InvoiceSherpa Blog
Posted on October 5, 2020

What is Cash Flow and Why Is It Important to Your Business?

Many small businesses struggle with one very important component daily -cash flow.

What is cash flow and why is it so important? It’s actually pretty straightforward:

Money flows into your business - payments from your customers - and money flows out of your business - payroll, expenses, etc. Cash flow is one of the foundations of your business, so it’s non-negotiable for business owners to understand it inside and out. 

 

In this article, you’ll learn about what exactly cash flow is, the difference between positive and negative cash flow, and many of the reasons why it’s so important.

 

What Exactly Is Cash Flow?

 

One term that you may have heard thrown around in the business world is “cash flow.” What sounds very simple, is actually an essential term that you need to know. 

 

Cash flow is almost exactly what it sounds like: it’s the flow of cash going in and out of your business. In order to be able to function properly, you need to have enough actual cash to pay for business expenses. 

 

Let’s dive into some of the intricacies behind cash flow and why it’s so important for you to understand.

 

Positive Cash Flow vs. Negative Cash Flow

 

If you have more coming in than going out, you have positive cash flow. If you have more going out than coming in, that’s the opposite: negative cash flow. 

 

Obviously, you’d rather have positive cash flow because it’s exactly what it sounds like - money in the bank. If it’s negative, you may be able to sustain that for a while, but eventually, your cash reserves will run out. Then you won’t be able to pay your employees, your landlord, your suppliers, etc. 

 

Negative cash flow is something that business owners should always be on the lookout for. As a temporary or deliberate dip, it’s not a big deal — but if your accounts have negative cash flow for too long, it will cause serious repercussions on your growth rate.

 

Importantly, your decision making will become more disillusioned with the reality you play with as your cash flow situation worsens. If nothing else, ensuring your cash flow is always positive guarantees not only your survival, but also your growth.

 

The Difference Between Cash and Accrual Accounting

 

But why exactly does cash flow matter? Isn’t my Profit and Loss statement a measure of my cash? Not necessarily. To explain that, let’s understand the difference between cash and accrual accounting. If you report on a cash basis, that means you count your income only when you have the money in your hand. So your Profit and Loss report won’t show any income from invoices that are as yet unpaid.

 

If you report on an accrual basis, that means you count your income as soon as you earn it, whether you have been paid or not. In that case, your Profit and Loss report will show money that is not in your bank yet. It’s still in your customer’s bank, so it’s not a part of your cash flow yet. (Technically, it’s still a part of theirs!)

 

Even if you report on a cash basis, however, there is a caveat. Your Profit and Loss reports show only the income and the expenses. Any Balance Sheet activity will not be reflected there. So even if your P&L shows a healthy profit, you might not really have that amount in your bank account.

 

Why Is Cash Flow So Important?

 

Now that we know what cash flow is, we need to understand why we should care about it.

 

There are many reasons. First, when a business is in the startup phase, there won’t be much cash coming in right away. A good business plan will allow for that. 

 

When you’re starting a business, study the industry to see what expenses you can expect before the sales start. Then project how much cash you’ll need to invest to get past that first sale. In the beginning, more money will be flowing out than in. 

 

Be prepared to meet expenses for several months before the cash really starts flowing.

 

What Is A Cash Flow Statement?

 

Once you are fully underway and cash is coming in, a cash flow statement is very important to make sure you have what you need. 

 

You’ll have to meet payroll, pay rent, buy supplies, and much more. Is your business generating enough cash to cover those things? If you extend terms to your clients, you’ll have to project when you expect those invoices to be paid.

 

Cash flow projections will be helpful to determine how much you are going to have and when. 

 

If you sell something for $5000 with 30-day terms, you know that in about 30 days, $5000 should be coming into your bank account. If payroll is $2000 per week, you know that much will come out of your bank account on a weekly basis. 

 

Your trusted advisor can help you set up projections to see whether enough cash is coming in to cover your expenses.

 

Another essential reason to monitor cash flow is growth. As your business grows, so do your expenses. 

 

Do you have enough cash to cover the added cost of more payroll, more inventory, more insurance, etc.? You’ll need to know your expected cash flow to make smart decisions about the future of your business.

 

Let’s wrap up what we learned:

  • Cash flow is the amount of money flowing in and out of your business
  • Positive cash flow means that you have more money coming into your account than is going out. Negative cash flow means just the opposite- more money going out.
  • Cash accounting takes into account only the money you actually have in the moment.
  • Accrual accounting takes into account any income, even if it has not yet been paid.

 

Understanding what cash flow is is just the first step for any business owner. 

 

Next, you need to know how to properly manage your cash flow to give you enough positive cash flow. 

 

This ensures that your business will not only stay afloat in the day-to-day, but that it will have the opportunity for continual growth.

 

What is Cashflow