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What is Cash Flow, and Why is it Important?

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Cash is the moving force of a business. A business needs cash to carry out its day-to-day expenses, and have enough left over to invest in growth and expansion.

Without having adequate cash, maintaining routine activities, such as repaying investors, paying suppliers, purchasing raw materials and paying salary to employees, becomes tough for business owners.

Therefore, every business needs to manage regular cashflow, and keep track of cash inflow and outflow to sustain for a long time.

What is Cash Flow in business?

Cash flow is the amount of money or cash flowing in and out of your business in a month. There are two ways in which cash flows – cash inflow and cash outflow.

Generally, cash inflow is maintained by customers or clients who purchase your products or services, and money comes into your business; whereas cash outflow is maintained by the expenses or tax payments, where money is going out from your business.

If more money is coming into your business and less is going out, then it means you have a positive cash flow. On the other hand, if more money is going out from your business than coming in, it means you have a negative cash flow.

The concept of cashflow plays an important role in determining the performance and financial health of a business in three prominent ways: 

Cash flow from operating activities: It depicts the amount of money that comes in or goes out from ongoing business operating activities such as electricity bills, advertisement costs,  providing various services to customers, etc. Cash flow from operating activities is important because it indicates the cash-generating potential of a business and shows whether a business has enough funds to pay its bill or operating expenses. 

It can be understood by net income from the income statement, changes to net income and changes in working capital. 

Cash flow from investing activities: It depicts the amount of money a company generates or has spent on investing activities like purchasing physical assets, investment in securities, etc. 

The company investing activities can be seen from its financial statements i.e, 

  • Balance sheet (overview of company’s assets, liabilities and owner’s equity), 
  • Income statement (overview of company’s revenue and expenses) and;
  • Cash flow statement (It shows the difference between balance sheet and income statement by showing how much cash is being spent on operating, investing and financing in a specific period of time). 

Cash flow from financing activities: It depicts the net cash flow used to fund a company. It is mainly required to understand the financial capacity of a company and how well a company is managing its capital structure. 

Examples include transactions involving debt, equity, and dividends.  

Difference between Cash Flow and Profit

As described above, cashflow is the inflow and outflow of cash from your business.

Profit is the money left after covering all the expenses and taxes of a business. In simple words, profit is your net income which you actually have in your hand after covering all your business expenses.

Both cash flow and profits are indispensable parts of a business. However, it is essential to note the difference between profit and cash flow. It might be possible that your business has higher profits, but a poor cash flow.

Let’s take a look at cashflow example; your business generates a profit of $30,000 in a month, but the cash flow statement only reflects $8000, because the rest is tied in account receivables (money coming to your business). In this case, your business can face problems like overspending money or ordering too much stock.

Why is Cash Flow important?

It is mostly due to the monetary shortfall that many small businesses collapse within months. Cashflow is an important factor of a business that cannot be overlooked. Here are some reasons to understand the importance of cashflow for a business: 

1. It helps make better business plans and decisions

All your business plans and decisions depend largely on the cash flow of your business. By continuously monitoring your cash flow statement, you will have a clear idea of how much money you have, and how you can utilise it to make better decisions for your business. 

Without maintaining your cash flow, you might make bad decisions that could be harmful in the long run. You may think that you have enough money to spend on things that are not relevant then. However, your cash flow statement reflects the opposite. This could be because of any reason, like you haven’t cleared your invoices, or paid your employees yet. 

Therefore, whatever may be the reason, understanding your cashflow statement will enable you to make better business plans and decisions.

2. It safeguards business relationships

If you are new to the business and don’t have enough funds to pay your suppliers, it can harm your business relationships and your overall reputation in the market. No businessman is going to sell you the merchandise without getting paid for it. You can strengthen your business ties only if you attempt to regulate your cash flows and clear your dues on time.

It is imperative to keep track of your cash flow. If you have positive cash flow, you can have a healthy cash rotation for buying supplies and selling goods. It will help you maintain a powerful presence, engage in new markets, and have progressively strong business contacts.

3. It assists in debt management

When you start a business, you have to borrow some money or obtain a bank loan to buy the place, utilities, and necessary equipment for your business. It’s your expected cash flow that helps you make those purchases.

In order to pay the money back, it’s important you expect positive cashflow in the future to clear the debts. Most companies adopt the strategy of having long term loans and short term credit accounts.

Each loan demands a monthly payment that curbs the limit of using the cash flow freely. However, being aware that there are loans to be paid helps you use your cash wisely.

4. It Leads to Business growth and expansion

Strong cash flow offers possibilities to invest in the expansion of your business, alongside debt management. You can think about establishing new locations, adopting new technologies, improving the infrastructure, and buying more assets for your business.

All this is possible only if you have a steady inflow. You don’t have to worry about the debts and can run into profits slowly. As your profits increase, your cash flow state also changes, giving you more flexibility in investments to further expand your business.

Moreover, even if you face negative cash flow at any time, you can still lead your business into profits if you take necessary actions related to expenses primarily based on the cashflow statement. This way, you can have a constant flow of money and expand your business.

5. It gives you operational flexibility

It is easier to handle a crisis situation when you have an ample cash flow, and you are aware of your liquidity constraints. Having enough cash at hand lets you operate your business efficiently.

In addition to this, with the availability of enough cash, you can also attract money lender firms and banks to give you loans at a low-interest rate. It implies the fact that it’ll be simpler for you to secure a loan if you are aware of your cash flow.

Thus, you can also improve your financial conditions significantly and continue to earn advantageous credit terms for loans.

Positive Cashflow

Positive cash flow is when a business receives more cash than spending it out. For instance, if you have started a business with $2000 and your business expenses account for some $1000. However, the amount you received for providing your business services is $4000. So, now at the end of the month, you will have $4000 which means you can say you have maintained a positive cash flow. 

Advantages of positive cash flow:

  • With positive cash flow, you can easily bear your business expenses and upgrade your technology or equipment to make your business more profitable. 
  • You can get more business opportunities by maintaining positive cash flow as more investors will like to deal with you and invest in your business. 
  • If you have access to enough cash, it will be easy for you to manage your debts, bear the damage of equipment, etc. and survive in the worst possible scenario. 

Negative Cashflow

Negative cash flow is when a business spends more cash and receives less of it. For instance, if you have started your business with $4000 and your business expenses are for some $5000. However, the amount you have been paid for your business services is only $500. This implies that you don’t have enough cash at the end of the month and it will be difficult for you to sustain your business. 

Tips for managing your cash flow:

Here are some ways to manage your cash flow so that you can prevent having a cashflow emerging situation: 

  • Prevent having too much stock: Keeping unnecessary inventory can disturb your cash flow. Keep regular track of your stock, which in turn will improve your cash flow.
  • Avoid unprofitable relationships: If someone doesn’t pay for the goods they have purchased from you and hamper your business growth, learn to say no to them and avoid contact with them for any future dealings.
  • Observe your monthly expenditures: It is important to pre-plan your business expenditures and spending in order to avoid a cash crisis in the long run.

Keep an emergency cash reserve: Having emergency cash reserves allows you some flexibility and security during a financial crisis. It is recommended to have enough cash to cover at least 3-4 months expenses beforehand.

Slate helps you to analyse your business cashflow in depth by understanding your business expenses, sales performance and other related things. It assists you to know where you business is standing financially and sends you collection reminders to manage receivables efficiently.

Conclusion

Now that you know what cash flow is, and why it is important to maintain a cash flow statement for your business, it’s your turn to apply what you have learnt here and run your business smoothly.

Slate Team

Slate Team

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