A Basic Lesson in Cash Flow Management
As business owners, we all know it's true: Cash is king! Without it, your business couldn't survive. That's because you need cash to operate and grow your business. How else will you ensure you're able to purchase supplies, pay your rent, advertise, hire employees or take care of the myriad other business activities that require money?
Cash flow is the lifeblood of any business, and it's imperative that you understand the inflows and outflows accordingly. So let's take a closer look at just how cash flow works:
Cash is generated into a business through:
- Sales of your product or service
- Loan or credit card proceeds
- Asset sales
- Owner investments
Cash flows out of a business through:
- Business expenditures
- Loan or credit card principal payments
- Asset purchases
- Owner withdrawals
These cash inflows and outflows can be categorized into three main business parts:
- Operating, which covers sales and business expenditures
- Investing, which covers asset sales and purchases
- Financing, which covers loans payments and proceeds, and owner investments and withdrawals
Ideally, you should be generating the majority of your cash flow from operating activities, that is, the sale of your products or services. This is critical for the long-term success of your business as the other two aspects--investing and financing--aren't viable ways to manage and grow your business.
Operating activities generate cash inflows and outflows through the sale of your products and services and the purchase of supplies and other general business expenditures. Operating cash flow reflects the daily activities of your business. There will be times that cash inflows and outflows are generated through investing or financing activities, but these are supplemental aspects.
The generation of cash flow from investing activities relates to the purchase and sales of your fixed assets (for instance, your property, plant or equipment). Financing activities generate cash inflows through the investment of money into the business by owners or lenders, such as loans and credit cards. When you pay off the principal of your loans and credit cards, you're then causing a cash outflow related to financing activities. (The payment of the interest on the loans and credit cards is classified as an operating activity.) When the owner invests or withdrawals money from the business, it creates a change in their equity and is associated with financing activities.
It's important to understand how the inflows and outflows of your business reflect the health of your company. There are times when you may want to generate cash flow from investing and financing activities. But for the long-term success of your business, you must be generating sales and therefore creating cash flow from your operating activities.
You can easily create a cash flow statement by simply taking into account all your business inflows and subtracting your cash outflows to equal the net change in your cash for any given time period, usually monthly basis. If you don't want to do it manually, one of the simplest ways to generate financial statements is to use an accounting software package.
Cash flow projections should be a part of your budgeting process to ensure that you're being proactive in managing your business. If you don't understand the basics of cash flow for your business, you may find yourself in a cash flow crunch where you're waiting for payments from clients but are still expected to pay your operating bills. That's especially important if you have a lot of sales on account: Then you have to have enough cash on hand to cover the daily bills until your clients pay you. This isn't an easy situation for a business to be in, which is why it's vital that you understand when you have cash flowing both out of and into your business.
It's really very simple: Understanding where your cash is coming from and going to is a critical part of smart business management.