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Cash Flow: The Money a Business Has to Spend
Cash flow, also known as operating cash flow and net cash, is the amount of money a business has available to spend and is normally referenced when talking about paying bills, operating expenses like payroll and buying supplies, or monthly expenses like rent and utilities. A cash flow statement is one of the three most important financial documents for your company along with your balance sheet and income statement.
Cash flow is different from a company’s profit in that cash flow is the money coming in and going out of a company’s bank accounts, and profit is the amount of money a company has on paper after subtracting expenses from revenue. Expenses like depreciation lower profit but don’t impact cash flow because no money leaves the business’s bank account.
That’s also why profitable companies can go out of business by running out of cash. They show a profit on paper with more revenue than expenses, but if revenue sits in accounts receivable, then the company will be short on cash and unable to pay their employees, rent, and other expenses. This lack of funds or an unexpected depletion is called a cash flow gap.
There are three types of cash flow that a business should track:
- Operating cash flow (OCF) is a measure of how much cash comes in and goes out from day-to-day operations and can be calculated with the following formula: Net Income + Non-Cash Expenses – Increase in Working Capital (or + Decrease in Working Capital) = Operating Cash Flow
- Investing cash flow (ICF) is a measure of the money being brought in or spent on investments including business acquisitions, capital expenditures (CapEx) like new trucks for deliveries, stocks and bonds, and other investing activities. The calculation to get your ICF is: Cash Flow from Investing Activities = Sales of Assets and Investments – Capital Expenditures – Purchases of Long-Term Investments – Business Acquisitions
- Financing cash flow (FCF) is how much your cash flow changes from financing activities like issuing stocks or buying stocks back, taking a small business loan, and making payments on assets you lease. FCF can be calculated using this formula: Cash Flow from Financing Activities = Debt Issuances + Equity Issuances – Share Buybacks – Debt Repayment – Dividends Paid
Cash flows for businesses of different sizes can be compared by using cash flow ratios and margins and looking at each industry’s specific average.
Seasonal businesses like real estate and gift shops in beach towns will have more month-to-month fluctuations than businesses with year-round sales like corporate consulting. Cyclical industries like car sales, trucking, and mining fluctuate more year to year than companies that deal in consumer staples, like toilet paper and laundry soap.
A good place to look for your benchmark is by checking your industry’s associations that do advocacy. If they don’t have it, you can purchase reports on financial ratios by industry from multiple statistics groups and business data aggregators like university business schools.
Now that you know what cash flow is, here’s how it can be applied to your business, and what parties will use these numbers as your business grows or needs funding.
Uses for Cash Flow Numbers
A business owner isn’t the only person who uses cash flow numbers to make decisions. Accountants, consultants, investors, and financial institutions will need them too.
Accountants, Bookkeepers, and Business Strategy Consultants
Your accountant and bookkeeper will be tracking your cash flows as they are important when you’re deciding whether to expand, hire, renovate or move to a new building. They use these numbers to determine what you can and cannot afford.
If you hire a business coach, they’ll be looking at these numbers to measure efficiencies across your company.
Each will be able to find areas where you can cut costs to increase cash flows, or calculate what your new business venture will need to bring in to get to a profitable level. The solutions could be substituting products or suppliers, increasing or decreasing staff, or upgrading equipment for larger outputs.
They can also use cash flow calculations to determine how long your business can keep running with unexpected lulls and slow seasons, or how long you’ll be able to use current cash flows to help fund a new location while you wait for it to get up and running. When you want to grow, these professionals can use your data to help determine by how much you need to increase cash flow to afford new staff, new equipment, and larger quantities of inventory.
Financial Institutions and Alternative Lenders
Cash flow is something lenders and banks use when a company applies for a small business loan, a business credit card, lines of credit, and more, as the financial institution will want to feel confident that the company can make financing payments with interest.
- Positive cash flow means the company has money in their bank account to spend.
- Negative cash flow means the company has no money available to cover costs.
Having a negative cash flow, even if it is only seasonally, will be a warning sign to potential lenders and creditors, so make sure you have a strong business plan, easy-to-understand explanations, and a proven track record before applying for financing if you’re facing a cash flow gap.
Investors
Investors will be curious about cash flow as they want to make sure they can get paid from the company’s profits. If a company’s cash flow is negative, it may not be a deal breaker, as the investors may have experience in the space and can help make it positive.
Investors and experienced business consultants can help you create a positive cash flow by:
- Finding better, more affordable suppliers.
- Teaching business owners how to negotiate better prices for services, making them more profitable.
- Fine-tuning operations to cut unnecessary expenses.
- Making introductions to their network to increase the business’s customer base and drive more revenue.
