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Cash Flow Management: The Secret to Success

Posted on January 16th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Cash flow is the lifeblood of any small business. Some business experts even say that a healthy cash flow is more important than your business’s ability to deliver its goods and services.

While that might seem counterintuitive, consider this: if you fail to satisfy a customer and lose that customer’s business, you can always work harder to please the next customer. If you fail to have enough cash to pay your suppliers, creditors, or employees, you are out of business!

What is Cash Flow?

Cash flow, simply defined, is the movement of money in and out of your business; these movements are called inflow and outflow. Inflows for your business primarily come from the sale of goods or services to your customers but keep in mind that inflow only occurs when you make a cash sale or collect on receivables. It is the cash that counts! Other examples of cash inflows are borrowed funds, income derived from sales of assets, and investment income from interest.

Outflows for your business are generally the result of paying expenses. Examples of cash outflows include paying employee wages, purchasing inventory or raw materials, purchasing fixed assets, operating costs, paying back loans, and paying taxes.

Note: An accounting professional is the best person to help you learn how your cash flow statement works. He or she can prepare your cash flow statement and explain where the numbers come from. But for a quick overview, here’s a simplified illustration: “Profit vs. Cash Flow Made Easy.

Cash Flow versus Profit

While they might seem similar, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS, but more importantly, it’s a gauge for monitoring the health of your business: “Which is More Important, Profit or Cash Flow?”

Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more important, it is concerned with the times at which the movement of the money takes place.

In theory, even profitable companies can go bankrupt. It would take a lot of negligence and total disregard for cash flow, but it is possible. Consider how the difference between profit and cash flow relate to your business.

Example 1: If your retail business bought a $1,000 item and turned around to sell it for $2,000, then you have made a $1,000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? You may not have the cash to pay the bills despite the profits you earned on the sale. Furthermore, this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and create debt. If this mistake is repeated enough times, you may go bankrupt.

Example 2: Another example is a business that is growing rapidly, such that it’s increased spending on inventory and overhead expenses to support sales growth surpass its incoming receivable collections creating a negative cash flow, which continues until the rate of growth tapers off to a sustainable level of sales (net positive receivable collections). This negative cash flow phenomenon, which I’ll call “permanent working capital,” is illustrated in our previous article, “The Effect of Sales Growth on Cash Flow.” Left unchecked, this scenario can also lead to bankruptcy, even if your Profit & Loss Statement reflects a decent profit.

Monitoring and managing your cash flow is important for the vitality of your business. The first signs of financial woe appear in your cash flow statement, giving you time to recognize a forthcoming problem and plan a strategy to deal with it (“Financial Planning, or Business Turnaround – Your Choice”). Furthermore, with periodic cash flow analysis, you can head off those unpleasant financial glitches by recognizing which aspects of your business have the potential to cause cash flow gaps.  In our next article we will analyze these gaps in greater detail.

 


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