Every small business owner wants to make a profit. While earning a profit is certainly one measure of the financial performance of a business, it doesn't necessarily mean that the financial health of the business is strong.
A business' cash position is one of the primary factors that determine its financial health. Does the business always have enough cash on hand to pay its bills on time, or is it constantly running behind and trying to catch up?
Here's why cash flow is important.
Why Does Cash Flow Matter?
History has shown that a large portion of new business startups fail as a result of cash-flow issues, not necessarily the result of inadequate profit margins. These are the reasons that effective cash flow management is important for every small business:
- Need cash to pay expenses: At a minimum, you need enough cash in your company bank account to pay vendors and operating expenses, purchase raw materials, pay day-to-day expenditures, meet payroll and make loan payments to lenders.
- Lenders look at cash flow: When a lender makes a loan, they want to feel comfortable that the business will be able to pay the loan back. Loan payments are made with cash, not profits.
- Maintain professional relationships: Having enough cash to repay loans and pay supplier payables on time improves professional relationships.
- Cash flow is a measure of financial health: Cash flow is an indicator of the financial health of your business and the amount of liquid assets that you have on hand.
- Make projections and decisions: You need cash flow projections to make more accurate plans and decisions, determine how to fund business growth and how to pay for capital expenditures and purchases of new equipment.
What Is Cash Flow?
Cash flow is the money that flows in and out of your business.
A business cash flow statement shows you where your money is going beyond what you see on a profit-and-loss statement. You must understand where you're spending your money.
A positive cash flow means that you have more money coming in than you have going out. A negative cash flow, on the other hand, means you have more money going out than you're bringing in.
When you have negative cash outflows, you have to cover that deficit somehow. You either have to have enough cash balances in your business’s cash bank account or a line of credit that you can draw down and get the cash to pay your bills.
In addition to making a profit, business owners should look at the cash in their bank account as a more accurate measure of the company's financial health.
Profit vs. Cash Flow
It's possible for a business to make profits but to have cash flow problems and go out of business. It's also possible for a business to be profitable and still not be able to secure financing and finance its growth.
Profit is the amount of money left over after subtracting expenses from revenues. This is an accounting calculation and does not represent a complete picture of a company’s financial health.
Profits can be manipulated with generally accepted accounting practices such as a bookkeeping deduction for depreciation, which that is a non-cash expense. But you either have cash in your bank account, or you don’t.
While a positive cash flow is usually good, a negative cash flow isn't necessarily bad. For example, suppose you have made a recent sale for $100,000 that netted you a 10 percent net income, or $10,000, and you invoiced your customer to pay in 30 days. In the meantime, though, you have to use cash to pay overhead business expenses, payroll, suppliers and other short-term debts.
This means that until your customer pays the invoice, you will have more cash going out than coming in, giving you a negative cash flow for that period of time. Even though you've earned a profit on the sale, you can't use the money until the customer actually pays and the cash is in your account.
Cash flow management is an important skill that every entrepreneur should have. In addition to making a profit, the small business owner needs to have an eye on maintaining up-to-date collections of accounts receivable to keep the company’s cash inflows steady, controlling inventory levels and maintaining an adequate level of working capital and the amount of cash in your bank account to cover all business expenses.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.