Imagine that over the course of a given month, your small and young wholesale company has a sales volume of $50,000. You’re relatively new, so you’re pretty proud of those sales! At the beginning of the month, you estimate your costs in rent, payroll, and raw materials at about $46,000.
So that’s $4,000 in profit, right? So you’re profitable! You broke even! Go you, new business owner!
But wait. A few of your bigger clients are other businesses, for whom you had to send invoices for some of that $50,000. Out of those, not every customer paid up immediately. For yet a few more sales, you’re still waiting for payments to process through the credit card company—so that money hasn’t actually hit your bank account. By the end of the month, you actually have a cash inflow of $45,000, with $5,000 in receivables still outstanding.
Now, in a single month, for that one snapshot in time—spending $1,000 dollars more than you made seems like no big deal. And in many cases, it really is no big deal!
But what if that’s happening every month for 3 or 5 or 10 months in a row? What if, over time, $1,000 turns into $5,000 or $10,000? Okay, now that sounds like a problem.
Then again, what if you know that at the end of the year, a big client was going to come through with a payment on a very large contract covering all that extra cost? The contract is signed, the client has a great payment history… You’re going to make a huge profit! Great! Problem solved, right?
Well, not exactly. Because if you can’t afford to cover your rent and pay your employees until then, your business might not actually make it to the end of the year.
As you’ve heard time and time and time again, “it takes money to make money.” In order for your business to operate, you need money in the bank to pay your employees, purchase inventory or raw materials, and cover all your other operating costs. To do this, you use either working capital that’s been invested in your business or the money you’ve received from sales and receivables.
The problem comes in when an otherwise healthy company—one that makes more money that it spends, with a high demand for its product or service and a strong volume of growth—struggles with the timing of expenses relative to sales. Even if the long-term financial trajectory of your business is strong, you can quickly get into hot water if you run out of cash by spending more in the short-term than you’re bringing in.
So while it’s true that—like in our example above—a single instance of negative cash flow might be no big deal, consistent patterns of negative cash flow can be the downfall of an otherwise successful company.
Many newer business owners hear the term “cash flow positive” and assume it means the same thing as profitability or “breaking even.” However, while the two terms are related, they’re not actually the same thing.
As it turns out, you can be profitable without being cash flow positive—and you can be cash flow positive without being profitable!
When you hear the term “cash flow,” it’s referring to the total amount of cash that’s being transferred in and out of your business. In order to be cash flow positive, you need to have more money coming into your business than is going out at any given time.
Profitability, on the other hand, measures a bigger picture number. Your profit is what you have left after all of your expenses are paid.
At the end of the year, did your business make more money than it spent? If so, you’ve turned a profit for that fiscal year—but you might’ve done so even while having several scary bouts of negative cash flow at various points throughout the year.
Calculating your business’s cash flow tells you where your money is coming from, where it’s going, and how the timing of your inflows and outflows of cash work together.
If you’ve never calculated your cash flow before, start with our free cash flow template to help with your analysis.
At the very top, you’ll list the cash on hand at the beginning of each month. If you have multiple business bank accounts, add up all of the accounts that you have for your total cash on hand.
If you’re trying to look at your historical cash flow—that is, how cash has moved in and out of your business in the past, rather than a projection for the future—you might be able to use your past bank statements to do so. Many bank statements include a column showing the bank accounts balance after each transaction. Start with the balance after the last transaction in a given month to determine the starting balance for the following month.
Next, you’re going to fill in your cash inflows and cash outflows—or in other words, you’re operating activities, investment activities, and your financing activities. The trick here, though, is to remember that we’re talking about cash—not invoices or purchases.
If you send an invoice to a client in June, but it isn’t paid in September, you’ll mark that as “collections on accounts receivable” in September. Similarly, if you pay for a purchase on a business credit card in April, but don’t pay the credit card statement including that purchase until May, you’ll mark the expense in May for the purposes of the cash flow statement—because that’s when the cash outflow actually took place.
After you input all of your cash inflows and outflows in a given month, if your closing balance (in the last row) is higher than your opening balance (first row), your cash flow for that month is positive. If it’s lower, your cash flow is negative.
For the sake of illustrating the difference between these two, let’s do a quick refresh on calculating your business’s profitability.
