Cash (flow) is King
In the previous delivery I looked at Financial- and Business risks for entrepreneurs. Closely aligned to these topics – and in my view much more important for an entrepreneur to grasp than an income statement or balance sheet – is the matter of cash flow. Cash flow is one of the most critical components of success for a business. Without cash, profits are meaningless. Many a profitable business on paper has ended up in bankruptcy because the amount of cash coming in does not compare with the amount of cash going out. So I want to decipher cash flow in this delivery.
Cash flow made simple
The purpose of this article is not to teach you how to compile a Cash Flow Statement, my aim is purely to create an understanding of why the management of cash flow is so important when running a business. So, let me look at the definition of cash flow first.
Most business owners believe their cash flow is defined as the revenues they generate less the expenses they have to pay. Not true. The answer lies in the fact that the accounting rules that govern the creation of financial statements are not about tracking the actual flow of cash through your business. They are focused on measuring profit or loss – not cash flow.
Cash flow is the difference between actual cash received and actual cash used in the process of doing business. Each day, month, quarter, and year, a business receives a certain amount of cash and pays out a certain amount of cash. Cash flow is a very real measure of how a business is doing, i.e. whether it will be able to pay its bills tomorrow or next week or next month. Profit, on the other hand, is revenue from the sale of services and products – whether payment in the form of cash has been received yet or not – minus all expenses – expenses paid in cash, expenses to be paid in cash at a later date, and expenses accounted for in other ways.
Simply put, profit is generally recorded when the sale is made and cash flow is recorded when the money is actually received. Now here’s something to think about – can a profitable business go out of business? The answer is yes! Let’s say you own am enterprise and are struggling to stay in business when you make a huge sale to Company X with an agreement to get paid in one month. You record the profit now (when the sale is made) but in two weeks, Company X goes out of business and is unable to pay you. Even though you show a profit, you don’t generate the cash you need to sustain the business and may have to close your doors.
Cash flow projections should be a part of your budgeting process to ensure that you’re being proactive in managing your business. If you don’t understand the basics of cash flow for your business, you may find yourself in a cash flow crunch where you’re waiting for payments from clients but are still expected to pay your operating bills. That’s especially important if you have a lot of sales on account, then you have to have enough cash on hand to cover the daily bills until your clients pay you. This isn’t an easy situation for a business to be in, which is why it’s vital that you understand when you have cash flowing both out of and into your business. So, understanding where your cash is coming from and going to is a critical part of smart business management. Moreover, you can improve cash flow by doing the following: Do everything within reason to collect payments sooner rather than later. If you are in a position to pay your suppliers slower, do it – though you will want to be careful not to incur any late fees or damage your relationships in the process. Also, anytime you can cut costs or sell more, you are improving your company’s cash flow and profitability.