Cash Flow: What Is It and Why Does It Matter?

As an entrepreneur, you’ve likely heard statistics about how common it is for businesses to fail. Perhaps most surprisingly, more than 80 percent of small business failures happen because of the same thing: cash flow.

That number alone should convince you cash flow is important for any business. What is it though, and why is it so important? This guide will break down the answers for you.

What Is Cash Flow?

Suppose you have a business with revenue of $1 million a year. That likely sounds pretty good. This business should have no trouble keeping the doors open, right?

Now suppose the business gets all its revenue in one lump sum at the end of the year. That means it has to spend January through November scrimping and saving or taking out loans to get by.

The problem here is the business’s cash flow. Cash flow refers to what liquid funds are coming into the business and what funds are going out at any point in time.

So, although this business makes $1 million in revenue, it has one month of $1 million cash inflow, and $0 in cash inflow for the rest of year.

For that one month, the business’s cash flow will likely be positive. There will be less money going out than there is coming in.

For the rest of the year, the business has negative cash flow. That means there’s more money going out of the business than coming in.

Why Does It Matter?

Cash flow determines your ability to manage your financial obligations. That might be paying rent or remitting taxes or even doing payroll for your employees.

If you have no money coming in, how will you pay these expenses? For the hypothetical $1 million business, it’s likely going to take out a lot of loans throughout the year. It will then pay these back at the end of the year when all the money comes flowing in.

When January rolls around, the business will be right back where it started.

What happens if the business’s revenue falls? Then it may not be able to meet its obligations. At that point, you may have to declare bankruptcy or close up shop.

This example is an extreme one. Most businesses have at least some cash coming in most months. For most business owners, though, the issue is that some months are less lucrative than others.

As noted, if revenue falls below expectations, then the business may not be able to meet its obligations. That can happen on a month to month basis for a business. You may be a little short one month, so you have to take on more debt or you try to defer a payment.

That can end up squeezing you harder later. If you have more inflow, you can get “caught up.” If you have a string of negative cash flow months, though, you might be closing your doors permanently.

Clearly, cash flow is important in keeping things “business as usual” for your company. A business can have high revenue, but poor cash flow can still take it under.

How to Calculate Cash Flow

Now that you know what cash flow is and why it’s so important, you likely want to know what it looks like for your business. You want to know how to learn your cash flow.

There are two methods for calculating cash flow. One is the direct method, and the other is the indirect method. The direct method simply adds up all types of cash payments and receipts.

The indirect method is a little more complex. To use it, you’ll need to start with your net income from an income sheet. Then you’ll need to adjust that line for taxes and other costs.

Which Accounts to Look At

You’ll need to look at accounts receivable, as well as inventory accounts. If the value of your inventory increased on a month-to-month basis, that means you spent more money here.

If accounts receivable decreased, this suggests customers paid their accounts. You should have more money coming in.

Cash from financing should also be considered. This includes cash coming in from investors or banks. Payments of dividends and repayment of loans are also included here.

The purchase or sale of an asset, like equipment, also must be factored in. This is considered an investing activity, because you’re investing in your business. Loans made to vendors or received from customers also fall under this category.

Most of the time, this category is “cash out.” If you happen to sell an asset, though, you may have a positive amount of cash flowing in.

Tips for Better Cash Flow

Your business’s overall revenue is important, but so is when the cash is coming in and when it’s going out. Negative cash flow can interrupt your business. So, how can business owners make sure they’re optimizing cash flow?

One obvious way is to make more sales, but you also want your customers to pay on time. If you invoice them, then you might offer an incentive to pay early.

You might be able to shift certain payments, like when you buy inventory. Another way to help both cash flow and revenue is to lower overheads. You could, for example, take steps to reduce employee turnover.

An example is giving them access to wage information. When employees get instant access to earned wages, they can avoid payday loans and other issues. In turn, they’re more likely to be satisfied with their jobs and less likely to leave.

Hiring and training costs employers a lot, on top of lost productivity and any severance you need to pay the departing employee. Reducing turnover can help you keep costs in check, which in turn can improve cash flow.

Get Better Advice to Manage Your Business

As you can see, cash flow is essential for any business operation. Improving it can help you keep your doors open and keep everyone on your team satisfied.

Looking for more tips about managing your business the right way? Check out our archives for more great advice on everything from finances to marketing and more.