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Accounting Basics - Understanding Your Cashflow

Cash flow is exactly how it sounds: the cash that flows in and out of your business during a set time frame.

As a business owner, your aim is to maintain positive cash flow; in other words, you should aim to have more money coming into the business than leaving it. Unfortunately, there may come a time when you find that the opposite of this is true and your business is facing negative cash flow.

One-off periods of negative cash flow are to be expected; however, if the period becomes sustained, it can affect how you run your business and your ability to pay your bills and other expenses on time.

A business’s cash flow is typically reported in a cash flow statement. But how do these work?

Understanding your cash flow statement

Typically, a cash flow statement is divided into three main parts: operations, investing and financing. These separate sections allow investors to assess the business's overall health.

  • Cash flow from operations: typically represents your revenue and expenses
  • Cash flow from investing: how cash flows from buying and selling investments and assets
  • Cash flow from financing: includes debt and equity, such as issuing stock, borrowing from lenders, loan repayments, and stock buybacks.

How do you produce a cash flow statement?

There are two ways to produce a cash flow statement: direct and indirect. Because the direct method provides a view of the actual cash flows, it is considered more transparent than the indirect method, which uses accrual accounting to produce the statement.

  • Direct method: lists the cash receipts and cash payments relating to the operating activities during the period.
  • Indirect method: starts with the net income from your income statement and adjusts for non-cash items. You also need to adjust for changes in your working capital, including accounts receivable, accounts payable, and inventory.

Why does a cash flow statement matter to your business?

Without understanding your cash flow, you won’t have a full understanding of whether you can cover the regular expenses in your business, such as payroll and utilities. It can also help to flag how much you rely on lending to cover your expenses. 

Once you have an in-depth understanding like this, you can begin setting budgets and troubleshooting cash flow problems. Also, from an investor standpoint, you’re able to show how well your business can bring in money and whether you’re covering your expenses.

How can you improve your cash flow?

Once you have a current cash flow statement, you can start planning for the future using cash flow forecasts to see how different potential changes will affect your business. Using these forecasts, you can begin implementing changes that could improve your cash flow.

Tip 1 - Plan for industry changes and challenges

When creating your forecasts, it’s likely you’ve only included changes resulting from your business activities. However, there are also changes which could occur due to changes in the industry.

Consider the following challenges that could occur over time, such as minimum wage increases, distribution cost increases, increases in raw material costs, or even changes in interest rates. Once you understand these changes and potential challenges, you can begin to identify areas to improve your processes.

Tip 2 - Consider the difference a day makes

What would happen to your business if you collected your receivables one day sooner? Or if there was bad weather and you couldn’t sell your stock until one day later? These seemingly small changes can have a lasting impact on your business.

Once you understand the scale of the impact on your business, you can assess whether you need to adapt your payment terms or offer staged payment solutions.

Tip 3 - Reduce payment delays

It can feel uncomfortable introducing payment terms, however, once you realise you need to have money coming in on a set schedule, it can make the process easier.

Clear communication can be the key to success here, including stating your payment terms on the invoice and chasing outstanding and overdue invoices with your clients. However, if your clients are still unable to pay on time, you also need to know how to escalate the situation and whether you allow for flexibility; this process will differ for each business.

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