What is cash flow in a business?
Cash flow refers to money moving into a business (like from sales revenue) and out of it (for critical expenses like rent, salaries, and business insurance). While it's important to focus on profit, cash flow can be a more real-time indicator of how a business is performing.
This article goes into detail about company finances to answer the question, “What is cash flow in a business.” Read on to learn more about this critical aspect of business operations.
Why cash flow is a critical indicator of financial health
As noted above, cash flow can be an important measure of a company’s financial well-being. Consider this example. You sell a large order on credit, with the revenue you record from the sale contributing to your profit figure. However, based on the purchase terms, you might not receive payment for the order for 30, 60, or even 90 days.
In the meantime, you’ve got expenses to pay, including your utility bills, employee salaries, inventory purchases, etc. Theoretically, those bills could come due two or three times before you get paid for the large order. In fact, you could find yourself scrambling to pay them near the end of the 90 days you’ve given the customer to remit payment.
So, while you have to make a profit to stay in business, it’s also essential to keep your business cash flow smooth and steady.
The benefits of reliable small business cash flow
Business cash flow has three main categories. Operations are day-to-day activities like bringing in sales revenue and paying staff and suppliers. Investing activities include things like buying equipment or purchasing property. Financing activities are what you do to fund the business, including taking on debt as needed.
Owners who understand those categories and are skilled in (and focused on) small business cash flow management have companies that enjoy many benefits, including that they can:
Cover their operational expenses
Paying suppliers, employees, rent, utilities, and other day-to-day costs requires a consistent flow of cash.
Invest in growth
Positive cash flow in business allows for activities like expanding operations, purchasing new equipment, hiring additional staff, and launching marketing campaigns.
Manage their debt
Paying down loans, credit lines, and other debts requires a steady stream of cash.
Handle unexpected expenses
Everything from urgent property repairs to unforeseen market changes can strain a company’s finances. Having a healthy cash reserve helps a business overcome these challenges.
Foster confidence in investors and lenders
Demonstrating strong cash flow is crucial for getting funding from investors or obtaining loans from banks. Like you’d expect, lenders and other stakeholders want to see that a business can generate enough cash to pay its debts.
Avoid insolvency
Ultimately, a lack of cash flow can lead to insolvency, where a business can’t pay what it owes its creditors. That’s true even if the company is profitable on paper. Having occasional business cash flow problems might not be a serious issue. But consistent negative cash flow means the business is spending more than it's bringing in, which can put its future at risk.
Tips for maintaining a healthy small business cash flow
A strong, consistent business cash flow doesn’t just happen. It requires careful planning and ongoing management. Here are some small business cash flow management best practices:
- Review cash flow regularly. Creating a cash flow forecast can help your business anticipate potential cash shortages or surpluses. This involves estimating cash inflows and outflows over a specific period, typically monthly or quarterly. Many owners find that when they start forecasting cash flow regularly, the accuracy of their projections increases significantly.
- Actively manage invoicing and collections. Bill customers promptly and implement effective collection procedures to help ensure timely cash inflows. You might consider offering early payment discounts to incentivize customers to pay faster. Using automated invoicing and payment systems can also streamline the process.
- Control business expenses. Carefully monitor and control your expenditures. Look for areas where you can reduce costs without compromising quality or efficiency. Negotiate better terms with suppliers when you can, explore alternative providers, and implement cost-saving measures.
- Review and enhance your inventory management practices. Maintaining too much inventory ties up cash and increases storage costs. Experiment with inventory management techniques, such as just-in-time inventory, to minimize inventory levels while ensuring you can always meet demand.
- Have an emergency-only line of credit. A line of credit you maintain only for emergencies can provide a safety net for unexpected expenses or temporary cash flow shortfalls. This credit line can help bridge the gap between cash inflows and outflows.
- Monitor key cash flow metrics. Track key cash flow metrics, such as days sales outstanding (DSO), days payable outstanding (DPO), and inventory turnover. Monitoring these figures can help you identify potential problems and areas for improvement.
- Maintain a cash reserve. As much as possible, build and maintain a cash reserve to provide a cushion for unexpected expenses or downturns in the business cycle. This reserve can be crucial for supporting business continuity.
- Get help from a professional. Owners of small businesses sometimes struggle to find time for cash flow management. If you’re in that situation, consider talking with an accountant or financial advisor who can help you develop a comprehensive but uncomplicated cash flow management strategy tailored to the specific needs of your business.
- Adapt your cash flow management practices. Today’s business landscape is continually shifting. Review your strategies and modify them as needed to ensure they continue to meet your requirements.
- Maintain adequate insurance coverage. Insurance is great for protecting cash flow, as having the right policies shields your business from large negative financial events. It’s a consistent monthly expense that addresses the potential of unexpected lawsuits or property damage, and the most you pay out of pocket is your deductible.
Keep the cash flowing.
A healthy cash flow is vital to every company, but especially for small businesses. By consistently forecasting cash flow, managing expenses, optimizing inventory, and implementing the other tips outlined above, you can ensure your business has healthy finances and position it to thrive and grow.
It’s been said that profit is important, but cash flow is king. Focusing on both will help ensure a sustainable and successful business.