As a business owner, do you wonder what cash flow is and why it is so important? Cash flow in its simplest form is the amount of money coming into the business and the amount of money going out. To be able to sustain your business and scale like a pro, it is important to make sure that there is a surplus in cash flowing into your business.
Cash is King
In the accounting world, there is often a saying that ‘Cash is King’. And it holds true for a business of any size. The profitability of a business is not necessarily a measure of how financially strong it is. More often than not, large multi-million dollar businesses that have impressively high volumes of sales go bust because they suffer from cash flow problems. As a business owner, it is highly crucial to understand the difference between profits and cash.
Profit doesn’t always equal cash
First, let’s talk about cash inflows. The main source of cash inflow for most businesses is money received from customers for products or services sold. For businesses like restaurants and retailers the inflow happens as soon as a sale is made.
For most other industries, sales are made on payment terms. In other words, the sale is recorded as a receivable (money owed to you by customers) until payment is made by customers. If you can’t collect what’s owed to you, you won’t have cash in your bank account.
On the flip side, the same applies to cash outflows. Some expenses need to be paid immediately such as wages, rent while the others could be paid later depending on the payment terms provided by the suppliers.
This is why your accounting system may also show a difference in cash and profits. If your business operates on accrual accounting, you recognise income and expenses based on the date of the invoice, even if the customer has not paid yet. In this case, you might show a profit without receiving the cash.
Due to this very reason, it is important to understand that profitability isn’t the same as cash flow. It is possible for a business to make a profit but have no cash left in the bank account.
Budgeting and Forecasting
So how do you get in control of your cashflow and avoid rainy days as much as possible? Apart from having back up funds in the bank account which isn’t always practical, another great way to keep a handle on cash is to have budgets and cash flow forecasts in place.
Because the cash flow estimates are based on your projected sales for the upcoming months, it is highly important to be as realistic as possible with the projections. Once you do so, the cash flow forecasts provide a great overview of the cash position for each month and helps you prepare in advance for months that are likely to be a bit more cash flow sensitive.
And remember, the cash flow forecasts are only as good as the budgets themselves so it is highly important to constantly revisit them and make tweaks based on any new developments.
Now is the time to become a cash flow savvy business owner!