By Denis Jakuc
When people talk about a business they own or are analyzing, the word they focus on is “profit.” This is understandable. Profit is what’s left over after all the expenses are deducted from the business’s revenue. Profit determines whether or not the business is making money, and is the basis of its tax bill.
But what’s equally important—often more important for a small business—is cash flow. Cash flow is the actual, real time inflow and outflow of money to a business. Cash flow tells you how much money you have to cover daily operations, inventory and equipment, payroll, and tax payments.
Positive cash flow indicates you have more money coming in than going out. In addition to taking care of operating expenses, positive cash flow can be used to pay down debt, invest in growth, pay dividends to shareholders, and provide a financial cushion against future financial setbacks. Negative cash flow indicates that cash on hand is decreasing.
Profit vs. cash flow
Which is more important? They both are, but for different reasons. Profit accounts for sales when they are made—NOT when you get the money. You then deduct from those sales your expenses when you incur them—NOT when you actually pay for them. So, you can be profitable for the month, but if your cash is tied up in assets or needed to pay bills, you won’t have the cash to pay expenses, which is why cash flow is important.
But you have to pay attention to profit, too. If you don’t stay profitable, you will eventually see cash flow decline. Cash flow problems can be solved by putting in money from owners, investors, or a small business loan. Of course, if you need outside financial assistance, you’ll find lenders and investors are way more willing to help a business that’s profitable.
More benefits of keeping track of cash flow
An accurate cash flow statement shows you where you’re spending your money (a P&L—profit and loss—statement doesn’t contain this information), so you can see where to cut costs. Your cash flow statement also protects your business relationships, making sure you have the money to pay employees, partners, and suppliers. Finally, cash flow tells you if you can afford to expand. Growth requires cash—for new employees, equipment, inventory, and facilities.
Calculating cash flow
Most accounting and bookkeeping software platforms offer ways to create cash flow reports automatically, and there are cash flow calculators and templates available online. You can also hire a business accountant or bookkeeper to calculate your cash flow, keep your books, and answer questions.
There are several kinds of cash flow statements, but to get a basic understanding of the concept, let’s look at the two most popular statements: the Cash Flow Statement, and the Cash Flow Forecast.
Cash Flow Statement
The Cash Flow Statement tells you how much cash you have available at a given point in time. Start with your net income for the month—the cash you took in. Let’s say you took in $100,000. Subtract any income that has yet to be paid by customers, say $50,000, and add the expenses not yet paid to vendors, say $10,000. That gives you Cash from Operations of $60,000.
Now add or subtract Cash from Investing. If you invested $10,000 in computers, you would subtract that amount. Now add or subtract Cash from Financing. You would add loan proceeds or capital contributions, or subtract your owner’s draw or shareholder dividends. Let’s say you drew $10,000 for the month. Subtract that.
Finally, add in the Beginning Cash you started with, say $5,000, and the calculation will give you the Ending Cash available: $50,000.
Here’s the Cash Flow Statement formula:
Cash from Operations +/- Cash from Investing +/- Cash from Financing + Beginning Cash = Ending Cash
For our example, it would be: $60,000 – $10,000 – $10,000 + $10,000 = $50,000.
Cash Flow Forecast
Equally important is predicting what your cash balance will be in the future. For that, you need a Cash Flow Forecast. This demonstrates whether you’ll be able to meet future financial obligations. It can help you make decisions, such as when to invest in your growth, and if you need funding from business loans, cash flow loans, property sales, or investors.
Start with Beginning Cash, which is the Ending Cash figure from your most recent Cash Flow Statement. Add the Projected Cash Inflows you expect to receive during the forecast period—a week, month, quarter, year, or even further out, if necessary. These cash inflows can be from customer payments, loan proceeds, or cash from investors.
Next, deduct your Projected Cash Outflows for the forecast period—vendor bill payments, rent, payroll, utilities, equipment and inventory purchases, loan payments, and service fees. The result is your forecast for Ending Cash.
Here’s the Cash Flow Forecast formula:
Beginning Cash + Projected Cash Inflows – Projected Cash Outflows = Ending Cash
Doing this forecast is especially helpful for determining when to buy a piece of equipment and how much financing you may need.
The accounting behind cash flow statements and P&L statements
The accounting approaches that create P&L Statements and Cash Flow Statements are different. The Accrual Accounting Method is used to create a P&L statement. Revenue is accounted for when it is earned—which typically happens before money changes hands. Expenses are also accounted for before any money is paid out.
For Cash Flow Statements, Cash Basis Accounting is used. Revenue is accounted for as income only when cash is received. Expenses are accounted for only when cash is paid out.
Cash Basis Accounting is simple and gives an accurate picture of the cash available. However, this approach could overstate the health of a business that’s cash-rich but has a large number of bills to pay that exceed cash available and the current revenue stream.
The Accrual Accounting Method accounts for money that will be coming in and money you will be paying out, so it’s a more accurate picture of your profitability. However, because this accounting approach does not track cash flow, it might not show a major cash shortage in the short term if your company is profitable in the long term. Accrual accounting can also be more complicated, since you have to account for items such as prepaid expenses and unearned revenue.
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InnovatorsLINK Business Writer and Brand Strategist
A business writer his entire career and successful businessman. He was a partner in a top-10 Boston ad agency, a senior level executive at Young & Rubicam NY and Interpublic Group, and, since 2003, an independent consultant for companies from startups to global leaders, positioning their brands and writing all forms of content to promote their growth.
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