profit minus operating expenses such as salaries, utilities, and supplies for the business. This type of profit shows how much money a company makes after paying its day-to-day bills, but before paying taxes or interest on debt payments. It can also be referred to as “earnings before interest and taxes.”
  • Net profit: Net income is calculated by subtracting your total operating expenses from your total sales revenue for a given period of time (usually quarterly or annually).

The Income Statement

The income statement is a financial statement that shows the revenue and expenses for a particular period of time. The income statement is one of the three primary financial statements—along with the balance sheet and cash flow statement—that business owners use to measure their companies’ performance.

The income statement is also called the profit and loss (P&L) statement or the income/loss statement (ILO). It’s often referred to as simply “the P&L” or “the profit.”

The term “income” is often used loosely in everyday language to refer to any form of money received, including salary, wages, and tips, as well as interest and dividends. But in accounting terms, only the first two types of income are counted on an income statement. Interest and dividend payments are considered investments rather than business revenues, so they are not included on an income statement unless they are specifically listed as “non-operating items” on a company’s financial statements.

Cash Flow VS Profit

Cash flow and profit are two important elements of a company’s financial performance. While both are needed to measure the success of a business, they are not the same. Cash flow is the money that comes in and out of your business. Profit is the amount of money that remains after you deduct all expenses and costs from the revenue your company earns.

Profit is what’s left over when you subtract all the expenses from the revenue your company generates. For example, if you sell $5,000 worth of goods and services, but have to pay $3,000 in expenses, then your profit would be $2,000.

Cash flow is the actual money coming into your business on a day-to-day basis. Cash flow includes money from sales receipts, refunds, or returns, payments from customers on accounts receivable (money owed to you by customers), proceeds from investments and more.

Profit does not include these items because they may not be actual cash inflow into your business—they are only recorded as income if they are paid in cash rather than on credit terms.

How to Analyze Cash Flow

Cash flow is the movement of money into and out of a business. It’s also the key to evaluating a company’s financial health. This evaluation can be either positive or negative, but it’s always reported in the same direction as earnings. A positive number means that a company made more money than it spent, while a negative number means that it spent more than it earned.

Knowing your exact cash flow is important because it tells investors how well a company can cover its short-term expenses—namely, its debt payments and other expenses that come due within one year. Cash flow is also an indication of a company’s profitability over time because it shows whether the business is generating enough funds to pay its bills.

Cash flow analysis is a way of looking at a company’s cash position over time. It can be used to figure out how much cash a business has on hand and how much money it will likely have in the future. There are three main types of cash flow analysis:

Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio (DSCR) is a measure of how much cash flow a company generates to pay off its debt. The ratio is calculated by dividing the amount of cash flow generated by an organization by the total amount of debt due.

Because the DSCR measures the amount of cash flow available to pay off debt, it can be used to determine whether a company has enough cash flow to make its payments each month. This ratio helps investors and lenders determine whether a company can continue to make payments on their loans or whether they need additional funding to support those payments.

Free Cash Flow (FCF)

Free cash flow (FCF) is a measure of how much cash a company generates from its operations. It’s a financial term that refers to the amount of money that a company has left over after accounting for all its expenses, including taxes and capital expenditures.

This information is useful because it provides a more accurate picture of the company’s financial health than income from operations. Cash flow can be used to calculate how much money is available to be paid out in dividends or reinvested in the business.

One of the biggest benefits of free cash flow analysis is that it allows you to compare companies with different capital structures. For example, if one company has a lot of debt on its balance sheet, while another doesn’t have any debt at all, then both companies’ incomes will look very different, but their free cash flows might be very similar.

FCF can be calculated by subtracting a company’s total operating expense from its total net income. The resulting number is divided by the number of shares outstanding to arrive at free cash flow per share.

Another way to calculate free cash flow is to subtract the sum of capital expenditures and net income from total assets. This calculation yields an approximation of free cash flow per share, but it’s less precise than the other method because it doesn’t account for all sources of revenue or all types of expenses.

Unlevered Free Cash Flow (UFCF)

Unlevered free cash flow (UFCF) is a measure of cash flow that is not impacted by leverage. It basically tells you how much cash you are generating after paying down debt. It’s important to use this metric when evaluating a company because it gives you a more accurate picture of how well the company is doing.

To calculate UFCF, add together EBITDA (earnings before interest, taxes, depreciation, and amortization) and then subtract out any capital expenditures (CAPEX). Capital expenditures are money spent on things like buying new equipment or buildings.

How Cash Flow is Calculated

Cash flow is the lifeblood of a business, and it’s critical to understand how it’s calculated. There are two ways to calculate cash flow: direct and indirect.

Direct Cash Flow Method

Direct cash flow is a method of calculating cash flow by deducting expenses from revenues. This method is used to determine whether or not a business has enough money to pay off its debts and continue operations.

You can calculate direct cash flow by taking all the business’s expenses, subtracting them from all of its revenues, and then dividing the remainder by 12. The result is a figure that indicates how much money your company has available at any given time during an accounting period (typically one year).

