cash flow explained

“All truth is found in the cash account.” – Charlie Bahr, Management Consultant

What is cash flow?

As the name suggests, cash flow is simply the money that flows in and out of your business. However, it is arguably the most important aspect of your business. And, it’s a good way for outsiders to track your business’s performance.

Josh Kauffman, author of “The Personal MBA,” explains it in simple terms:

“The Cash Flow Statement is straightforward: it’s an examination of a company’s bank account over a certain period of time. Think of it like a checking account ledger: deposits of cash flow in and withdrawals of cash flow out. Ideally, more money flows in than flows out, and the total never goes below zero.”

Realistically speaking, many businesses will find their cash flow drops below zero, especially during the first year of operation. Negative cash flow, to be clear,  means a decline in the cash balance over a specified period of time. It’s not as bad as a negative cash balance, which means you’re bouncing checks. So you can have negative cash flow, temporarily, but negative cash balance, never. That said, if you can avoid a negative cash flow, do. It can lead to negative cash balance and that would make many aspects of running a business harder: getting loans, attracting investors, paying suppliers and employees, and growing the business.

According to global banking institution HSBC, there are three things you should keep in mind as you learn about managing your cash flow and your business finances:

  1. Profits are not cash
  2. Timing is of the essence
  3. Many businesses fail due to lack of cash, not lack of profits


What is a cash flow statement?

A cash flow statement is a record of the change in the cash balance a business has on hand at any given time. Businesses can use the cash flow statement to record what has occurred to cash; or a cash flow projection to forecast into the future in order to determine future needs for cash.

You will need to include a cash flow projection in your business plan document and you will need to keep an eye on cash flow so long as your doors remain open for trading. This means, keeping an up-to-date cash flow plan as you run and grow your business.


Why is understanding cash flow important?

While it is perfectly possible to be profitable on paper, there’s a big difference between money you’re owed and cash on hand. This is why even a profitable business can go bankrupt if for example their receivables are not paid on time. This in turn will mean they cannot pay their own bills and operating expenses.


Good cash flow management can have a major impact on the success of your business. With a positive cash flow, you will be able to make inventory purchases, hire new staff and spend money on the things that matter, including paying yourself a salary!

On the other hand, if you manage your cash flow poorly—perhaps if you spend too much at the start—you won’t have any cash to spend on acquiring new leads and on advertising. If you don’t watch your cash flow on a regular basis, you could be setting yourself up for failure. Not to mention the mental stress of having to make back every dollar you spent in the early stages of setting up your business.

Consider the following scenario:

You’re a truck dealer. You purchase a used truck outright for $20,000 in January. Six weeks later you sell that truck for $30,000. Your related cash flow for January is -$20,000 and your cash balance goes down by $20,000 during January (but nothing happens to profits or losses). Your cash flow goes up by $30,000 in February (which is also the month in which the $30,000 sale and the $20,000 direct cost appear in the profit/loss statement. So you made a $10,000 profit in February with $30,000 in sales and $20,000 in cost of goods sold. And the $20,000 outlay in January doesn’t show up in profits at all. That’s an instant example of how cash flow is different from profits.]


Let’s consider a slightly different scenario:

In the above scenario, we assumed you get the $30,000 when we sell the truck. However, many businesses, including some truck dealerships, sell on credit. That doesn’t mean credit cards or financed auto purchases, it means the standard business-to-business practice of delivering the goods and services along with an invoice that the business customer pays later.  So in that case, they don’t get the $30,000 until later, when the business customer pays the invoice. That makes cash flow much worse, but doesn’t affect profits at all. You’ll still have made a sale (and the profit) but you don’t get the money for it until later, when the business customer pays the invoice. The profit is only on paper.

Now, for the record, that truck purchase was what we call inventory —the goods you buy with the intention of selling them later. What you pay to buy inventory doesn’t show up in the profit or loss until that item is sold. There too, you see the difference between cash and profits.

These simple scenarios have probably given you a good idea of why it’s important to keep track of earnings and expenses. After all, if you don’t do this, how will you know when to purchase inventory, how much you can purchase, whether or not you can hire an additional employee, and, more critically, if you can actually afford to pay your own monthly bills, particularly if you splash out on a company Monster truck!

How do I calculate cash flow?

To make matters simple, we’ve created a cash flow calculator. Each month, thousands of entrepreneurs use this calculator to manage their financial success. You can use it to experiment with factors that may affect your cash flow.

There are two commonly accepted methods for calculating cash flow, direct and indirect. I’m using the direct method for this post. The indirect, however, is just as common, and just as accurate. For more on that, try the indirect cash flow method.

If you prefer to do your calculations manually, or would like to understand how net cash flow is calculated, here’s a simple, four-step explanation (using the direct method):

Note: be sure to read all four steps in order to calculate net cash flow. Here, we will be working out cash flow based on three primary business activities—operating, financing, and investing activities.

1. Work out your operating expenses and write the total down


First add up incoming cash from operations: cash received from the sale of goods, services, receivables from customers, cash interest, and dividends. And notice, as you follow along, that incoming cash isn’t the same as sales; at least not for business-to-business sales that involve leaving an invoice and getting paid later. Sales on cash count immediately, but sales on credit don’t.

Once you’ve done this, figure out the total amount of outgoing cash from operations: payments for goods purchased, employee salaries, taxes, fines, interest paid to creditors, etc. This includes buying inventory to be sold later. Ideally, you keep inventory for only a short time, so it doesn’t clog your cash flow.

Now, subtract total outgoing cash from total incoming cash. This will give you your total operations cash flow. Write this down.

