Resource Corner

The Business Owner's Guide to Cash Flow

Learn why cash flow is the lifeblood of small business, making it vital for small business success.
Paper icon with text

Cash flow is the lifeblood of your business, and recognizing its importance is vital for your success.

Since healthy cash flow helps ensure you have the cash coming in to cover your operating expenses, it makes up a central component of your business’ financial health. The ability to effectively manage your cash flow also puts you on track to reach your longer-term business goals. Strong cash flow means you’re more likely to have the cash on hand to address challenges as they arise.

In this article, we’ll delve deeper into what cash flow is and what it means for your business, what healthy cash flow looks like, and strategies to manage your cash flow to support your goals. 

What is cash flow?

In its simplest form, cash flow is the amount of cash and its equivalents coming in and going out of your business over time. 

Outflows are what’s going out, including your expenses — such as employee salaries and debt payments — and inflows are what’s coming in, including revenue from sales, royalties, or investments.

A business is cash flow positive when the inflows exceed the outflows. Conversely, a business is cash flow negative when the outflows exceed the inflows. 

Why cash flow matters

First and foremost, cash flow tells you about the financial health of your business. 

If businesses don’t know how to manage their cash, they may not know how to manage a shortfall — or they may find themselves in a shortfall without realizing it. 

As a result, business owners without a strong understanding of their business’ cash flow risk relying on debt to remain in operation. They may have difficulty creating budgets without a firm understanding of the cash flowing in and out, and risk running out of the liquidity they may need to achieve their milestones. 

On the other hand, maintaining positive cash flow sets your business up for success. Over time, it helps create a cash buffer to help businesses weather rising costs or economic uncertainty, and enables business owners to re-invest in the company and fuel growth.

Regularly analyzing cash flow can also alert business owners to a change in the business. By identifying a reduction in cash flow early, business owners can investigate the problem and act accordingly — before a cash flow problem undermines the business.

Finally, a firm understanding of the business’ cash flow is often essential to secure business financing. Lenders look at a business’ cash flow statement to assess their creditworthiness — and strong cash flow may signal to lenders that you’re likely to pay them back. As a result, business owners may be more likely to be approved for financing, and may be able to secure financing at a favorable interest rate. 

What does healthy cash flow look like?

The “right” cash flow depends on your goals and the stage of your business. 

Early on, many successful businesses may operate with negative cash flow as they aggressively invest in operations to lay the foundation for future growth. Highly seasonal businesses may find their cash flow ebbs and flows throughout the year, with positive cash flow during peak seasons and negative cash flow during off seasons. 

However, healthy cash flow generally means that the business earns more than it spends — and established businesses should generally operate with a net positive cash flow. 

Factors that contribute to a healthy cash flow include:

Collecting payments on time

Ideally, all your customers pay on time so you’re not worrying about how to fund your expenses or your next investments. The later a customer pays, the more it contributes to an unstable and potentially unhealthy cash flow because you may need to find other funding sources. It could also mean paying for additional expenses such as overdraft fees or late fees from vendors in the event your business cannot make payments on time.

To improve your cash flow, you want to lower the amount of time you collect money, or the average number of days you collect payments. A common formula to use is DSO (Days Sales Outstanding) or AR (Accounts Receivable) days on hand. 

Business owners can lower their DSO or AR days by encouraging customers to pay earlier. They may negotiate more favorable payment terms — for example, negotiating payment from 45 days to 30 days — impose fees or penalties on customers who pay late, or offer a slight discount for customers who pay upfront or early. 

Having enough cash to pay vendors and expenses on time

Accounts payables, or the amount you need to pay for your expenses, can wreak havoc on your cash flow if you don’t have enough cash on hand. You want your DPO (Days Payable Outstanding) or AP (Accounts Payable) days on hand to be longer than your DSO so that you can ensure you have enough cash by the time your bills are due.

For example, if your DPO averages 45 days and your DSO is 60 days, then you have a shortfall of 15 days. In other words, the business has a 15-day gap between when it has to pay vendors and when the business gets paid.

To improve your cash flow, you want to make sure your DPO is less than your DSO.

You want to be in a position where you collect funds prior to being obligated to pay. For example, you may negotiate terms with clients that allow you to collect payments within 30 days, but negotiate terms with lenders and suppliers that allow you to pay debts or expenses at 45 days.

How to analyze your cash flow

Proactively monitoring your cash flow helps you safeguard your business from potential challenges, and business owners should check in on their cash flow regularly to assess the business’ financial health.

To help you analyze aspects of your cash flow, consider asking the following questions:

  • What are my plans if cash flow is negative?
  • How can I lower DSO? Is it possible to increase DPO?
  • Does my business have more access to funding if needed?
  • Are my cash flow numbers accurate?
  • Is my business earning more than it is spending?
  • How can my business increase profit margins?

To learn more about where your business stands or to help you get answers to these questions, contact us to receive a complimentary comprehensive cash flow analysis. 

All content is for informational purposes only and does not constitute legal, tax, or accounting advice. You should consult your legal and tax or accounting advisors before making any financial decisions.