The direct cash flow method does not include other types of income or expenses, such as interest earned on savings accounts or paid on debt. These are considered indirect cash flows because they do not directly affect how much money is available for operations; instead, they help determine how long it will take for a company to pay off its debt or retire its savings account.

Indirect Cash Flow Method

The indirect cash flow method is a calculation of the future cash flow that will result from an investment. It does not include specific details about how the business will generate this cash, but instead focuses on how much it will receive from customers and how much it will spend on materials.

The indirect method is used when the company has not yet been able to identify an opportunity that can be monetized, but they believe there is one out there. The investor is essentially buying into their vision, rather than making an immediate return on their investment.

For example, if you were considering investing in a coffee shop and you knew that coffee shops make a large amount of money off iced drinks during the summer months and less during the winter months, then you would use this method to calculate your potential return.

When calculating indirect cash flow, you have to make several assumptions about your business: what its revenues will be, how much it spends on expenses, and how much money will be needed to invest in capital improvements or other assets. You can also use the indirect cash flow method to determine if your company will be able to pay off debt in the future.

How to Manage Cash Flow

Managing cash flow is an important part of running a business. It’s what allows you to keep your company’s operations running smoothly, make sure you have enough money to pay your employees, keep the lights on, and pay for the things that keep your business running like office supplies and equipment. 

When you’re managing your cash flow, it can be difficult to know where to start. Your business is unique and so is the way you manage your finances. But there are some basic principles that apply across the board, and these will help you get started with your own cash-flow management process.

Make Monitoring Easy

The first step in managing your cash flow effectively is monitoring it closely. Here are some tips on how to do so:

Create a budget that includes all income and expenses. If possible, break down expenses into categories such as salaries and wages, rent/mortgage payments, and utilities. This way, you’ll know exactly how much money is coming in and going out each month.

Keep track of your income and expenses in real-time. You can do this by setting up an automatic transfer from your bank account directly into a separate account that you’ll use specifically for tracking your business’s cash flow. That way, you won’t have to worry about forgetting or missing payments—it will all be taken care of automatically.

Make sure your accounting system is set up to help you easily track expenses and income by date, vendor, and type of transaction (such as credit card). This will make it much easier to see what areas need improvement or adjustment as needed.

If you’re just starting out, there are plenty of free options out there that can help you get the hang of managing finances before investing in something more advanced.

If you have a small business owner’s kit through your bank, they may offer a basic tracking tool that can help keep things organized without taking up too much time or energy on your part. You can also find individual software packages designed specifically for small businesses online. 

Reduce Costs

An important step to managing cash flow is to reduce costs wherever possible. This can include reducing payroll, outsourcing services (such as customer service), and cutting unnecessary expenses like office supplies or travel costs. 

It’s important not to cut too deeply here—you don’t want to put yourself in the red! But if you can trim just a few percent off your monthly expenses without impacting service levels significantly, those savings will add up quickly over time.

Cash in on Assets

When it comes to managing cash flow, make sure that you are using all your assets for their intended purpose. For example, if you own a manufacturing plant, make sure that you are producing products when there’s enough demand for them — rather than stockpiling inventory or waiting for customers to come along before making more items available for sale. This can help ensure that you don’t end up with excess inventory on hand, which costs money and ties up capital that could be better spent elsewhere within your business. 

Get a Business Line of Credit

When you are a new business, getting a line of credit can be especially helpful. A line of credit means that a bank will extend an amount of money to you upfront so that if there are times when there isn’t enough cash in the bank to cover expenses, you can borrow against this line of credit until more revenue comes in. This gives businesses some insurance against fluctuations in cash flow, so they don’t have to panic if they have an unexpected expense one month or a slow period at the end of their fiscal year.

If you get a line of credit from a financial institution, it’s important to remember that their policies can change over time—so be sure to read their terms carefully before signing anything.

Lease Equipment

Leasing equipment is a great way to manage cash flow. When you lease, you pay a set amount each month for the use of the equipment. This fee includes all maintenance, insurance, and repairs on the equipment. You can also buy out the equipment at any time and own it outright.

Leasing allows you to pay less upfront than buying new equipment outright would. This can be especially beneficial if your business is just starting out and you don’t have enough money saved up yet to purchase all the equipment that it needs.

Another benefit of leasing equipment is that if you sell your business or close its doors permanently, you can return the equipment to the original leasing company and receive an agreed-upon amount for its return.

Cash flow management isn’t just about making sure there is enough money in the bank account at any point in time. It also means making sure you have enough cash coming in during slower periods so that when things pick up again, you are ready to take advantage of the opportunity.

Cash flow is one of the most important aspects of a business. When you’re starting out, it’s not always easy to manage it, but it’s definitely worth the effort.

Key Takeaways

Cash flow management can be confusing when you are just starting out—but it doesn’t have to be. Start small and stay organized to make the process easier. Adequate cash flow management is the surefire way for a small business to succeed in these competitive times.

For more helpful advice, check out these helpful articles.

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