What is cash flow and why is it important to a small business?

Understanding cash flow and how to manage it is essential when running a small business. It ensures you have sufficient funds to pay your bills and stay afloat. 

Misunderstand it, and your business could fail.

What is cash flow?

Cash flow is a measurement of the amount of cash coming into your business from selling your products and services, and the amount going out to pay suppliers, employees, and other bills. 

If you have positive cash flow, this means more money is coming into the business than is going out, so you can pay your bills on time.

If you have negative cash flow, you have more money going out of the business than you have coming in, which can make it more challenging to cover bills and other expenses. 

Understanding cash flow in business

As a business, you need to make sure you have enough cash in the bank to cover due payments. 

If you’re struggling with cash flow, you might not be able to meet regular payments, which could ultimately lead to much larger financial issues for your business and even see it fail. 

Why is cash flow so important for small businesses? 

Cash flow is a critical part of running your small business. Without it, your business won’t survive. Even profitable businesses can experience cash flow issues from time to time. 

Cash flow enables you to meet your financial obligations and stay afloat. While larger businesses might have reserve funds to cover any shortfalls, smaller businesses often rely on their predicted monthly income to help them meet their financial obligations. If they run into problems, it’s not uncommon for business owners to use their personal funds to cover the shortfall.

For this reason, it’s crucial to keep an eye on your cash flow and know how to manage it. Doing so can help you plan ahead and balance your inflows and outflows of cash so that you can still meet essential payments. 

Positive cash flow can also help you build a good business credit rating, which can be beneficial when securing finance through things such as business loans and credit cards. 

• 6 easy ways to get finance for your business

Types of cash flow

There are three main types of cash flow:

1. Operating cash flow

This is the cash flow directly linked to the production and selling of your goods or services. It’s also known as cash flow from operations (CFO), and you calculate it by taking the cash you’ve received from sales and subtracting the operating expenses you paid during that period. 

It shows whether you have enough cash coming in to cover your operating expenses and to grow your business. 

2. Investing cash flow

This indicates how much money has been generated or lost through short- and long-term investments. It includes research and development, as well as assets such as land, buildings or equipment. It also includes buying and selling investment products such as stocks and securities. 

Negative investing cash flow isn’t always something to worry about as it can often indicate your business has been investing in expansion and growth.

3. Financing cash flow

This refers to the money used to fund your business. Money coming in could be from bank loans, while money going out could be your loan repayments. 

If your financing cash flow is positive, it can suggest you’re investing in your business. However, it can also indicate you’re relying too much on finance. 

Cash flow vs profit: What’s the difference? 

Cash flow is the amount of money moving in and out of your business over time. Profit is the amount of cash that is left over from sales revenue, once you’ve deducted all your costs.  

Business profit tells you how successful you are at selling your products. However, cash flow is a better way of indicating the overall health of your business. It tells you how much money you have available to keep your business afloat and expand.

It’s possible for your business to be profitable but also have a poor cash flow, which means they are both important metrics.

How to manage cash flow in a new small business

There are several steps you can take to manage your cash flow as a small business:

Keep accurate records

Keeping accurate records is critical when running a business, so don’t let this get out of hand. You should update accounting information on a regular basis so you can easily see the financial state of your business. 

If you’re struggling to keep on top of things, use accounting software to help you stay on track and think about hiring an accountant to help.

• How to keep accounts for small businesses 

• How to track business expenses

Plan ahead

Looking ahead can give you a better idea of what’s coming up in the next few months and ensure you have sufficient funds to meet your financial obligations. It can also help you to identify issues early on so that you can take steps to fix them. 

Invoice quickly

Invoicing customers promptly should reduce delays in payment and give you more cash to work with. Automated payment methods can make it easier for clients to pay you, so you don’t waste time chasing them. 

Regularly update your cash flow forecast

You need to update your cash flow forecast on a continual basis. Your business’s financial situation is always changing, so you need to alter your forecast accordingly. Closely monitoring cash flow data means you can make better and more accurate predictions, helping to keep your business out of trouble financially. 

Keep your business and personal finances separate

An important part of understanding business cash flow is to keep your business and personal finances separate. Mixing the two can lead to confusion and make it much harder to establish how much cash your business generates. 

Build a cash reserve

If you can, try to build up a cash reserve over time. This gives you a financial cushion to manage unexpected events and expenses and puts your business in a much stronger position. 

Building a cash reserve can also reduce the likelihood of turning to cash flow finance to see you through. This is a form of short-term borrowing, but to qualify, you must demonstrate you are an established business by providing accounts and trading records, as well as evidence of a well-managed cash flow budget. 

What are cash flow statements?

A cash flow statement is a financial statement that looks like a profit and loss statement and balance sheet. It reviews the past month, quarter, or year to show how much money has moved in and out of your business. 

Creating a cash flow statement can help you better understand how your business manages its cash and whether it’s generating enough to stay afloat and grow. It can also help you to identify profitable areas and problem spots in your business.

What are cash flow forecasts?

A cash flow forecast predicts upcoming income and expenses over a specified period so that you can estimate your business’s cash position in the future. 

It can help you to predict when your business might have a shortfall or when you might have a surplus. This can enable you to make the right decisions in advance to help your business survive or grow. 

For example, if you’ve predicted a shortfall, you could reduce overheads or find new investment. If you’ve predicted a surplus, you could look to expand into additional markets or invest in new products. 

Common cash flow problems for small business owners

Some of the most common cash flow problems you might experience include:

• Slow customer payments: Receiving late payments can threaten your cash flow as you have already covered the costs of the service or product but haven’t recouped the payment.

• No cash reserve: If you don’t have an emergency pot of cash to fall back on, you can quickly have cash flow issues if an unexpected event or expense occurs. 

• Lack of profitability: You need to make a good profit to maintain a positive cash flow, so look for ways to increase your profit margin. 

• Poor bookkeeping: If you don’t keep accurate records, it becomes difficult to understand your cash flow and make accurate forecasts. 

• Debt burden: Although a business loan can help to get your business off the ground, an over-reliance on debt can negatively impact your cash flow if you struggle to keep up with repayments. 

How can you improve cash flow in a small business?

There are plenty of ways to improve cash flow in a small business. We’ve briefly outlined some of them below:

• Get better at forecasting: Create a weekly or monthly forecast covering the next three months or more so that you can plan ahead.

• Encourage customers to pay early: You could do this by offering a discount for early payments or increasing your payment options.

• Lease equipment: This can be better for your cash flow than paying for equipment upfront.

• Review your inventory: Get rid of any products that aren’t selling well, even if you have to sell them at a lower price.

• Reduce unnecessary spending: See if you can cut back or negotiate a better deal on certain expenses.