The blood of business is cash flow. It will inform you that a business is doing well and surviving or is flatlining.
This simple fact notwithstanding, a mind-boggling 82 percent of business failures are due to management’s ignorance of the management of cash flows, not because there are no profits. When it comes to going bankrupt, a waiting list of customers and a backlog of orders will not be of any use. How? Profit is a matter of opinion, whereas cash is a reality.
This article will unravel what cash flow really is, why cash flow is more important than profit, and how to make the art of keeping your business alive.
Part 1: What is Cash Flow? (The Definition)
The simplest definition of cash flow is the net inflow and outflow of cash and cash equivalents in a business over a certain period of time.
Inflow: The sum of money that is given to a customer, loans, investments, or the sale of assets.
Outflow: Cash paid on rent, salary, inventory, tax, and loan repayment.
Whenever the inflow is more than the outflow, then positive cash flow (surplus) occurs. Negative cash flow (shortfall) is where outflow exceeds inflow.
The most important of the subtexts, though, is timing. You can send an invoice today, but the customer will pay in 90 days, creating a hole in your cash inflow. You will be obliged to pay out today the amount of the payroll that you have collected today.
Part 2: Dead End Trap: Profit vs. Cash Flow
It is this one alone that is a misconceived notion in business. They do not mean each other.
Profit is a term used in accounting. An amount of money less certain costs on paper, such as the depreciation of expenses and accrued revenue (sales you have made but have not been paid).
Cash Flow: The actual money that is in your bank account at this time.
The Situation: The company, which deals with construction,n signs a 1M contract (Revenue). They use 600k of material (Expense). The profit they have is 400k. They, however, paid the supplier 600k in advance,e but the client will not be paying within 120 days. The company is making a prof, but does not have cash to pay the electric bill. This is tered, growing broke.
Rule of Thumb: You can make do without profit in a month. Without ca, sh you cannot live a week.
Part 3: The Three Pillars of Cash FlTo
In order to control the cash flow, you should be knowledgeable of the three different types of cash as defined by the typical accounting practices:
1. Running Cash Flow (OCF): The Vital Sign
It is money that enters into the world as a consequence of your core business activities of selling goods, or offering services, paying suppliers,s and paying employees.
The reason why it matters: The only possible source of growth is the positive OCF. This being a negative, disconnects the business model.
2. Cash Flow (ICF) Investment
This includes cash payments to long-term assets (equipment, property, software) or receipt ofcash fromm the sale h of long-term assets.
Why it is important: It is normal when there is a negative ICF in a growing company (buying new machinery) as a normal condition. But given that the OCF is negative and the ICF is negative, then you are selling your future to pay in the present.
3. Financing Cash flow (FCF)
This is a cash flow between the company and its owners/creditors (loans taken, dividends paid, stock issued, debt repaid).
Why it is significant: The fact that it is all about financing (loans or investment funds) means that this is a warning sign to investors.
Part 4: Cash Flow Statement (Your Diagnostic Tool)
The Cash Flow Statement is among the three key financial statements (along with the Balance Sheet and Income Statement). It cannot be changed with the assistance of creative accounting, as the Income Statement.
What it tells you:
- Sources: What was the actual source of the cash?
- Uses: What was the actual use of the cash?
- Net Change: Has the bank account been increased or decreased?
The positive cash flow (operations) that is consistent and strong, with investing (growth) and financing (strategic debt) inflows, characterizes a strong business.
Part 5: Successful Ways to Improve Cash Flow
When you are in a cash crunch, the following measures should be put into effect:
1. Invoice Faster & Smarter
The waiting time to pay does not start until the invoice has been received. Electronically transfer invoices immediately after the job has been done. Pay through automated payment reminders and a discount of 2/10 net 30 (payment within 10 days).
2. Plan Inventory as a Terrorist
Inventory is a terminology of cash that you cannot use. It is on shelves collection dust. Install Just-in-Time (JIT) system. Something that has never been sold within 90 days should be discounted or resold to the supplier. Cash stock.
3. Stretch Payables (Without Breaking Trust)
When you are saying that you are paid on net 30, do not pay on day 10. Pay on day 30. On the other hand, request suppliers to extend their terms (net 45 or net 60). Get the cash from the supplier as a loan without interest.
4. Develop a Cash Reserve (The “Runway”)
Intend to keep 3-6 months’ operating expenses in a separate and liquid account. The buffer helps alleviate seasonal decline or default of the clients.
5. Use the “Rolling Forecas.t”
Having a predetermined annual budget is of no use. Put together 13-weekek rolling cash flow forecast that is updated on a weekly basis. Here you will be wanting in the future, so you can secure a line of credit in advance of the crisis.
Part 6: Red Flags (Early Warning Signs)
- Watch for these symptoms of a cash flow stroke:
- The custom of charging overdrafts is becomingthea norm.
- You are making use of credit cards to pay suppliers.
- You pay payroll or tax (taxes can be the biggest unsecured debt; do not defer taxes).
- There is an increase in sales, and a decrease in the bank account.
Summary: Cash is King, but Flow is the Kingdom
The aim of a mature business is profitabilit,y but the state of survival is the cash flow. A skyscraper (profit) can not be constructed without a strong foundation (cash flow).
You should no longer be thinking about this matter of your Income Statement. Beginning with analyzing your Cash Flow Statement every week. One question per day in the morning: Do I have enough cash today to cover what I leave tomorrow?
The question is the business.
Summary using bullets (Key Takeaways)
- The cash flow 2 Profit: Profit is a hypothetical amount; cash is real.
- Three types: Operating (core), Investing (assets), Financing (loans/equity).
- The 90-day trap: You may go bankrupt waiting for a customer to pay you a lucrative invoice.
- Action step: Develop a rolling cash forecast today, 13 weeks.
