What is cash flow and why is it important?
Good cash-flow management is vital for any business. Sales may be high, and on paper you could be in profit, but if there’s not enough money to cover your expenses while you’re waiting to be paid, it’ll be hard (if not impossible) to keep your business afloat.
Here’s a look at cash flow and why it’s so important.
Good cash-flow management is vital for any business. Sales may be high, and on paper you could be in profit, but if there’s not enough money to cover your expenses while you’re waiting to be paid, it’ll be hard (if not impossible) to keep your business afloat.
Here’s a look at cash flow and why it’s so important.
What is cash flow?
Cash flow is the money that comes in and goes out of your business each month. Money flows in when you get paid (inflow), then flows out again when you pay an expense (outflow).
Take a restaurant owner: cash flows into their business when a customer pays the bill at the end of their meal. But cash goes out again when the owner pays their staff, suppliers and rent or mortgage on the restaurant.
In business terms, cash flow can be considered positive or negative.
- Positive cash flow is when you have more money than you’re spending.
-
Negative cash flow is when you’re spending more money than you have.
How you manage your money each month can be the difference between having a positive or negative cash flow.
How can cash flow be used?
Understanding and effectively managing your cash flow means more than just covering expenses while you’re waiting to be paid.
The way you manage your cash flow each month gives an indication of how financially stable your business is.
For example, your net cash flow, the difference between your inflows and outflows over a certain period, shows how your business is performing in the short term.
Monitoring your cash flow cycle can help you budget more effectively. By tracking your cash flow over a period of time, you’ll have a better understanding of where there are shortfalls and where there is a cash surplus. This can help you make adjustments to ensure that gaps are covered or to work out how much available money could be re-invested in your business.
Potential investors will also look at your cash flow, together with your revenue and income, to get a clearer picture of how your business supports itself and whether there’s potential for growth.
Cashflow and cash payments
Some businesses like pubs, restaurants, shops and market traders do a lot of their trade in cash. They take money from customers and sometimes use the cash to pay suppliers or other bills.
If you receive cash payments, it can be difficult to keep track of your cash flow, especially if the money hasn’t had a chance to go into your bank account before being spent.
But whether you’re paid in cash, or pay business expenses from cash out of your pocket, you must keep track of everything. You’ll need a record of all receipts and invoices, including cash transactions, for your tax return – and that includes dipping in and out of the ‘petty’ cash fund.
Not declaring cash-in-hand payments is illegal. It will mess up your cash flow, and you could also be losing out on potential tax deductions.
Why is cash flow so important?
Cash flow affects everything to do with your business, whether it’s paying the bills, building a reputation, increasing its value or investing in future growth.
A healthy cash flow allows your business to support itself, handle unexpected costs and take advantage of investment opportunities. Poor cash flow means you’re constantly chasing your tail. If you’re struggling to pay your bills, you’re likely to be overdrawn and building up debt.
Many talented start-ups go under in their first year: not because their products won’t sell, or their ideas aren’t innovative – but simply because they run out of money. You might argue that it’s a struggle to secure enough financial investment. But to attract investors, you need to be able to demonstrate good cash flow management – and that means effectively juggling your inflows and your outflows.
Tips for managing your cash flow
If your inflows and outflows are out of sync, the following tips for good cash-flow management could help you strike a better balance:
Make use of accounting software
You don’t need to be a financial whizz to benefit from accounting technology. There are plenty of easy-to-use business management apps and internet-based tools to help streamline your invoicing and keep your bookkeeping accurate and up to date.
Many accounting software apps can automatically send out invoices and prompt customers if a payment is overdue. Online invoicing also saves time and money, eliminating the need for paper, envelopes and postage costs.
Be clear about your payment terms
Be clear from the start about when you expect to be paid. You can set your payment terms, which could be 14 days, 30 days or even ‘payment on receipt’.
In some cases, for example, if you have a service-based business, you could request a percentage as an up-front deposit, then agree for the remaining balance to be paid when the project is completed.
You could also offer a discount as an incentive for early payments.
Charge a late payment fee
One of the main causes of cash-flow issues is late payments. According to the government, the total amount for late invoices owed to small businesses is currently £23.4 billion . This is having a direct impact on the cash flow and ultimate survival of many SMEs. In a bid to crack down on delayed invoice payments, the government has made reforms to the Prompt Payment Code (PPC), which will slash the required payment period to small businesses from 60 to 30 days.
This is called ‘statutory interest’ and is 8%, plus the Bank of England base rate.
