What is Cash Flow?

You often hear that small businesses fail because of lack of “Cash Flow”. But what does “Cash Flow” really mean to a small business owner from a practical standpoint? Learn more in this week’s blog.

Cash flow.  It is what makes a business run (or not).  But what is cash flow? 

The Merriam Webster dictionary defines cash flow as:

1: a measure of an organization's liquidity that usually consists of net income after taxes plus noncash charges against income

2: a flow of cash; especially : one that provides solvency

If you are a professional accountant or a stock analyst, that first definition might mean something to you.  But that doesn’t really help an entrepreneurial business owner (or mean anything from a practical standpoint).  The second definition sounds better, we all want to have cash flowing and be solvent.  But that definition is still fairly theoretical level and doesn’t help you much on a practical level.

So instead of using a definition in this case, let’s use a description instead.

Here is my practical description of Cash Flow for small business owners:

Cash Flow is the ability to analyze and manage your cash in a way that maximizes your ability to stay in business and meet your financial obligations in a timely manner.

I know that this does not quite sound practical yet, so let me explain what I mean to you.  There are two terms in my description that are the essence of cash flow.  Those terms are analyze and manage.

Analyze

Analyzing your cash flow is looking at what happened to the money that came in (and should have come in) and understanding why it happened that way.  This involves knowing all the pieces of what happened to your money and what should have happened.  For instance, do you have accounts receivable that is taking too long to come in?  If you allow payment terms of net 30 (the customer is supposed to pay in 30 days), but your customers are not paying you until 60 days (or more), that is going to have an effect on your cash flow.

On the payment side, do you have a system for paying your bills when they are due or do you just kind of pay them when they are due (or when you have money)?  Do you have a system for making purchases outside of normal operations?  If you have a business that is making money on the income statement, but you never seem to have cash, are you buying capital items (equipment, buildings, etc.) and paying for them out of operating funds that shouldn’t be paying for those items?

You need to take time to look at what you are doing in order to understand what is really happening to your money, even when you understand the whole process.  But that is only the first of the two parts that make cash flow work.  You also have to be able to manage what you are doing with your money.

Manage

Managing involves more than just performing the tasks of taking the money in and sending it back out.  In order to manage your cash, you have to be able to take your analysis, understand what is going on and then do something with it.

To manage you need to prepare a budget that covers three main areas: operations, capital expenditures and cash projections.  A budget will help you see what you have to spend and what issues, both good and bad, are coming your way.  When you know the issues you can take action in advance to prevent a cash shortage or to use excess cash to your benefit, even if it is just on a short term basis.

So if you want to stay in business and meet your financial obligations in a timely manner, analyze your business so you understand how the cash is working and manage it by preparing your budgets so you can take deliberate action before it is time to shut your business down.

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God Bless your week!