Cash Management · June 23, 2020

Why Managing Cash Flow Is a Critical Skill for Business Owners

Keeping your business thriving is about more than profitability. It's also about the day-to-day financial operations. For example, you need to pay your key suppliers on time in order to deliver your product or service to your customers—and a business might be profitable for the month or quarter but not have enough cash on hand for a particular week.

How is this possible? It all comes down to managing cash flow. Let's take a closer look at the concept and highlight what business owners need to know about it to ensure success.


What is cash flow?

Cash flow refers to the amount of cash that comes into and out of a business during a specific time frame. With a positive cash flow, more money is made than spent. Negative cash flow indicates more money is going out than coming in.

Cash flow has three sources

There are three different types of cash flow. When you hear companies say they're cash-flow positive, they're referring to operational cash flow, which is critical to long-term success. This is the cash that a company generates or loses from actual day-to-day operations.

The money generated or used in investing activities is called investing cash flow. This encapsulates how much a business spends on acquiring assets, like equipment or buildings, and how much it generates from selling assets. Financing cash flow is what your business receives from loans, outside investors or cash infusions from owners. It also accounts for the money spent on principal payments, paying off investors or distributing earnings to owners.

Know what impacts your cash flow

How quickly your customers pay has a major impact on your cash flow. That's why it's a good idea to be careful about to whom you extend terms. If you offer 30-day terms but your customers typically pay late, you may be waiting 45, 60 or 90 days for payment. Implementing and consistently enforcing a good credit policy will help ensure you extend terms only in cases where it makes fiscal sense.

How soon you pay your bills also has a huge impact. To be cash-flow positive on a weekly basis, your inflows must exceed your outflows each week. That means you need to time your bill payments with your customer receipts. You could also use credit cards for any accounts without terms, giving you additional time before you need to use company cash.

How to calculate your cash flow

So, how does this all work in practice? Let's say you provide marketing services to other firms and outsource the graphics work. You pay one employee $1,000 for a week of work and an independent contractor $750. If you invoice your client $2,500 and they pay 30 days later, you had negative operational cash flow of $1,750 for at least three weeks. This means you had to use a line of credit or other source to cover the cash gap, despite making $750 before overhead.

However, if you paid the independent contractor in 30 days, the negative operational cash flow is $1,000. In this case, you matched the timing of your bills—your payment to the independent contractor—with your receipt of cash. Alternatively, if you required pre-payment of 50%, or $1,250, and paid the independent contractor in 30 days, you would have had positive cash flow of $250 over that three-week period.

That's a significant difference in how much cash you have on hand to invest back into your business.

Forecast your cash flow

According to CB Insights, 29% of failures among new businesses occur because they ran out of cash. This won't be an issue for you if you look at what's happening weekly and forecast that out over 12 weeks. This longer time period gives you significantly more time to come up with options and figure out how to generate or access more cash. If you're aware 10 weeks in advance that you won't have the cash to cover payroll, you have time to pursue alternatives. You could request deposits or pre-payments on large orders, collect from late-paying customers or negotiate extended supplier terms.

Managing cash flow is a skill you can hone with practice. Not only will having this tool in your toolkit ensure you have the funds to operate your business, it'll also eventually reduce your reliance on outside financing and help you manage operations efficiently.

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This information is provided for educational purposes only and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. First Citizens Bank (or its affiliates) neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.