From small businesses and medium-sized enterprises to the large corporations in the world, one of the most important things that businesses need to focus on is their cash flow. This is regardless of their size, niche or industry.
Cash flow, for the better word, keeps a business going. It is what keeps your organisation alive on a daily basis, and is what makes sure there is enough ‘fuel in the tank’ to keep things running.
Cash flow is the “life blood” of a company. If a business does not focus on its cash flow at all times, there is a considerable risk that it will spend much more money than it makes. This means it will consistently run at a loss, run out of money and be forced to close down.
This article will outline everything you need to know about cash flow. This includes what cash flow actually is, how it affects your business and - importantly - the different methods of reporting your cash flow that many businesses get wrong.
What is cash flow?
Cash flow, in the simplest terms, refers to the movement of cash in and out of a business.
Positive cash flow occurs when a business has more cash coming in than going out. This, in an ideal world, is what every business should strive to achieve. When there is more money coming into the business than out, that indicates a healthy business on the way to profitability.
Negative cash flow occurs when a business has more cash going out than coming in. Unfortunately, this is very common when businesses are just beginning their operations. This is because they experience high start-up costs, and it takes time for them to generate the inflows they need to pay off their investments.
What are the types of cash flows?
There are generally three types of cash flow that businesses should be aware of:
- Operating cash flow
- Investing cash flow
- Financial cash flow
We’ll outline in further detail what each of is means below.
Operating cash flow
Operating cash flow (sometimes known as cash flow from operating activities) refers to the cash flow generated from the daily operations of a business, such as sales and expenses. It essentially represents the ‘cash impact’ of your net income.
Investing cash flow
Investing cash flow refers to the cash flow generated from investment-related activities. This includes measures such as investing in financial securities, and purchased physical assets like property or equipment, and the sale of capital assets.
Financial cash flow
This refers to the movement of money in and out of a business over a period of time. In better terms, financial cash flow is a measure of a company’s ability to generate cash and its liquidity position.
It is calculated by taking the difference between the cash inflows and cash outflows of a business during a specific period of time, such as a quarter or a year. The money might move to and from a company, its investors, creditors or owners.
The Cash Flow Statement: Where cash flow is recorded
Cash flow is recorded and reported on a business’ cash flow statement.This is a financial document crafted to analyse what happened to the cash of a business during a particular period of time.
It shows the various areas where you used cash and received cash. It also shows where a company reconciled the beginning and end of cash balances.
How cash flow affects your business
As explained earlier, positive cash flow means that a company is generating more cash than it is spending, while negative cash flow means that a company is spending more cash than it is generating.
Therefore, the state of your cash flow impacts a business in a tremendous way. We’ll highlight some of the more prominent impacts of a cash flow below.
- It helps businesses pay their bills on time
A positive cash flow allows businesses to pay their fixed costs (such as their bills) on time, which is crucial for maintaining good relationships with suppliers, avoiding late payment fees and overall keeping constant the most important inflows of your company.
Things includes things like your employee’s salaries, electricity costs and lease payments.
If you are constantly experiencing a negative cash flow, that will eventually mean you won’t be able to pay your fixed costs. Your suppliers will become creditors, you will quickly gain a poor reputation in the market, and you may eventually be forced to liquidate.
- It allows businesses to invest in growth
Positive cash flow enables businesses to invest in growth opportunities, such as expanding their product line or entering new markets.
This is because external investors will trust your business to take care of their money, and generate returns for them in the long-term.
If you have a constant track record of negative cash flow, investors will think twice before trusting their money with you.
- It helps businesses manage their debt
Negative cash flow can make it challenging for businesses to manage their debt obligations, such as loan repayments. A positive cash flow, on the other hand, can make it easier to manage debt and avoid defaulting on loans.
- It allows businesses to make better decisions about their future
Understanding your cash flow can help you make better financial decisions and plan for the future.
For example, if you can see that your business has experienced positive cash flows after the past three investments, you can have some degree of confidence that you will maintain a cash flow if the fourth investment you are looking into is similar.
By knowing when cash is coming in and going out, businesses can identify trends within their operations and make adjustments to improve their financial position.
You’ll get the idea from the above that managing cash flow effectively is crucial for the success of any business.
Cash Flow vs Profit: What is the Difference?
Cash flow is a term used to describe the movement of cash in and out of a business over a given period. It is an important aspect of any business, regardless of its size or industry.
However, very importantly, cash flow is not to be confused with profit.