2. Calculate cash flow from your financing activities


This includes cash spent or received from stocks, bonds, and other securities.

First add up the total amount of incoming cash from financing activities: proceeds from the sale of goods, investment earnings, any contributions received, cash from borrowing, and so on.

Next add up outgoing cash from financing activities: cash paid toward debt, cash paid to buy back shares, dividend payments, etc.

Now, subtract total outgoing cash from total incoming cash. This will give you your total financial cash flow. Write this down below your total cash flow from operations.

3. Calculate cash flow from your investing activities

Incoming Cash from Operations - Ougoing (2)

First add up the total amount of incoming cash from investment activities: cash from the sale of stocks or bonds, cash from the sale of company-owned assets, etc.

Now add up the total amount of outgoing cash from investments made: cash paid to acquire debt, cash paid to purchase assets, and so on, whatever is relevant to your business.

Now, subtract total outgoing cash from investments you’ve made from total incoming cash due to investment activities. This will give you your total investment cash flow. Write this down below your total financial cash flow.

4. Now calculate your net cash flow for the period you have selected

Incoming Cash from Operations - Ougoing (3)

To do this, you simply need to add the three ending figures you worked out above:

Add your total operations cash flow to your total financial cash flow and then to your total investment cash flow. This will give you your net cash flow.

What does a cash flow statement look like?

By this stage you understand what cash flow is, why it’s important, and how to calculate it. What you might not know, is what a cash flow statement looks like.

Here’s a great example from the LivePlan app:



You can tweak this statement to suit your own needs. Ideally, check with your accountant or bookkeeper to ensure you’re creating a cash flow statement that is accurate and easy to understand.

How often should I review and revise my cash flow forecast?

Forecasting cash flow is important because it will allow a business to identify future problems with cash. It will show them when they may expect a shortage and thus, allow them to make plans in advance to ensure this doesn’t impact day-to-day business activities.

If you’re just getting started and cash is tight, it’s a good idea to have a solid understanding of when you will need to make pay outs. In this scenario, consider forecasting your cash flow on a daily basis.

Otherwise, most companies tend to forecast their cash flow on a weekly or monthly basis.

How do I manage my cash flow?

Cash Flow Management

Managing your cash flow will require good record keeping and regular cash flow forecasting.

Now you need to learn to manage your cash flow. As we said above, good cash flow management will help you succeed, while poor cash flow management could cripple your business.

Regardless of whether you’ve been operating for a year or for five, there are always things you can do better.

With that in mind, here are a few tips on monitoring your cash flow and on projecting and meeting cash flow needs.

How to make monitoring your cash flow easy:

  • Keep a daily record of incoming and outgoing cash
  • Deposit any checks received on a daily basis
  • Use numbered cash receipts and account for all of them
  • Use numbered checks for disbursements
  • Send customer invoices within two days
  • Collect receivables within two months

To encourage those that owe you money to pay on a timely basis, consider offering discounts; taking deposits immediately as a sale is made, and performing credit checks on those that don’t pay with cash.

Likewise, when it’s your turn to pay up, take full advantage of a creditor’s payment terms. Don’t pay for something 20 days before you should. Rather, be timely and set up an electronic transfer. Don’t forget to take advantage of any discounts creditors offer you as well! However, be wary of making payments too early as it will make it hard to forecast cash flow and will make cash flow unpredictable.

How to project your cash flow needs and then meet those needs:

  • Anticipate payroll
  • Preempt outstanding debt payments
  • Set aside money for emergencies
  • Set aside money to allow for growth
  • Use short-term financing when necessary
  • Arrange for a line of credit with a bank before you are short on cash


What to watch out for

So that you’re not surprised by the state of your finances, it’s good to consider where your cash will go when you get started, and where most of it will go on a monthly basis.

1. Factor in your start-up costs

Every business will have initial start-up costs. Perhaps it’s a lease on an office, or marketing expenses, or initial inventory purchases, or hiring the services of a contractor. While you may have to take this in stride for a year or two, you should also allocate an amount of cash to these early expenses. It’s best to have this in mind before you start your business.

2. Keep an eye on inventory and receivables

As with your initial start-up expenses, as you grow, so too will your need for inventory, and your receivables. If at all possible, set aside cash to finance these things. Or, keep a close watch on them.

3. Rapid growth can put you in a tight spot

As you grow, you will likely need more cash on hand to finance inventory, receivables, marketing expenses and other large acquisitions. This may result in a negative cash flow, which, if not managed carefully over time, could eventually force you into bankruptcy. Many a rapid growing business has been unable to cope with growing demands and has had to close shop due to poor cash management.

man purchasing with money

Cash is king!

Be organized, but accept that you’re human

Occasionally, you may not be able to make a payment due to negative cash flow. Ideally, you will have predicted this in advance, but if not, accept the fact that you really cannot predict the future and take preventative measures.

Banks are far more willing to lend to those people that know months in advance they may have a cash shortage. This makes you look financially responsible. Plus, if you don’t end up having a shortage, you don’t need to take up on the loan you were offered, it’s just a nice safety net to have in place.

Also, consider turning to your suppliers. Given that you’ve got an active working relationship with them, they will be the ones most invested in your success. They may be able to offer you a short-term loan.

In general, keep an eye on your cash flow and make forecasting a habit. Any time you see expenses exceeding incoming cash, take this as a sign to be frugal.

See Also: Cash is King

Have you got any questions related to cash flow?

At Bplans, we work with entrepreneurs and aspiring entrepreneurs on a daily basis. We’ll be happy to help answer your questions and perhaps, create additional guides where you feel you need them. Let us know how we can help. Leave your comment below.


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