Taking the entrepreneurial plunge? Remember, cash flow is king

Small business owners run into it time and time again. Sales are up and profits are good, but they don’t seem to have any money. Often they learn the hard way – cash (or in this case, cash flow) is king. To understand how this can happen, you should understand the difference between profit and cash flow:

Profit is the difference between income and expenses. Income is calculated at the time the sale is booked, rather than when payment is received. Likewise, expenses are calculated at the time the purchase is made, rather than when you pay the bill.

Cash flow is the difference between cash inflows and outflows (actual incoming and outgoing cash). Income is not counted until payment is received and expenses are not calculated until payment is made. Cash flow also includes infusions of working capital, either from investors or debt financing.

There is a simple analogy that just about everyone can understand – a checkbook. Cash flow is often calculated the same way a checkbook registry is handled. When the money is deposited in a checking account, it’s logged in the registry. When a check is written, it’s logged again. However, if one were to log a paycheck prior to actually depositing it, and worse, actually wrote checks against it … well, you get the idea.

Additionally, if one were to charge an expense on a credit card, it wouldn’t change the amount of money in the checkbook until after the credit card bill was paid. In the same way, debt for the business doesn’t change the actual cash flow for the business until after the debt is paid.

The same thing can happen at a small business, especially if the accrual accounting method is used or the business offers any payment terms. Most of a business’s cash outflows, like rent and payroll and vendor invoices, are fixed on a monthly billing cycle. Cash inflows or sales aren’t quite that fixed. So when it comes time to pay the bills, small businesses may find that they don’t have quite enough cash on hand, although their income statements look healthy.

Cash flow budgets

A monthly cash flow statement reveals the current state of affairs. A cash flow budget is a core tool in maintaining control over company finances and an apt measurement of the financial health of any business. Developing a cash flow budget isn’t that difficult, either.

There are four basic elements in a monthly cash flow budget:

  • Starting cash, or what you have on hand at the beginning of the month.
  • Cash inflows, or all the cash received during the month, including sales, paid receivables, interest, or cash from sales of assets or stock.
  • Cash outflows: All fixed and variable expenses, plus additional long-term asset purchases such as machinery and equipment.
  • Ending cash: This is calculated by adding starting cash to cash inflows for total cash, and then subtracting cash outflows.

Your ending cash figure is carried forward as starting cash for the second month. Remember, cash inflows and outflows are recorded in the month that they transpire. Debt, accounts receivables, and payables are not logged. Simply put, cash in and cash out. Certainly, there are several software packages that make this even easier, but a simple Excel spreadsheet can do the same thing.

The bottom line is this: Only a positive cash flow will allow a small business to prosper and grow. Even a small decrease in sales can have a powerful impact on cash flow. By keeping an eye on the bottom line, businesses of any size are much better able to go with the flow.

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