Cash flow and profit are two important, yet different, financial metrics that businesses use to measure its financial performance and viability.
- A ‘positive cash flow’ and a ‘profit’ refer to two entirely different things!
Profit isalso known as net income - i.e. the amount of money that a company earns after deducting all of its expenses from its revenue.
In other words, profit is what is left over after a company has paid for all of its costs, including salaries, rent, supplies, and taxes. Profit is usually calculated over a specific period, such as a month, quarter, or year.
Cash flow,however, is a very different concept. It is the amount of cash that flows in and out of a company overa given period. It includes all of the cash that a company receives from its customers, as wellas any cash that it pays out to suppliers, employees, and other expenses.
A business can have a positive cash flow in a year,but still make a loss in a quarter of that same year.Similarly, a business can have a negative cash flow, but still run on a profit.
For example, a business may receive an influx of cash if they borrow a huge sum of money from a creditor. They may expect a loss that year, but can feel comfortable that they have enough cash to offset that loss, and create a positive cash flow the next year.
- Cash flow and profit represent different aspects of your business
One of the key differences between cash flow and profit is that cash flow represents the actual cash that a company has on hand, while profit is based on accounting principles and may not always reflect the company’s actual cash position of a company.
For example:
- A company may have a positive net income but still have negative cash flow if it has a lot of unpaid bills or is carrying too much inventory.
- As explained in the example earlier, a company may have a negative net income but have positive cash flow if they have received external financing to carry them through.
- Cash flow and profit are inherently different metrics
Cash flow is a more short-term metric than profit.
Profit is usually calculated on a quarterly or annual basis and represents the overall financial health of a company. It represents how much money the business is actually making.Cash flow, however, is more focused on the immediate future and helps companies manage their day-to-day operations.
By managing cash flow effectively, companies can ensure that they have enough cash on hand to pay their bills, make investments, weather any unexpected events and profit in the long-term.
By understanding the difference between these two metrics, businesses can make better financial decisions and manage their finances more effectively.
Accrual-based vs cash-based accounting: What is the difference?
Now that you understand the difference between cash flow and profit, it is important to understand whento record them. This will be essential for accounting for things such as income tax and GST.
Keeping track of things such as your revenue and your expenses is absolutely essential to understanding your cash flow, and how much profit you can expect to make. So how do you keep track of them?
There are two ways of doing it: cash-based accountingand accrual-based accounting.The difference between them is essentially one of timing.
Cash-based accounting
Cash-based accounting refers to determining your cash flow based on when income and expenses actually change hands.It takes into account things like disbursements and cash receipts, but does not consider invoices as income, or bills as expenses, until they have actually been paid.
The cash-based accounting method is ideal for:
- Small business owners and sole traders - this is because the method is very easy and does not require significant resources.
- Cash-only businesses - while rare, some businesses don’t accept card payments, so credit-related liabilities aren’t really a problem for them.
- Businesses without inventory -cash-based accounting focuses on flows of money as opposed to tracking where inventoried goods are. This is a problem if you have inventory, but not an issue at all if you don’t have it.
This method is generally much simpler to use and is easier when it comes to calculating GST. The downside is that it is not always accurate, and also can’t really help with making long-term decisions because you only have a daily snapshot of your finances at a particular moment in time.
Note also that, when accounting for GST, some businesses are not actually allowed to use the cash-based method of accounting unless they have express permission from the Australian Tax Office to do so.
Accrual-based accounting
Accrual-based accounting refers to determining your cash flow based on the moment that a business raises an invoice to a client or customer, or receives a bill.Bills are perceived as expenses, and invoices are perceived as income, even if money won’t actually change hands for another 30 days.
In other words, accrual-based accounting takes into account accounts payable (bills that you need to pay) and accounts receivable(invoices that will turn into income later down the track).
The accrual-based method is ideal for:
- Businesses that accept or make payments on credit card -this is most businesses these days. Sometimes, it takes time for credit-based payments to settle.
- Businesses that track assets and liabilities - businesses that consider their inventory and short-term investments as assets will use the accrual-based accounting method. Any expense (like a bill) that hasn’t been paid, will be considered a liability.
- Businesses required by law to use accrual-based accounting -the Australian Tax Office won’t allow you to use the cash-based accounting method for calculating GST in certain circumstances.
When*mustthe accrual-based accounting be used?*
You must use the accrual-based method to calculate GST if you do notfit into the criteria to use the cash-based method.
