What is cash flow?
Cash flow is a summary of the movement of cash in and out of your business. Businesses use cash flow statements to analyze cash flow and gauge how well money is being managed.
The cash flow statement gives you a snapshot of your cash inflows and cash outflows.
- Cash inflow refers to cash received. It’s cash generated from the sale of goods or services. A business can also receive cash in the form of interest income, royalties, investing activities, and licensing agreements.
- Cash outflow refers to cash spent on business expenses. Payments made to suppliers, wages, dividends paid to shareholders, and money spent on fixed assets are all cash outflow examples.
Keeping track of cash flow is one of the most important parts of managing your finances. It doesn’t show you how profitable you are or what your income is for a set period. But it does reveal whether you have enough cash on hand to cover your operating expenses and stay in business.
Over 80% of businesses fail because of poor cash flow management. There’s a simple solution for this: cash flow analysis. When you track cash flow, you can better understand your company’s financial health and make informed spending decisions.
A Cash flow report shows you whether you have enough cash in any time period to cover expenses and invest in growth—or not. By watching and optimizing the movement of cash in and out of your business, you can stay operational and thrive. But first, you need to know what cash flow is and why it matters.
In this article, you’ll learn:
- What cash flow is
- Why understanding cash flow matters
- How to analyze cash flow using a cash flow statement
Cash flow vs. profit
Cash flow and profit are two different metrics that describe your company’s financial health. You need one to drive the other.
Cash flow is the net balance of cash moving in or out of a company.
- A positive cash flow indicates your company has enough money to pay employees and creditors and stay operational.
- A negative cash flow indicates more money is leaving the business than coming in.
Profit is what your business has left over after deducting all expenses from revenue. Like cash flow, it can be a positive number (net profit) or a negative number (a loss).
Analyzing profits is really about assessing how good you are at running a business. Analyzing cash flow is more about money management.
Here’s where they intersect: you need to master cash flow if you want to sustain your business and your profits.
Why cash flow matters
Cash flow helps you understand your business’s liquidity, financial flexibility, and performance.
You look at cash flow over a period of time—you can, for instance, evaluate your cash flow for the past year or quarter. You can also create a cash flow forecast to understand your business’s finances for the upcoming year.
Here’s what you’re uncovering when you track your cash flow:
How much liquidity your business has to pay employees and creditors
Will you need to take out a loan or improve your accounts receivable process to ensure you won’t run out of cash? Or is your company cash-happy and capable of covering operational expenses easily?
How flexible the business is
If there’s a positive cash flow forecast for the upcoming year, you know how much you can invest in growth activities, such as hiring or investing in new equipment. If it’s negative, you know you don’t have the flexibility to jump on opportunities.
How well the business performs financially
Usually, a business with a positive cash flow is in good shape. It’s appealing to investors and lenders because it can clearly meet its financial obligations. On the other hand, a negative cash flow can indicate trouble and a risk of closure.
How to analyze cash flow
A cash flow analysis dives into how much money is flowing into your business and where it comes from. It also reveals the cash outflow—how much is going out and what you’re spending money on.
When you conduct a cash flow analysis, you learn two things:
- If you have enough to cover operational expenses.
- If you have money left over after covering those expenses.
You’ll need to prepare a cash flow statement to see where money is flowing to and from.
What is a cash flow statement?
The basic tool businesses and accountants use to understand the movement of cash is the cash flow statement.
This financial statement reveals whether your cash flow is positive or negative, and it’s one of the main three financial statements businesses use to understand their financial position. The other two are the income statement and the balance sheet.
A cash flow statement describes inflows and outflows from three main areas: operational, investing, and financing activities.
You’ll total income and expenses from all of these areas when preparing the cash flow statement.
Cash flow from operating activities
This looks at cash flow for main revenue-generating activities (selling goods or services).
It includes cash receipts from customers, which will be positive on the cash flow statement. You’ll also list cash paid to suppliers, cash paid to employees, interest paid, and taxes paid. These are your operational expenses, and they’ll be deducted from your revenue.
- Receipts from the sale of goods and services +
- Payment to suppliers, employers, and taxes (-)
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Cash flow from investment activities
This looks at inflows or outflows from buying or selling of investments or other long-term assets.
- Purchase of investments or other long-term assets (-)
- Cash receipts from the sale of investments or long-term assets +
Cash flow from financing activities
This part of the cash flow statement summarizes the movement of cash as it relates to activities that fund the business. It includes liabilities and equity.
Liabilities:
- Proceeds from long-term debt +
- Long-term debt payments (-)
Equity:
- Common stock issued +
- Dividends paid (-)
How to prepare the cash flow statement
There are two methods: the direct method and the indirect method. Either way, you need to first gather your cash inflows and outflows. Then you’ll calculate your net cash flow and compare it to your starting cash balance.
Direct method
The direct method subtracts cash outflows from the net income. It’s easier and more straightforward for small businesses to use the direct method.
Indirect method
The indirect starts with the net income and works backward, adding or subtracting non-cash revenue and expenses, such as depreciation and amortization, and a gain/loss on a sale of a long-term asset. This method gives you more detail in the operating activities section, but is harder to calculate manually.
Cash flow statement example
Here’s a cash flow statement example for a small business called Dinah’s Donuts. This is an example of the direct method, which is easier to calculate by hand. To use the indirect method, it’s easier to use accounting software that helps you factor in more data points.
Dinah, the business owner, is using the direct method to create the statement for cash flows. All she needs to do to prepare her statement is find the net cash for operating, investing, and financing activities. Then, she adds up these three figures to determine the net cash flow for the year.
After that, she’ll compare her net cash flow to her beginning balance to determine her ending cash balance. That’s what she has in cash at the end of the year. If it’s positive, she might decide to use some of the money to invest in growth opportunities in 2024.
If it’s negative, Dinah knows she has to be more conservative when creating her budget for the upcoming year so she can try and improve her cash flow.
Dinah’s ending cash balance is positive. In fact, she nearly doubled her cash balance. Flush with cash, Dinah decides to invest in marketing to try and increase sales in 2024. She also plans to hire another employee to help her make the donuts and sell them to her growing clientele.
Why your business should analyze your cash flow
After doing a cash flow analysis, you gain an overview of your spending. You might also be able to spot opportunities for generating more cash in the short term. For example, Dinah knows she has the cash available to spend on activities that should help her bring in more revenue while maintaining an optimal cash balance.
In this way, the cash flow statement is useful for short-term planning and getting a granular view of your financial position.
It is work, however, to juggle all of these numbers. That’s where automation software comes in. With tools for your accounts receivable, accounts payable, and accounting, you can pull the numbers you need from your systems, plug them into your financial statements, and gain the insights you need to run a successful business.
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