What is cash flow for small businesses?
At the end of the day, no matter how passionate you are about your business or how much of a change you hope to make in the world through your products and services, running a small business is largely about making money. After all, people don’t work for free, right? While you don’t have to be a financial expert to maximize your company’s profitability, it’s important to have a handle on the amount of money you’re bringing in.
All small businesses, whether they’re still in their start-up stage or they’re ready to expand their business operations, should have a clear understanding of cash flow. More than just your bank account balance, cash flow analysis can help you paint a picture of just how profitable your business is. You’ll also better understand what you can and can’t afford, like hiring new employees and offering higher, competitive wages.
Grab a cup of coffee, because there is a bit of technical jargon ahead, but in no time, you’ll have an expanded understanding of how to track the money you make.
What is cash flow?
In the most basic terms, cash flow is the amount of cash that comes into your business and the amount of cash that flows out of your business.
If you make more money than you’re spending, you have a positive cash flow. Conversely, if your cash outflows are larger than what you see on your income statement, you may have a problem. Business owners can create a series of financial statements to track their cash flow or hire a professional to monitor their company’s financial performance.
Calculating your cash flow isn’t as simple as subtracting your expenses from your sales, as there can be a range of aspects to consider. In some situations, you may have to factor in depreciation, investing activities, and future cash flows to see where you stand. Some small business owners determine if they have enough cash by calculating their net cash flow. This number is the total of your investing activities, financing activities, and operating activities.
In short, it shows you the difference between your cash inflows and cash outflows. If you need to track your company’s finances more carefully, there are additional options to consider.
Operating cash flow is perhaps the most fundamental way to track your company’s business activities.
First, you’ll need to calculate your net income. You can do this by adding up your sales and subtracting your expenses, like the cost of goods sold, interest, amortization, and operating expenses. Remember, your net income is not how much cash you have in hand at the end of the month.
Once you’ve calculated your net income, you’ll add back in applicable items like depreciation, deferred income tax, or unrealized gains or losses, as well as changes in your working capital.
Why are these distinctions so important? A company can have a positive operating cash flow but still lose money if they’ve taken a loss for depreciation during a certain period. Even if that’s the case, business owners shouldn’t get too discouraged as there are several other types of cash flow reports to consider, some of which can help prove to potential lenders that you’re on the path to real profitability.
For some, operating cash flow is used to explore a business’s more short-term financial activities, while free cash flow can speak to performance over a longer period of time.
Considered a better set of metrics than net income alone, free cash flow is calculated by determining your operating cash flow and subtracting your capital expenditures like computer or office equipment, light fixtures, or even building a factory on a recently acquired piece of real estate. Since free cash flow is an indicator of how much cash a small business has, it’s an ideal way for investors and shareholders to see how stable a company truly is.
In keeping with the theme of investments, some businesses find they also need to determine their discounted cash flow. This type of calculation considers the value of an investment during a given period based on what its future cash flow could look like. A somewhat complicated formula to use, business owners and investors alike can figure out if an expansion, new equipment, or any other type of opportunity is worth it based on the company’s average rate of return.
If your start-up is just forming, it’s normal to feel like these terms are more complex than you can utilize right now. Remember, though, that as your business grows, you’ll want to have a statement of cash flows, also referred to as a cash flow statement, to help you keep track of your financial obligations and ensure that you are, in fact, profitable.
How do I manage cash flow?
Too often, business owners are tempted to look at the actual cash in their bank account and feel as if they have a positive cash flow. As we’ve now learned, that’s certainly not always the case. How can you manage your cash flow effectively without cutting back on your expenses and losing sleep over your future cash flows? Here are a few ideas that can help businesses of all sizes:
- Learn the ins and outs of your company’s cash flow. If you aren’t sure where your money is going or how much you have coming in, it will be that much harder to manage your cash flow effectively. It’s smart to update your financial statements regularly and make small changes along the way. Some companies prefer to change when they pay their suppliers to promote a more positive cash flow situation.
- Ask for—and enforce—on-time payments from your customers. It’s estimated that customers pay roughly two weeks past a given due date, so don’t be afraid to be more proactive when it comes to following up on your outstanding invoices. Consider setting up automatic email reminders that go out several times as the due date nears and make phone calls when needed. While it’s hard to let go of a customer, especially if you’re struggling to turn a profit, one that doesn’t pay you doesn’t help your bottom line at the end of the day.
- Remember that inventory equals cash. Small businesses that sell goods know firsthand that every product sitting on your shelf is just your own money staring you in the face. If you make two large inventory purchases each year, your funds are almost being held hostage until you sell all of your items. Unless business is booming and you can’t keep things on the shelf often enough, consider making smaller and more frequent inventory orders to maintain more liquidity in the business.
- Try to negotiate with customers and vendors alike. It’s not advised that you pay your bills late by any means, but if you purchase raw materials and it takes some time before you can sell your goods for a profit, see if your vendor is willing to accept payment a week or two after your purchase. Likewise, customers who make large purchases from you may want several months to pay their invoices. Your level of flexibility is up to you, but you can ask them to pay sooner so that it helps you to maintain a positive cash flow.
- Consider utilizing accounts receivable financing. Start-ups experiencing a significant negative cash flow may want to explore this option if they have a large number of outstanding invoices. There are a range of accounts receivable financing companies that will purchase your invoices at a rate that’s lower than face value, giving you the cash you need to continue operations. This option can be tough to recover from, as interest rates of these loans may reach up to 64%.
- Shop for a cash-flow loan. What if you need a cash flow boost, but you don’t have outstanding invoices to leverage? Companies can apply for a cash-flow loan as a short-term option to increase their bottom line. These loans often include high interest rates and shouldn’t be used for regular expenses like rent or payroll. Instead, it’s advised that cash-flow loans are used for one-time expenses that will ultimately help to increase your profitability, like purchasing a new piece of equipment.
It can’t be reiterated enough how important it is to manage your cash flow from the very start of your organization. While there are infinite circumstances that could negatively affect your business that are out of your control, no business owner should have to shut their doors due to their inability to manage their profitability on paper. Should you find yourself in a situation where you’re experiencing a negative cash flow month after month, and you cannot rectify it, you may want to consider consulting with financial professionals for additional help.
How do I get a cash flow statement?
Most types of accounting software can generate all of the financial statements you’d need, including a cash flow statement and a balance sheet—the document that lists your company’s assets and liabilities. Together with an income statement, you’ll have the three financial documents that any investor would need to review to determine your company’s liquidity and future potential. Some small business owners prefer to hire an accountant to handle this part of their business, while others take a more hands-on approach.
Remember, even businesses that operate with literal cash only, like a cleaning business or a tattoo shop, need to keep track of their cash flow. The IRS is often more inclined to audit these types of companies, and you’ll want to have all of your documentation in line ahead of time. Even if the idea of an audit doesn’t worry you, all types of businesses should implement a cash flow statement during the formation of their company as it can help you to see your success in black and white.
As you’re tracking all of your income and expenses, don’t forget to account for your small business insurance cost. If you need a new policy and aren’t sure what to look for, Huckleberry can help. Start-ups can receive a free quote online in minutes, and before you know it, you’ll know exactly how much your insurance will cost so that you can document it on your cash flow statement.