Your cash flow numbers matter to more than just you as a business owner. The people you trust to guide you and the institutions you look to for financing will use these figures to determine how financially efficient and creditworthy your company is.
Positive and Negative Cash Flow
Having a negative cash flow can be a cause for concern. As a business owner, you won’t have the funds to fix machinery when it breaks, you may struggle to make payroll, and without cash coming in, you could find it difficult to get financing. At the same time, the negative cash flow could be temporary because you just stocked inventory for the busy season or made a large purchase.
Other times, you may decide to buy large equipment with cash reserves instead of leasing it. By using your cash reserves, you may have a negative cash flow vs. spreading out payments by leasing the equipment or taking an equipment financing loan. In cases like this, the negative cash flow is expected and you’ll begin recovering quickly as customers pay for services and invoices come due.
Amazon operated on a negative cash flow cycle model for years to power its growth. You can read more about their cash flow model here in this article from CBER at NYU and here on Harvard’s Business Review.
As long as you have explanations for negative cash flows and timelines for when cash will begin coming in again, negative cash flows aren’t necessarily a bad thing. Positive cash flow can also be misleading.
If a company had a slow season and ran out of cash, they could take a short-term business loan or working capital loan to fund operations while they get back on their feet. The sudden influx of cash will show a positive cash flow, but it is misleading because the cash is actually a debt and comes with interest payments. Similarly, getting a large payment from a customer, but having to pay debts with the majority of the cash, is another situation that may make cash flow seem better than it is.
When the payment first arrives, you’ll see a large positive cash flow. Once you pay down your debts and cover expenses, your cash flow is now much lower, as it is measured in real-time.
This is why it is important to know what the causes of positive and negative cash flows are, and how to optimize your processes for spending and receiving cash, including with investments, operations, and financing.
In the beginning, we talked about how cash flow is different from profit. Now we’ll get into how it is similar but different from gross and net revenue.
Cash Flow Is Different Than Gross and Net Revenue
Cash flow is different from net revenue in that net revenue is the total amount of sales after taking out discounts, and does not include operating costs or expenses. Cash flow is different from gross profit as gross profit subtracts the costs of selling products and services (COGS or cost of goods sold) but does not account for utilities and non-sales or service-based expenses.
Cash flow is the actual amount of money a business has to spend in their bank account and not just the numbers on paper after you reduce specific expenses and costs.
You can have positive gross or net revenue but negative cash flow if you don’t collect enough accounts receivable to cover COGS and other expenses that you must pay in cash versus on credit. When this happens, you’ll want to look for expenses you can cut or ways to optimize your sales, marketing, manufacturing, and operating expenses so that you have money in your bank account once a product or service is delivered.
Cash Flow Is Not the Same as Net Profit
Net profit is a fixed number that represents the amount of money available after all business expenses have been deducted. It is similar to cash flow in that it shows the money available, but cash flow measures actual changes in real money each time you make a purchase or collect a payment.
Net profit is used when looking at larger, long-term business decisions like hiring, expanding by acquiring a competitor, or opening new locations, while cash flow is typically examined as it relates to covering short-term and immediate expenses. So what happens when you run out of cash to cover immediate expenses because you’re waiting for accounts receivable? This is called a cash flow gap, and there are ways to fill these financial holes.
How to Fix Cash Flow Gaps
A cash flow gap is when a company has bills or expenses due while they are waiting for money to come in from customers, a credit card company to release funds, or invoices to get paid. Cash flow gaps can be stressful when bills like rent or electricity due, and when you have to make payroll. Luckily there are financial solutions to help fill gaps in cash flow.
- Short-term business loans have quick approvals and can be used to buy equipment or supplies, stock inventory, cover working capital, make payroll, and more.
- Changing collection terms from net 45 or 60 to net 30 can bring cash in faster if your customers are able to make payments earlier.
- Lines of credit and business credit cards can be used to cover gaps in cash flow, but they should mainly be used when you can pay the balance back before the high interest rates kick in.
- Invoice factoring is a way to get cash fast by selling invoices to another company. You accept external capital at a lower amount than the invoice is valued at, and the buyer collects from your customers.
- Merchant cash advances can fill a cash flow gap by exchanging a portion of your upcoming credit and debit card sales for a cash payment.
- Self-funding is another option. But this strategy puts your nest egg at risk, so make sure you feel confident you’ll recover the money.
Cash flow is the measurement of how much money is coming in and going out of your company in real-time. A negative cash flow could happen because you’re investing in the future of your company, while a positive cash flow could be the result of taking a business loan and not a sign of being profitable. Forecasting your cash flow is important to make sure your company is on the right path, and now you know how to do it.
QuickBridge does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
