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Businesses can't operate without working capital, and working capital dries up without a positive cash flow. While it seems logical that companies can't spend money they don't have, a deeper explanation is needed to foster a better understanding.
Cash flow and profitability aren't the same thing. The timing of incoming payments is crucial. Businesses may receive payments at the end of the month, but when inventory needs replenishing three weeks before payments come in and there's no money to pay for it, there's a big problem. Let's go more in-depth to get the best possible understanding of cash flow.
What cash flow indicates for your business
Positive cash flow, or having more money than overhead, indicates that a business's liquid assets are increasing. It's a sign of growth. Liquid capital is needed to pay the bills, reinvest in the business, and save enough money to cover expenses during slow times.
Former football star turned coach Lou Holtz once said, "In this world, you're either growing, or you're dying." This concept is especially true for businesses. If your company has negative cash flow, it's dying a little more every day. If you don't have cash, you'll have to liquidate illiquid assets (assets that can't be sold quickly) to continue operations.
Common accounting methods
There are two main accounting methods that business owners use to track their expenditures, income, and profitability. Each method has a specific use for businesses.
The first method is called the accrual method and consists of preparing financial statements. In the accrual method, the accountant records revenues only after the good or service finishes. The actual date of payment is unimportant.
Cash-basis accounting follows how cash moves through a business and tabulates net income. This type of accounting is suitable for giving a clear picture of the positive or negative cash flow situation at any given time. Using this method, you can determine how much liquid capital is in the bank and is spendable. While the cash method can tell you how much money you have, it doesn't enlighten you about whether your business is profitable. It is an accounting principle to match expenses with associated revenues during a specific period.
Many businesses use accrual accounting, where they record income and expenses regardless of whether payments have come or not. When they send their invoices, the amount of the bill is recorded as income immediately. A business looks profitable on paper but can come up short when it's time to pay the bills. That's why many business owners say that profit isn't real and is just an accounting trick that makes businesses qualify for lines of credit to keep operating. The bottom line is, your business can have a positive cash flow and still be unprofitable. It can also have a negative cash flow and still be profitable.
How can you find out if your business is cash flow positive or negative? At the beginning of the month, tabulate how much cash you have on hand that you can use, without including any unpaid invoices or collections. Subtract from that amount your expenses, including operating overhead, debt repayment, investor payments, and other monthly bills. If you have money left over, your business is cash flow positive. If the number is negative, you have a negative cash flow.
The reality of your finances
The difference between cash flow and profitability is clear. Cash flow is a reflection of the reality of your liquidity and operating capital. It's a good indicator of growth or decline. Profitability is nothing more than an accounting of the money that should be there within a specific time period, but isn't necessarily going to arrive, justified against expense sheets.
Lines of credit
These days, it's understandable that businesses need extra capital to stay on top of buying trends. When supplies are needed to fill orders that haven't been paid for yet, business owners are in a difficult position. That's why accrual accounting methods are essential.
Bankers need to know that a business is making sales and will pay the bills every month if they extend a line of credit. If they can see that a company expects enough revenue to cover the bills, they will open up liquid operating capital to help the business meet demand. Business financing is important and can help a struggling business meet its true potential.
Moving forward
This article has covered calculating cash flow, profitability, and the most common accounting methods and their purposes. This information can be used in your business operations and will be helpful in years to come. Put simply by Charles Schwab, "If there's not enough money in the bank account, you don't spend it."
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BBB of Southern Piedmont and Western N.C. contributed this article.
