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Cash Flow Basics: Key Concepts and Terms

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Basics of Cash Flow

A majority of the businesses around the world are small businesses. According to OECD data, the figure is 99%. Another thing they have in common is cash flow problems. Regardless of whether a business is in an advanced economy, emerging area or somewhere in between, cash flow and cash flow basics are a universal lifeblood and stumbling block.

In the United States alone, most small to medium-sized businesses (SMEs) only have enough cash on hand to cover 27 days of normal costs of doing business. Even the superstars, the top 25% of SMEs only have two months of cash reserves to fund their businesses.

We don’t believe that any SME ever intentionally overlooks its cash flow basics. It’s just matter of finding the right resources to explain the concepts and the best tools to manage financial health.

That’s why we’re providing an overview of some of the basic cash flow concepts and terms. It’s not a glossary so the words won’t be in alphabetical order. Instead, they’ll be grouped by concept in order to add context to each explanation.

Cash flow basics 101 — A definition of cash flow 

In its simplest form, cash flow is the amount of money the comes in or out of a company. A primary indicator of financial health, cash flow shows how efficiently a business is running and if that business is able to pay its bills and keep the lights on.

A business that’s cash flow positive has enough money available to meet its current and most-pressing financial obligations. A business that’s cash flow negative has more debt than income and might struggle to meet its financial responsibilities.

There are instances where a company is cash flow negative and is doing so intentionally, such as going through a launch or investment phase. However, in most cases, unless it’s planned or managed, most businesses would prefer to be cash flow positive.

Inflows, outflows and everywhere your cash goes

Income earned through sales, assets that can easily be converted into cash and funding, are called inflows. Cash used to pay for expenses and investments are referred to as outflows.

Some more cash flow basics every business should know are the difference between recurring cash flows and one-time cash flows.

recurring positive cash flow is a predictable, reliable income source, like retainer or subscription fees billed to customers, while recurring negative cash flow is a consistent expense, like payroll.

one-time positive cash flow (sit down for this) is a singular influx of cash. One example would be cash from the sale of equipment, land or facilities. A one-time negative cash flow would be a large purchase or expense, such as an insurance deductible for flood damage.

In the same vein, a fixed cost is something like leasing costs for office or retail space. No matter how many widgets you sell, you’re still paying a set rate for your kiosk. This is another shocker: A variable cost changes. These are things like fuel, utilities and raw materials.

Long story short, in most cases, you want your recurring positive cash flows to be greater than you recurring negative cash flows. You also want to be aware of your fixed costs and do as much as you can to control or plan for changes in variable costs.

Get more tips: How to read a cash flow statement.

A cash flow statement explained

There are three fundamental financial statements for tracking and measuring a business’ financial health:

  • Cash flow statement (statement of cash flows)
  • Profit and loss statement (P&L or income statement)
  • Balance sheet (statement of financial worth or net worth)

As per its name, a profit and loss statement compares revenues against costs and expenses to determine if a company is profitable. A balance sheet compares what a business owns to what it owes in order to indicate the amount of working capital, cash reserves available to cover near-term commitments and recurring expenses.

cash flow statement brings information from the profit and loss statement and balance sheet together by analyzing the flow of cash through the company in terms of day-to-day operations, capital investments and financing activities. (This is one of those cash flow basics to remember.)

  • Operational cash flow literally includes all the nitty gritty expenses (labor, inventory, etc.) that go into making and offering the goods and services a business provides.
    • It also includes accounts receivable and payable (ingoing and outgoing invoices).
    • Current assets and liabilities are two key terms related to this concept.
      • Current assets (counted as part of your inflows) include your cash on hand and any assets that can be quickly sold to generate cash within 12 months.
      • On the flip side, current liabilities (tracked as outflows) are your expenses that must be paid within 12 months.
    • Investment cash flow represents the purchase of long-term assets, like buildings and equipment.
    • Cash flow from financing activities is the money that comes from loans or lines of credit. Depending on your business model, this can also include investors.

Every business financial statement has a specific function. What a cash flow statement does differently is that it helps identify patterns in terms of how and when money is coming into or leaving a business.

Publicly traded corporations have to share their cash flow statements. The average small business doesn’t. Instead, for SMEs, its cash flow basics and measurements are vital financial management tools.