Let’s say a company is 50 days late in paying you an invoice for £1,000:
8% interest of £1,000 = £80
+
Example BoE base rate of 3% = £30
Annual interest = £110
£110 divided by 365 days = 30p daily interest
50 days x 30p = £15 in interest
You’ll need to send a new invoice for £1,015.
Check customers’ credit history
If you have a large order from a new customer, you might want to check out their credit history before doing business with them. You can get a credit report from one of the three main credit checking agencies: Experian, Equifax or TransUnion. This could help you decide if the customer is a safe bet or a potential financial risk.
Cut back on unnecessary spending
It might seem like less hassle to stick with a known supplier, but shopping around could get you a better deal and help you save money. You could always go back to your original supplier and see if they’re prepared to match the price.
You could also save by switching energy providers, especially if you’ve been on the same tariff for a while.
Shopping around and comparing quotes could also help you cut the cost of your business insurance.
What is a cash-flow statement?
A cash-flow statement shows the exact amount of money that’s coming in and going out of your business over a set period – monthly, quarterly or annually. Unlike an income statement, it will only show money from sales that have already gone in, not money that still needs to be paid.
A cash-flow statement can be used to assess the short-term financial health of a business. It’s usually divided into three parts:
- Operating – shows the amount of money generated by the business’s core activities, in other words, products and services.
- Investing – cash spent on equipment, assets or investments. For example, buying a new piece of equipment or a property.
- Financing – any changes in debt, loans or dividends that affect cash flow. For example, cash raised by selling stocks or bonds, or a bank loan.
How to analyse a cash-flow statement
A cash-flow statement can help you check that your available cash is keeping pace with your profits. If you’re making a lot of sales but are still waiting for money to come in from invoices while making your own payments, you’ll see a fall in your net cash flow.
If your net income is more than your operating cash, you’ll want to find out why your profits aren’t transferring into cash.
If you’re consistently generating more cash than you’re using, it shows you’re in a good financial position to pay off debts or even expand.
A cash-flow statement can also be used to predict future movement of money in and out of your business. Cash-flow forecasting can help you estimate the amount of money you’ll need at any given time. You can then use this information to make adjustments and cover potential shortfalls.
Frequently asked questions
What’s the difference between cash flow and profit?
Cash flow and profit aren’t the same. Cash flow refers to the money that goes in and out of your business on a monthly basis. Profit, also known as net income, is your revenue minus expenses.
It’s possible to make a profit and have a negative cash flow. If you’ve made a lot of sales but haven’t been paid yet, on paper you’ve still made a profit. But if you don’t have enough money to cover your expenses while waiting to be paid, your cash flow will be negative. Without a healthy cash flow, your profits won’t mean anything, and your business could soon be in trouble.
What is revenue?
Revenue is the gross income of your business. In other words, what your business makes in sales or its primary activities before any expenses like rent, salaries and taxes are taken out.
What is annual cash flow?
Annual cash flow is the amount of cash that goes in and out of your business during the tax year.
Your annual cash inflow is the total sum of money received from payments, investments and dividends or interest over the course of the tax year.
Your annual cash outflow is the total sum of money paid by your business over the course of the tax year.
Total cash inflow – total cash outflow = annual cash flow
This can be either positive or negative.
Is negative cash flow always bad?
Negative cash flow doesn’t always mean your business is suffering.
When you’re just starting out a negative cash flow is normal, and essential. Initially, your resources will be needed to pour money into establishing your business and developing your brand. A positive cash flow in the early days could be a sign of too much cost-cutting, which could compromise your relationships with new clients and employees.
All companies can suffer a temporary cash-flow problem, especially if they’re in the process of expansion. Seasonal businesses might also experience negative cash flow during slow periods. That’s why forecasting is essential. You’ll be able to estimate when cash flow is negative and take measures to adjust your spending or raise necessary capital until business picks up again.
If you can’t justify negative cash flow through expansion or seasonal variations, then it could be a bad thing. Losing money consistently over time means debts can start building up and lay-offs may be inevitable.
Equally, a positive cash flow isn’t always a good thing. If you have a whole heap of cash sitting in your bank account, you could be missing out on investment opportunities that could help your business grow.
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Mubina Pirmohamed - Business and landlord insurance expert
With almost 15 years’ experience in the insurance industry, Mubina is an expert from one end to the other. From leading the introduction of new products, marketing them, innovating them, all the way to handling claims with customers. At some point in her career, she’s done it all.