The cash-based method can be used when:
- Your business has an aggregated turnover of less than $10 million
- You aren’t carrying on a business, but the GST turnover of your enterprise is $2 million or less
- You account for your income tax on a cash basis
- The ATO has agreed with you that you can account for GST, regardless of your turnover, and your organisation is a government school, an endorsed charitable institution or trustee of an endorsed charitable fund, or a gift-deductible entity (unless it operates a fund, authority or institution that can receive tax-deductible gifts or contributions).
If you do not fitinto any of the above categories, you are still allowed to ask the ATO if you can be permitted to account or GST utilising a cash method.
How to manage your cash flow
Below, we’ve outlined five steps to help you manage your cash flow, no matter the size of your business and no matter what kind of accounting method you use.
- Forecast your cash flow
By forecasting your cash flow, you can anticipate any potential cash shortages and take steps to address them. This can include delaying payments, renegotiating terms with suppliers, or securing additional financing.
You can forecast your cash flow as follows:
- First, determine a period you actually want to forecast.This could be a month, a quarter, or even a year. The period of time you select will depend on your business needs and the level of accuracy you want to achieve in your forecast.
- Second, determine your expected sales or income for the period you have selected.This can be based on historical data, market research, and trends in the industry. You can look at the amount of income you earned in the previous quarter, for example, in order to determine your expected income for the following quarter. It is important to consider any potential changes in the market that may affect sales or income during the period you are forecasting.
- Third, estimate your inflows.This includes any cash that will be coming into your business during the forecast period, such as payments from customers, loans, or investments. It is important to consider the timing of these inflows, as they may not always align with your expected sales or income.
- Fourth, compile your estimates into your forecast.This will provide a detailed view of your cash flow for the selected period, including when you can expect cash to come in and go out of your business.
- Finally, review your forecast against the actual results at the end of the period.This will help you identify any discrepancies between your estimated cash flow and the actual cash flow, and make adjustments to your forecast for future periods. Regularly reviewing your cash flow forecast can also help you to identify potential cash flow problems before they occur, and take steps to address them.
- Stay on top of your accounts receivable.
Make sure you are invoicing your customers on time and following up on any outstanding payments. Some tips and suggestions on managing your accounts receivable include:
- Establishing how long you can wait to get paid.The amount of time you can wait will depend on your business needs and cash flow requirements. It could be weeks, months or years.
- Listing payment terms on your invoice.This should include the due date for payment and any penalties for late payments. Clearly communicating your payment terms can help to avoid any confusion or disputes with customers.
- Tracking your payments.Keep track of payments as they come in and follow up on any overdue payments. Consider using accounting software or invoicing tools such as Xero, MYOB or Quickbooks to help you manage your accounts receivable more efficiently.
- Offering discounts for early payments.This can be a great way to incentivise customers to pay on time.
- Manage your inventory effectively.
This only applies to businesses that have inventory.
Keeping too much inventory on hand can tie up cash, while not having enough inventory can lead to lost sales.
As such, make sure you are monitoring your inventory levels and adjusting them as needed.
- Control your expenses.
Keep a close eye on your expenses and look for ways to cut costs. Some practical ways to do this include:
- Conduct regular expense audits: This involves reviewing all of your business expenses and identifying areas where you can cut costs or find more cost-effective solutions. This could involve negotiating with suppliers for better prices, finding ways to reduce energy consumption, or switching to more cost-effective tools or software.
- Implement cost-saving measures: This could involve introducing energy-efficient lighting, reducing paper usage, or encouraging remote working to reduce overhead costs.
- Monitor and control employee expenses: Employee expenses can be a significant source of cost for businesses, particularly if they are not monitored and controlled effectively. One way to reduce these costs is to implement strict expense policies that set clear limits on what employees can spend and how they can claim expenses. This could involve using pre-approved vendors for certain expenses, requiring receipts for all purchases, or setting strict limits on travel and entertainment expenses.
- Plan for the future and be proactive
Use your cash flow forecast to plan for the future. By having an accurate picture of your cash flow clear in your mind, you can much more easily identify opportunities for growth, such as launching a new product line, or preparing for potential challenges, such as economic downturn.
Having a proactive approach to cash flow management is important because it will help you to consistently maintain a healthy financial position and avoid cash shortages
Indeed, by being proactive a business can anticipate and plan for its cash needs in advance, which allows it to make informed financial decisions and avoid unnecessary expenses. It will also help it stay on the path to growth and prosperity.
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