Of all the factors that make a business successful, cash flow is perhaps the most critical. With a strong enough cash flow, even a struggling business can usually continue to trade for a while; long enough, in some cases, to turn its fortunes around.
Cashflow is the movement of money to and from a business
Cash flow can be summarised simply as the movement of money into and out of your business. It is distinct from cash (which is the amount of money you have on hand) and profit (which is revenue minus expenses). To explain further:
Cash is all of the money a business has on hand, whether it is money in the bank or milk change in a tin by the coffee machine. Some short-term, highly liquid (i.e. readily and easily saleable) assets can also be considered cash. Whether a company’s cash balance grows, shrinks or remains level will depend on its cash flow.
Profit, or net income, is a business’s earnings (revenue) minus the amount spent earning it. Net income is probably a better term as the word profit implies a positive figure; if a company spends more on operating costs, stock and tax than it earns, it is in fact making a loss.
Profit is recorded whether it has been realised or not. Your customer’s payment might still be sitting in their bank account, and the company’s tax bill might not be due for another six months. This means that profit cannot be spent in the way that cash can. In other words, a profit that you’ll realise in March is no good if you need the money in January.
This is why cash flow is important. Cash flow is the money moving through a company at a given time. Accounts receivable will be recorded in a profit and loss report for a period, but only cleared payments can be considered in cash flow calculations. Expenses payable will be recorded under P & L, but only expenses paid count as cash flow.
In one month, a business sells stock worth £5,000. The cost of purchasing, storing and shipping the stock was £3,000, meaning the month’s profits are £2,000.
However, the customers who bought the stock did so on credit, and won’t pay until the following month. This means that cash flow for the month is currently negative: cash received (£0) less outgoings (£3,000) is minus £3,000.
If this were a normal month, the company would likely have sales revenue from the previous month coming in. But if it was the company’s first month of trading, it would need to find another source of finance for the purchase of the stock in order to ensure that it had adequate cash flow.
Cash flow is arguably more important than profit, particularly for a smaller company, because without access to the money needed to fund vital operations even a profitable business will run into difficulty. This is why recording your cash inflow and outflow is essential.
Cash can be injected into a business in one of three ways: investments, brindging loans, revenue and other finance Interest on investments and savings also contribute to cash inflow. A lot of cash flow problems arise because a business has insufficient backing, has trouble securing finance, or has difficulties chasing down payments from clients.
Imagine that, as a rule, your company typically invoices clients within seven days. Now imagine that you change that period from seven days to 14. All of a sudden, an extra week’s worth of profit is not coming in until next month. Your cash inflow shrinks, and you have less money to pay rent, wages and other monthly expenses, which eat into your cash balance. Suddenly, your cash balance is negative.
Your company is still just as profitable as it was, but you do not have enough cash on hand to pay vital business expenses. You can’t reduce expenses, because they are existing commitments. You can’t sell goods or property, because the sales will take a while to realise. You are in a very sticky situation.
Such stories are common, and highlight perfectly the importance of cash flow. If you had planned for this change and calculated ahead of time how it would impact your cash flow, you could have prepared by securing from elsewhere the finance needed to keep your cash balance in the black and ensure that your business continued to run smoothly.
Cash can leave a business in many ways: rent and bills on your commercial premises, repayments to your creditors, hiring or purchase costs for equipment and stock, salaries for your staff, dividends for your shareholders… the list goes on. What is crucial is that the cash inflow meets all of these costs.
Positive balance sheet
If your cash inflow exceeds your cash outflow, your overall cash flow is positive – a very good position to be in. It means that your cash balance will go upwards, and you will be able to finance further investments and growth.
Should you have inert cash in a business?
Holding onto too much cash is not considered desirable, because inert cash will not earn money in the way that invested cash can. Nevertheless, it is ideal to have enough cash to cover all of your capital expenditures, plus some extra for emergencies. How much this is will depend on a number of factors, including how ‘capital intensive’ your business is (companies that rely on a lot of equipment often need to replace it, requiring additional outlay at occasionally unexpected times) and the strength of your industry as a whole.
Is it possible to predict when a business might need cash?
The key to good cash flow management is to know ahead of time when you will need extra cash, both in the short and long term. This means creating and sticking to a sound business plan and regularly reviewing it so that it remains in line with your goals and the general performance of the market in which you operate.
If you are experiencing difficulties managing cash flow and require a short-term boost to your funds, you might consider a bridging loan which is short-term secured finance which are designed to be turned around quickly, allowing individuals and companies to access funds within a matter of days.
If you would like to discuss applying for a bridging loan with one of our advisors, request a quote or get in touch using either of the numbers at the top of this page.
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