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What is cash flow and why does it matter?

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Every small business owner wears a number of hats as they begin their journey as an entrepreneur. One of those hats is often accountant or bookkeeper, as business finances can't be neglected. When it comes to these roles, knowing the answers to "What is cash flow and how do you use it?" is key.

To ensure your business is healthy in the near future and long haul, let's examine what cash flow is, then dive into how you can perform a cash flow analysis and create a statement of cash flow.

What is cash flow?

Cash flow is a financial forecast that allows you to see money coming in and leaving as a result of things like your business activities, expenses, and debts. 

Positive cash flow is when a business’s money coming in exceeds its cash outflows. This is typically a good thing, as a positive cash flow often equates to stronger working capital. With working capital, a business can purchase necessary equipment, hire employees, and invest more in the growth and success of their business. Positive cash flow also opens you up to the possibility of paying back loans and other debts.

Negative cash flow is when your business has more money going out than it has coming in. On the surface, this probably sounds like an issue, and in some cases it is. If your financial statements show you're spending a small fortune on rent and have poor cash inflows, negative cash flow can point to a less desirable situation.

While negative cash flow due to low revenue is bad, it's not uncommon for startups. Startups often have a large initial investment in their businesses. Assuming these investments have a good rate of return, negative cash flow is both a necessity and a sign the business has the tools to grow.

Positive and negative cash flow are very different. Again, while positive cash flow may seem preferable, one isn't necessarily better than the other. Negative cash flow could come from investing activities, and result in a huge payout. And a positive cash flow could be a result of living too frugally and not growing your business. But in either event, cash flow is important.

Why is cash flow important?

Profits and revenue are often the primary focus of businesses, since you can't operate a business without them. But cash flow offers a much more useful look at your company's financial health.

For example, let's say your company recently experienced a nice uptick in profits but your business bank account balance is steadily dwindling. If you're paying attention only to the profits, you could wind up thinking you’re doing great, but suddenly find your bank account depleted. By looking at your overall net cash flow, you can see if your company is in the green or falling into the red.

Beyond highlighting your financial performance, cash flow is also useful for investing in and growing your business. If you have a positive cash flow, you likely have healthy working capital. With that money, you can hire new employees, secure the marketing or advertising agency you need, make loan payments, and buy new equipment. Ultimately, cash flow is the lifeblood of your company. 

Now, let's take a look at performing a cash flow analysis so you can start gauging your financial health.

Understanding a cash flow statement

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Cash flow management is the only way to ensure your next cash flow statement is a healthy one. But before you dive into cash flow management, you need to understand what your cash flow statement is telling you.

A cash flow statement is a document that gives a monthly rundown of your various cash flow activities. Below, we’ll cover the primary types of cash flow activities that play a vital role in your company's financial health.

1. Cash flow from financing activities

The cash flow from the financing activities section of a cash flow statement shows the funds your business receives or doles out. Your cash flow from financing (CFF) includes any issued equity, debt, dividends, or even lease payments. This information can be especially useful for potential investors, as it gives them an idea of your business's financial health and whether your funds are managed well.

To determine your financing cash flow, you can use the following formula:

Issuance of debt or equity – (repurchase of debt or equity + dividend payments) = CFF

Once you've determined your cash flow from financing activities, you can have a better idea of your company's health as far as funding is concerned. Again, this can help you determine if your company is in a good spot to attract investors, or if you should first focus on some housekeeping.

2. Cash flow from operating activities

The cash flow from operating activities breaks down your company's income, which consists of regular operations over a set accounting period. Operating cash flow (OCF) looks at your accounts receivable, any depreciation on property or equipment, operating expenses, and income after financial obligations to determine your cash flow over a given period.

If you wanted to determine your cash flow from operating activities over a specified period of time, you'd want to use the following formula:

Operating profits + changes in working capital + non-cash items = OCF

Once you've completed this formula, you'll have a clear look at your cash flow from operating activities. This information will give you a holistic view of your company's finances as it pertains to decisions within your immediate control.

With this information, you can see if you need to make any changes to how you're operating. For example, if you notice a big part of your operating profits is being eaten by the cost of your building, perhaps some inventory or real estate management is in order. It's possible you have more space than you need, or that you're wasting valuable space with products that aren't selling.

3. Cash flow from investing activities

Most businesses wind up investing in one form or another. Cash flow from investing activities is any cash generated or lost through investments. Like your general cash flow, this number could be negative, indicating that you're losing money through investing. Positive cash flow from investing, on the other hand, can let you know that you’re investing in the right things.

To determine your cash flow from investing, simply do the following:

Gains from investments – losses from investments = cash flow from investing activities

Short-term losses can happen, but if you notice you're consistently losing money as a result of investments, it's time to make a change. Be sure to keep a pulse on your investing cash flow, as bad investments can quickly eat into your net cash flow and hurt your working capital.

Going with the (cash) flow

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You can't control everything in business, but with the right knowledge, you can get ahead of issues and better prepare yourself financially. By understanding your cash flow, you can rest easy knowing you have an accurate picture of your company's financial health, and you’re making the best decisions for your business. You can also begin researching and implementing best practices to optimize your free cash flow.

When you have the knowledge necessary to stay ahead of funding issues, you can enjoy being a business owner who makes decisions that positively affect your business’s finances.

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