There are two steps to calculating the profitability of your company. The first step is calculating your gross profit, which is your revenue minus the cost of goods sold.
So let’s say you own a bakery and brought in $50,000 revenue for the month of May, but the baking supplies cost you $25,000: your gross profit would be $25,000.
Revenue — Cost of Goods Sold = Gross Profit
Cost of Goods Sold: -$25,000
Gross Profit = $25,000
Of course, unless you’re selling your baked good out of your mom’s basement, you know that your baking supplies aren’t the only costs of running and managing your bakery. You also have your operating expenses like rent, equipment, payroll, marketing, which brings us to the second step: calculating your net profit.
Gross Profit — Operating Expenses = Net Profit
Cost of Goods Sold: -$25,000
Operating Expenses: -$15,000
Net Profit = $10,000
When you compare these two calculations side by side, it becomes a lot clearer that simply calculating your profit doesn’t show the whole picture of how your business is doing financially. Because profit doesn’t tell you when those inflows and outflows of cash are occurring, it doesn’t serve as a day-to-day indicator of your business’s financial well-being.
Profit doesn’t tell you if you’ll make payroll next month. It doesn’t tell you whether you can purchase a new batch of inventory. It doesn’t warn you that you could be instantly broke the minute the tax bill comes in. So while profit is an important measure of success, it tells you nothing about survival.
As we previously discussed, your income statements don’t show your entire business, so even if you’re showing profit on paper, you may not have enough money to pay your bills. That’s where cash flow management comes in.
By properly managing your cash flow, you’re getting a significantly more accurate read on the financial health of your business. Your budget is simply an estimation of the cash inflows and outflows of your company. And an estimation, as you know, is just that: a rough sketch. Your cash flow projections, on the other hand, can tell you exactly what’s happening—so you can prepare accordingly.
To make sure your cash flow forecast is as accurate as possible, analyze your business indicators, estimate your sales booking timeline, understand your budget, be a diligent collector, and of course, be sure to regularly maintain and update your forecast.
Properly managing your cash flow will benefit you in multiple ways, but one of the best things it can help you do is be prepared. Things would be a lot easier if your cash inflows and cash outflows were the same each month, but both unfortunately and fortunately that is not the case.
If you own a seasonal business, you can start to identify certain patterns in your cash flow fluctuations. You might notice that, during a few months out of the year, your money is extra tight. But by managing your cash flow correctly you can prepare for this lull of cash and avoid coming up short when the bills are due.
There’s nothing more stressful than running into money issues—especially if you’re an entrepreneur who’s looking to grow a successful business. You’ll be able to reduce these anxieties, not by letting things happen naturally, but by taking control!
If you’re keeping track of the money coming in and going out of your business, you’ll be aware of when your bills are due, and you can predict and prepare when you’re going to have a cash flow shortage. You’ll be able to relieve the anxieties of the unknown and to sleep easily knowing that you’re prepared for what’s to come.
If you’re applying for a small business loan, one of the first things a lender will look at is the health of your company’s cash flow. This shouldn’t surprise you, since a lender’s main objective is to make sure you’ll be able to pay back your loan. Show them you can properly manage your cash flow and they’ll be much more likely to trust you.
As a lender knows, unexpected costs pop up—so if your margins are too tight, they’ll be reluctant to offer you a loan. Of course, you should always plan to have a little extra padding in your bank account, especially for this reason (wink, wink).
Part of the profit a business earns will typically go right back into the business to help out with growth. But as you know, even if your Profit and Loss Statement is showing you made a profit on a given week or month, you might not have that money in hand just yet.
By keeping a close eye on your cash flow, you’ll know exactly how much money you currently have on hand and how much you have coming in. This way, you always know exactly how much money you have to set aside for growth.
By now, you’ve already learned how to use our cash flow projection template to track and project your business’s cash flow. But what happens if you don’t like what you see?
There are a few different things you can do to manage your company’s cash flow in order to avoid a dangerous scenario. Let’s take a look at the options you have available.
Before you do anything else, the first pillar of positive cash flow is that you should always be prepared for the worst. If you do have a negative cash flow situation in a given month, you don’t want that single fluke to permanently damage your business! That’s why it’s so important to have some amount of cushion in place in your cash on hand.