While business models and structures vary, most SMEs will pay the most attention to operational cash flow as part of their cash flow analysis and forecasting.

The direct versus the indirect method of reporting cash flow 

The difference between cash and accrual accounting and how each one calculates net income lies at the heart of the direct and indirect methods for reporting operational cash flow.

Operational cash flow is singled out because it’s the main areas affected by differences in how inflows and outflows are tracked. Warning: It’s a little dry for the next few paragraphs, get ready to skim…

  • Net income is the total amount of money a company has left once all other expenses are taken out.
  • The cash method of accounting tracks income and expenses as they take place.
  • The accrual method includes future income and expenses before they’ve actually hit the company’s books.

Businesses that use cash-based accounting are able to easily use the direct method. This is because they’ve already tracked the actual cash movements in and out of the business as part of the net income.

As most small businesses use the accrual system, the indirect method requires that flow of cash be added back in when net income is entered into the cash flow statement.

When you use the indirect method, you have to account for the actual amounts that come in and out, like accounts receivable (money coming in from customers) and accounts payable (the money you owe to others).

And that’s more detail than you probably ever wanted to know about the direct and indirect method. (So much for just cash flow basics.) Big picture: Whether you scramble or poach your eggs, in the end, you’re still eating eggs.

If you’re curious, when you request a free cash flow forecast from ForwardAI Predict, we use the indirect method in our calculations.

Cash flow management and monitoring — the basics

One of the cash flow basics that every overview should cover is all the terms that relate to management and monitoring. Cash flow management refers to the entire process of monitoring your cash flow from the creation of cash flow statement to analyzing the results.

The process starts by creating a weekly or monthly cash flow statement. Once the statement is complete, you can perform a cash flow analysis or deep dive on the numbers.

Cash flow forecasting (cash flow projections) are the inferences and predictions drawn from the regular creation and analysis of cash flow statements. A cash flow forecast is a report that contains these interpretations.

Then there’s a cash flow budget that compares the projections in a cash flow forecast with the actual numbers reported in your cash flow statements.

When you bring all these details together to determine how much cash moves in and out of your business and when it happens, you have a cash flow cycle (cash conversion cycle).

It’s sort of like a Russian nesting doll with the cash flow statement as the smallest doll and forecasting and budging being the next sizes up. Each level of detail and analysis builds up to create a larger whole.

Learn more about cash flow and financial health. 

Cash flow versus profitability — what you really need to know

The more you read about cash flow and cash flow basics, the more you’ll see discussions on the difference between cash flow and profitability.

What you need to know is that profitability just means that there’s money coming in. On the other hand, cash flow shows the money coming in and going out. Cash flow helps you determine your break-even point when the amounts coming in equal the amounts going out.

Profitability is only one side of the coin. A business can be making money, but money can also be leaving a company at a rapid or unexpected rate. It happens — more often than anyone would like.

Here’s an example: Jane’s bakery, Cake-and-Bake, is extremely popular. She’s got so many orders, she can barely keep up. Since business is booming, she bought a few more industrial mixers and hired more staff.

What she didn’t do was project was how much cash was coming in from the current and future orders — before buying new equipment and hiring more people. The result: She went too far beyond her break-even point. She found herself low on dough (pun alert) because the cost of the mixers and the new staff members was more than amounts coming in from existing orders.

Short-term liquidity versus long-term solvency 

Liquidity and solvency are often mentioned together, especially in discussions on business financial health. The key takeaway is that liquidity is a short-term measure of your ability to pay your bills.

Solvency is the long-term measure of your ability to keep your company running over time. It’s often used as an indicator of the overall viability of your business model.

Most areas within a cash flow statement and forecast focus on liquidity. This is especially true for operational cash flow, where most of the current assets and liabilities are tracked.

Solvency is often evaluated in terms of debt levels and equity (primarily recorded in cash flow from financing activities). It measures how much ownership the company and its founders have retained in comparison to outstanding loans and/or investor and shareholder agreements.

Take a bow… you’ve just covered some of the basics of cash flow.

It wasn’t that bad, was it? One more concept that’ll change how you see your cash flow basics is automation. You don’t have to build spreadsheets or toil away endlessly to create cash flow forecasts. With ForwardAI Predict, you can use the information you already have in your accounting software to create easy-to-read cash flow forecasts.* Learn more and get started today.

This article is for informational purposes only and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.


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