Understanding cash flow basics, key terms and concepts

Most businesses understand the basic concept of cash flow. It is simple after all. Cash comes into a business from your clients, and cash goes out when you pay your expenses and suppliers. But is it really that easy?

If we use the ultra-popular iceberg analogy, there’s a lot more to cash flow than you think. In this article, we’re going to explore cash flow to see what lies beneath the surface. We’ll be looking at the following cash flow management fundamentals:

  1. What is cash flow: a basic definition of the term cash flow
  2. Why you need a cash flow statement: what it is and what it does
  3. How to manage cash flow: why this is important and how to do it
  4. Cash flow versus profit: understanding the difference
  5. Liquidity versus solvency: the long and short terms of cash flow
  6. How to create a cash flow forecast: the simple formula you need to know

1. WHAT IS CASH FLOW?

The term cash flow is rather self-explanatory. Put simply, cash flows in and cash flows out of a business. Monitoring the ways it flows in and out can tell you how efficiently your business is running.

The first step in getting to know your cash flow is to follow the money. Understand where it’s coming from and where it’s going. When you monitor your cash flow you’re looking at whether you can pay your bills, keep the lights on and even when it’s time to take your business to the next level. Ultimately, it’s the tell-all indicator that every business needs to keep a close eye on.

2. WHY YOU NEED A CASH FLOW STATEMENT

If you’re tracking your business’ financial health, you’ll undoubtedly be looking at a few financial statements. These will be your profit and loss statements, balance sheets and cash flow statements.

Profit and loss statements are true to their name. Put simply, they show you whether or not your business is profitable. Balance sheets are there to indicate how much working capital you have (i.e. what cash you have to spend). Cash flow statements marry the two to show you a more comprehensive view of how cash is flowing through your business. That is, where it comes from and where it goes.

Your cash flow statement also comes with the added bonus of showing you some important patterns. Patterns that tell you where you can improve your business and your profit margins. For example, where money is being spent unnecessarily or where you could spread out your expenses. It will also show you where your cash flow is constricted; through long payment terms with your clients, for example. This can help you see where external finance such as invoice finance or a flex loan could be necessary to bridge any gaps in cash flow.

3. HOW TO MANAGE BUSINESS CASH FLOW

Many small businesses underestimate the importance of this step. Tracking your income and expenses is vital to not only knowing your cash flow, but knowing your business.

Cash flow management is the process of monitoring your cash flow. And it’s easier than you think. To begin tracking your cash flow, you need to start with making cash flow statements on a weekly or monthly basis. We recommend that you start with weekly. Cloud-based accounting software like Xero, Quickbooks, and Sage all have helpful tools that will help you monitor your cash flow with ease.

4. CASH FLOW VERSUS PROFITABILITY

Once you have a handle on your current cash flow, you might be wondering what it all means. First of all, what’s the difference between cash flow and profitability? We say a business is profitable when there’s money left over after you subtract all your business expenses from your total income.

Profit is a sure indicator that your business is a success, but cash flow shows you whether or not you’re running an efficient operation. Cash flow will not only be the ticket to keeping our doors open, but it will show you where you can improve to make the best of your business.

5. LIQUIDITY VERSUS SOLVENCY

These two terms can be a little confusing but the key thing to understand here is that it all comes down to timing. Liquidity is your ability to cover your current liabilities with your current assets. Can you cover all your expenses right now? If the answer’s yes then you’re considered “liquid”.

Solvency, on the other hand, is how well you manage your business and prepare for the future. If your creditors all come knocking at once, solvency asks if you’d be able to cover these costs. In other words, liquidity is looking at your business in the short term and solvency is having a glance at the future and your business in the long term.

Both aspects are crucial when it comes to cash flow. They help you answer these questions: Is your cash flow enough for right now? Is your cash going to be flowing enough in the future?

6. HOW TO CREATE A CASH FLOW FORECAST

Once you know how to make a cash flow statement you’ll have a good idea of average and historic cash flow in your business. But what happens when you want to plan ahead and think about your solvency? When a business wants to grow or prepare for a busy season, it’s important to have an idea of what money will be coming and going in the future. That’s when you need to start thinking about how to calculate future cash flow.

To do that you’ll want to know how to create a cash flow forecast. It’s pretty straightforward once you know the cash flow formula. In simple terms, a cash flow forecast refers to the amount you expect to spend and receive over a period of time. It works like this:

Beginning cash is the capital you have in your business right now. Projected inflows are the amount of cash you expect to come in (from orders or projects you’re working on). Projected outflows refer to the cash you’ll spend to keep your business moving. That’s operational costs like salaries or rent and capital expenses like new equipment or upgrading a piece of software.

We’ve made it even simpler for you by creating a cash flow forecast template that you can download for free here. Once you’ve downloaded it you can put what you’re expecting to spend and receive in, and use it again and again.

WHAT NEXT?

Now that you’ve got the basics covered, find out what you can do to boost your cash flow.

At MarketFinance we understand how important your business is to you, and that you need healthy and reliable cash flow to make it a success. That’s why we offer quick and easy invoice finance and flex loans to help get your cash flowing when you need it.

This article was originally published in December 2019 and was updated in August 2021.