In the cash flow template, use the “cash balance alert minimum” as a guide for your intended cash flow cushion. This way, the document will call to attention if you’ve dipped into your cushion and hit a dangerous cash flow situation. Most accountants recommend at least one month’s operating expenses as an available cushion. But if you need a smaller starting point, aim to always have enough cash on hand to at least cover the next payroll period.
As you filled in your cash flow template, it might have quickly become glaringly obvious that accounts receivable is one of the biggest cash flow challenges your business faces. “But wait!” you say to yourself, “I did all that work in June! You mean it didn’t do anything for my business until the client finally paid up in September?!”
Unpaid invoices are known to be among the biggest cash flow killers out there—particularly for small B2B businesses, who are the most likely to suffer delayed payments from their business clients. Without being proactive about collecting payments from your clients, you could quickly be on the way to a dangerous cash flow situation.
But there are things you can do to increase your chances of getting paid faster for the work that you do.
First, the basics: follow up on invoices with payment reminders at 30, 45, and 60 days. Implement late penalties on your invoices. You might even consider offering discounts for clients who pay early!
Then, consider the convenience factor. Are you still mailing a physical invoice, then waiting for clients to process that invoice and mail you a check every month? That’s a lot of extra lag time, and it’s all avoidable if you go digital instead! Use an accounting software like Freshbooks to send invoices over email, and even set up online payments and auto-pay functions for retainer clients. Don’t underestimate the value of making it easy and convenient for customers to pay up.
But even if you have a strong cushion and are managing your receivables, you still have to pay attention to the flow of cash leaving your business. Are you spending big money on inventory during months when you’re not selling much product? Do you have more employees on staff than you have the work to support?
Go back to your cash flow projection and look for line item expenses that are disproportionate to your sales. What are ways that you cut back or wait to spend that money when you actually have it on hand?
In some cases, the answer might simply be that you’re spending more on various one-off expenses than you can afford. Those “petty cash” costs can add up quickly to damage your cash flow. (Yes, even the tax deductible ones!) So make a budget for your day-to-day expenses and stick to it.
For many businesses, April can be the ugliest month of the year from a cash flow perspective. You work with your accountant, your return is ready to file, and… “Wait. We owe all that?”
If you find yourself surprised by your tax bill, one of two things can happen. Either you have the cash on hand to pay the bill but it totally kills any cushion that you had, or you wind up paying severe penalties to the IRS or your state government for back taxes. And no one wants either of those!
Avoid a windfall of expenses each April by calculating and paying estimated income taxes to the state and federal authorities every quarter. Consider opening a secondary checking account for your business, and earmark a set amount of cash each month to be paid in as quarterly taxes. By making more frequent payments and setting cash aside for those payments monthly, it won’t hurt quite as much to see all those hard-earned dollars go out the door in taxes.
Quick Tip: If your business is in a high growth mode, remember to take that into account as you calculate your estimated taxes. If your revenue increases 75% year to year—chances are, your tax bill will increase accordingly!
Managing cash flow can be particularly tricky for seasonal businesses, for whom revenue varies dramatically at different times throughout the year. If you still have to pay for rent, essential personnel, and other expenses at times of year when there’s little to no money coming in, then it’s easy to understand how that can turn into a scary cash flow situation—and fast!
For this reason, seasonal business have to work even harder to plan ahead, hanging onto enough cushion during high sales seasons to cover operating costs throughout the year—and even to pay for inventory or personnel in preparation for the next busy season.
However, for many seasonal businesses, simply planning ahead isn’t enough. If you’re in a seasonal business and struggling with cash flow, are there any alternative sources of revenue that you could pursue in the off season?
For example, a Christmas tree farm might double as a wedding venue in the summer. A swim school might use its instructors to provide tutoring services during the school year. Your second source of revenue might be almost completely outside the traditional services you provide. Don’t be afraid to think outside the box!
While redirecting your business to be cash flow positive is certainly possible, it’s not an overnight process. There’s no magic formula or switch you can flip to suddenly get back on track.
Becoming and staying “cash flow positive” is a long-term business journey. (Get it? That’s why we made you this roadmap!) But if you’re paying attention, tracking as you go, and making corrections as needed, you’ll eventually reach your destination.