What is cash flow, anyway? Become a master with this comprehensive guide and watch your business thrive.
Do you ever struggle to cover your expenses at month-end because you don’t have enough cash? Understanding “what is cash flow?” is a great start.
If you answered yes to this question, you’re not alone. Many small business owners experience the same problem: They suffer from poor cash flow caused by factors like insufficient client work, slow-paying clients and large unplanned expenses.
But exactly what is cash flow? And why should you even care? In this post, you’ll learn nearly everything you need to know to help you become a master, including:
- What it is
- Why it matters
- How to calculate it
- How to track it
- How to improve it
What Is Cash Flow?
To understand cash flow, begin by learning what it isn’t. Firstly, it’s is not profit. Profit is the difference between revenue and expenses. It’s possible for a business to be unprofitable while having good cash flow and vice versa. This can happen, for example, when a business owner deposits their own money into a bank account, which improves the flow of cash but not profits.
Secondly, it is not working capital. The two are often used interchangeably, but working capital is current assets minus current liabilities. It is the money you can use to fund cash shortages.
So, what is cash flow?
It’s the total amount of money flowing in and out of your business. When more money is flowing in than out, you have positive cash flow and your business is in the black. Conversely, when more money is flowing out than in, you have negative cash flow and your business is in the red.
Changes in the flow of cash usually result from operating, financing and investing activities—although operating activities can often have the largest impact.
Examples of Cash Inflows and Outflows
Let’s look at a few examples of inflows and outflows for these various business activities to help us unpack cash flow a little better:
- Inflows: money received from clients
- Outflows: money paid to cover rent, utilities, travel, cell phone and other expenses
- Inflows: cash received from a bank loan
- Outflows: monthly loan repayments
- Inflows: money received from selling assets like equipment
- Outflows: money paid to purchase equipment
Why Does Cash Flow Matter?
Cash flow plays a crucial role in:
Keeping your business afloat. You need cash flow to pay the bills and cover the day-to-day, or you risk closing your doors. Your goal is to maintain positive cash flow and ensure you’re always earning more than you’re spending.
Growing your business. A business that’s growing will need enough cash to reinvest—to purchase new equipment, invest in advertising, offices and so on—all while covering costs.
Making smarter business decisions. Knowing your cash flow informs your decisions. For example, let’s say that you plan on buying a new laptop and that at the end of the month you discover your income far outweighs your expenses. You can now confidently make that purchase because you have enough cash.
Conversely, if you’re in the red, you may choose to put that purchase on hold until your situation improves. In either case, you’ve made a smart decision because you’ve been tracking your cash flow.
Seasonal businesses. Seasonal businesses usually have marked slow and busy periods, and unpredictable cash flow. They need to carefully manage their cash flow year-round, so they have enough cash to tide them over during the slow periods.
Better money management. Understanding your flow of cash helps you understand how you’re managing your money and what business activities are leading to increases or decreases in cash flow.
If, for example, you discover you have a profit come year-end but are struggling to cover the bills each month, getting to grips with the inflows and outflows will help pinpoint any problems so you can fix the situation.
But How Exactly Do You Calculate Cash Flow?
Calculating cash flow usually involves preparing a cash flow statement that consists of the three core areas mentioned earlier:
Although you can calculate your cash flow for any period, it’s historically done monthly. There are two ways to prepare a cash flow statement: the indirect and direct method.
The Indirect Method
The indirect method is more straightforward and recommended for most business owners. With this method, you adjust the net income based on cash inflows and outflows. Below is an example cash flow statement using the indirect method:
Cash flow from operations
Net Income: $10,000
Your net income for the period you want to evaluate from your income statement
Adjustments to reconcile net income and net cash:
Increase in accounts payable: $1,000
Add expenses still to be paid
Increase in accounts receivable: ($2,000)
Subtract money still owed by customers
Net cash from operations: $9,000
The total after all additions and subtractions
Cash flow from investing
Purchasing equipment: ($2,000)
Selling equipment: $1,000
Net cash from investing: ($1,000)
The total after all additions and subtractions
Cash flow from financing
Money from a line of credit: 900
Payments on credit: ($200)
Net cash from financing: $700
Ending cash flow balance: $8,700
Net cash flow from operations + net cash from financing + net cash from investing
The Direct Method
The direct method differs in one small detail: Net cash flow from operating activities is calculated differently. Instead of adjusting your net income, you list the payments (expenses or outflows) and receipts (income or inflows).
You then subtract your expenses from your income to obtain the total cash flow from operating activities before adding net cash from financing and investing. Here’s an example of how to calculate cash flow from operations using the direct method:
Cash received for services delivered
Office space: ($1,000)
Equipment and office supplies: ($100)
Accounts utilities: ($300)
Net cash flow from operations: $6350
Subtract monthly expenses from income
How to Track Your Cash Flow
Because changes in cash flow often result from fluctuations in income and expenses, a good starting point is to monitor these two variables.
Tracking Your Income: It Starts with Your Invoices
Track your invoices so that you know who has paid you, who hasn’t and how much money you’re earning each month. By tracking your invoices and keeping a secure record, you’ll also be better prepared for tax season.
Consider cloud accounting software that stores your invoices in one easily accessible place, provides you with at-a-glance overviews of your income and reminds you when any invoices are overdue (more on that in a bit).
Tracking Your Expenses: It Starts With the Right Expense Categories
You also need to maintain a firm grip on your expenses so you can compare them against income to determine profits. Here are two expense tracking best practices you may want to implement:
Organize business expenses into tax-friendly categories, so you understand your spending habits and can reduce your total tax bill. Typical business expense categories include office supplies, bank fees, utilities, cellphone and data costs, travel and entertainment.
Upgrade your expense tracking methods. If you’re still recording expenses in spreadsheets or storing receipts in a filing cabinet, it may be time to upgrade to a more modern solution. The right cloud accounting software, for instance, will simplify your expense tracking by letting you:
- Connect your bank account—say goodbye to manual entry
- Snap a photo of a receipt with your phone and upload it to the cloud for easy access later on
- Mark an expense as billable, add a markup and pull it into an invoice to view at a glance how your business is performing thanks to expense, and profit and loss reports
The bottom line? Keeping tabs on your income and expenses helps you better understand the movement of cash and your spending habits. This understanding, in turn, improves your decision making.
Five Ways to Boost Your Cash Flow
Now that you know what cash flow is, why it’s important, how to calculate it and how to track it, here are five ways you can improve it.
1. Become a Master of Your Books
Some small business owners face cash flow problems because of messy books. Maybe their invoices aren’t readily available in one location. Perhaps they don’t track their income or expenses throughout the year and instead scramble during tax season.
Regardless, this disorganization means they never really know where their business stands at any given time—how much they’re earning or spending, whether they’re profitable, and even how much money is flowing in and out. In some cases, this disorganization leads to overlooked invoices and large outstanding sums of money.
If so, it’s time to get your books in order. Consider using cloud accounting software that helps you keep your income and expenses up to date, lets you invoice with ease and ensures you remain on top of outstanding invoices.
2. Get Invoices Paid Faster
If you’ve ever experienced late payment, you’re not alone. According to Fundbox, 64% of small business owners face late payment problems. This may not necessarily be a major concern if it happens infrequently or you have a basket of clients.
But if late payment becomes a recurring theme and/or you hit a slow period, it can be problematic—with you unable to pay the bills and grow your business.
The solution is to get paid faster and use the right tools, so your finger remains on the pulse of those late payers. Here are several ways to get your invoices paid on time:
Send invoices promptly. The sooner you send invoices, the sooner you get paid.
Be courteous. Research by FreshBooks shows that being polite in invoices improves the chances of getting paid on time by 5%.
Ensure the payment terms are clear, so clients know when to pay you. Avoid ambiguous words like “net 30” and “upon receipt.”
Create invoices that are free of common errors, so you avoid constant back and forth with clients.
Send reminders just before the invoice due date. Clients often forget about invoices because they have a lot going on. Sometimes they just need a gentle reminder.
Include online payment options that make it easy for clients to pay you directly from the invoice. The right cloud accounting solution accepts payment via multiple options including Visa, Amex, Mastercard and even Stripe.
And for overdue payments? Follow up with those clients and send late payment reminders. Certain invoicing software will instantly tell you when an invoice is overdue. It will also let you set late payment reminders that run on a schedule, so you avoid those awkward money conversations.
3. Get a Cash Advance on Unpaid Invoices
Late payment is sometimes unavoidable, especially when working with larger companies that adhere to strict policies—often paying their suppliers 30, 60 or even 90 days after receiving an invoice.
Because your business doesn’t stop running while you wait to get paid, you need adequate cash flow to cover you. If your income can’t tide you over, you could apply for a bank loan. But, there’s no guarantee the bank will approve your loan. And even after approval, there’s often a long waiting period.
The better approach is to get a cash advance on those unpaid invoices through a company like Fundbox, a FreshBooks partner. Fundbox provides cash advances on your invoices within 24-48 hours of approval, and offers a flat fee for the duration of the loan unlike many other companies that inflate the first few payments.
Fundbox is totally transparent about the fees: Each time you request an advance, you’ll see how much money you’ll get, what the fees will be and what the payment schedule is. And if you pay early, the company waives all remaining charges.
Getting started with Fundbox is easy. Connect to Fundbox from within FreshBooks to receive details on your credit limit. Once approved, you’ll notice a “Get an Advance” button on top of your invoices. Select that button for fast access to cash.
4. Request an Upfront Deposit
Deposits provide you with a cash injection—a godsend for larger projects that span months. They also ensure clients remain invested in the project from the start as deposits formalize the entire relationship. Furthermore, a client who happily pays a deposit is far more likely to cover the rest of the invoice.
5. Reduce Your Monthly Expenses
Finally, you can improve the flow of cash by cutting monthly costs. We’re not talking about cutting that morning latte or other small expenses that make you happy. Instead, we’re talking about cutting non-essentials and being just a little more prudent with how you spend your money. Here are a few ways you can start saving money today:
Cut unnecessary subscription costs. We all have those monthly subscriptions we rarely use and keep for those “just in case” moments. But those moments rarely arrive. Cancel those subscriptions and save money.
Negotiate your monthly bills. Yes, it is possible to negotiate your monthly bills with companies—whether it’s your insurance or even cell phone bill. Simply call those companies, tell them you’re a loyal customer and would hate to leave, and ask what they can do for you. This technique is surprisingly effective.
Cash flow is the lifeblood of your small business. It keeps your business afloat; it helps you grow. Unfortunately, some small businesses don’t fully understand it—until it’s too late, and they no longer have the cash to cover the bills.
But you don’t have to suffer the same fate. This post provided you with almost everything you need to know to help you conquer cash flow—from what it is and how to calculate it, to how to track it and improve it so your business can thrive.