Understanding the Importance of Cash Flow
Regardless of the size of the business, managing finances and keeping track of the investments are crucial for business success. Whether you are a startup or an established business, penning down your cash flow activities is just as important as determining your profit. In this guide, you’ll study why cash flow is important, but before we go into that, let’s find out the answer to the most basic question, what is the importance of cash flow?
What is the Importance of Cash Flow?
If you’re a new entrepreneur, understanding the concept of cash flow may not be easy. In simple terms, cash flow is the money that moves in and out of a business in a given period. When you pay regular expenditures such as rent, monthly loan payments, taxes, payments to suppliers, mortgage, etc., the money goes out. If you obtain supplies on credit, you’ll pay your creditors or accounts payable at a future date. When you do, cash will move out.
On the other hand, when your clients or customers pay for the products or services they purchase, cash comes in. Just as supplies might be acquired on credit, you might be selling your products or services on credit. Customers who purchase from you on credit are referred to as accounts receivables. When they make the payments at a future date, cash will again move in.
In other words, cash flow helps you evaluate how much money is generated from business activities and how much is spent. Right from the start, it serves as a strong measure of liquidity and performance.
To further clarify the concept, let’s use an analogy to explain cash flow. Cash flow is similar to a water tank. The water tank that’s in regular use hardly retains its collection for long. Water is added from the top and drained from the bottom as often as the owner sees fit. If the aim is to keep the tank full, more water needs to come in than go out.
That’s exactly how cash flow works. If you have more cash coming in than moving out, you have a positive cash flow. When you’re paying more than what’s coming in, you have a negative cash flow. This net change in cash inflows and outflows are shown in an organization’s cash flow statements.
Now that you have a clear understanding of what cash flow is, let’s examine the importance of cash flow.
The Critical Importance of Cashflow
As the key indicator of your business’s financial health, cash flow is the lifeblood of your business. The greater the positive cash flow, that is, the amount by which your cash inflow exceeds your cash outflow, the more freedom you have to improve your operations and enhance your investments. You should be able to hire more employees, acquire more stock, open up branches in newer locations, or re-invest in your business in other ways.
Hence, positive cash flow fosters business growth. Let’s now dig deeper into the importance of cash flow for specific business aspects:
Until now, you might be of the view that profitability is most critical to the smooth running of your business. And that as long as your income statement shows a net profit, you can rest assured that your business is on track. Unfortunately, that’s not necessarily true. As shocking as it is, you could earn a profit and yet be forced to close down. This happens when you run out of cash and your business becomes bankrupt.
If you’re not familiar with eCommerce accounting procedures, you might be confused about how a business can run out of cash in spite of being profitable. To clarify the notion, let’s take a simple example. Suppose you launch a bakery with $2,000 in hand. With this amount, you purchase bake cakes and ingredients. A customer buys all the cakes you produced for $6,000 on one-month credit. When we say ‘on 1-month credit’, we mean that you agreed to receive the payment for the sale after a month.
In this case, you earned a revenue of $6,000. Based on the accounting standards, revenue should be recognized and recorded when it’s received. You need not wait until it’s received. Thus, you’ll record it as a sale of $6,000. Your initial cost was $2,000, so you’re left with a profit of $4000 ($6000 – $2000).
As you can see, you have $6,000 in revenue and $2,000 in profits, but your cash is NIL. Your money is stuck with a debtor, so you can’t pay your store rent or your utility bills, order more bakery supplies, or in other words, conduct business until you receive cash from your customer at the end of the month.
Now imagine this scenario in the real business world. No matter how large and profitable a company is, if it fails to maintain a positive cash flow, it can face serious trouble. Let’s take a look at another example. A large company sells goods valued at $ 70,000 to its customers on a 60-day term. To produce the products, the firm obtains supplies valued at $30,000 that it must pay to its suppliers within 30 days. Plus, it also needs to pay $20,000 in rent, payroll, and other expenses within 30 days.
Unless the company has cash reserves, it won’t be able to pay the combined $50,000 to keep the business running. As a result, the company can become insolvent, sell off its assets to pay for the debts, and close down.
Even if you successfully convince your creditors to extend the due date, the poor cash flow position and delays in payment can cause you to lose your lenders, suppliers, and vendors. This can seriously impact your business performance in the future.
The key to achieving your short and long term business goals is sensible decision-making. Better cash flow visibility translates into rational decision-making. With an in-depth understanding of where your money is coming and going, you find yourself in a better position to make informed decisions. Such decisions are more likely to succeed and help you achieve your underlying business goals.
For example, if your primary aim is to maximize revenue, maintaining a stable cash flow position will help you multiply your earnings at a faster pace. When you have a complete picture of where the bulk of your earnings are coming from and where they’re going, you should be able to identify the core ways in which the revenue is being generated and then focus on them. You get familiar with new revenue routes and thus, your decision-making is focused on areas that will drive business success.
Besides, analyzing finances is extremely important for the improvement of business performance. This becomes even more important as your business grows. In the present-day corporate world, data is fast becoming the most critical asset for companies. Today’s most successful tech giants including Google, Facebook, Uber, etc., all rely on data. The more data-driven you are, the more competitive you’re expected to be.
However, the value of your data is close to zero if it’s not properly analyzed. Financial data analysis provides you with insights that help you make superior decisions. Through comprehensive financial analysis, you’re able to gain a better grip on the flow of money and ensure its optimum allocation. This ultimately results in business success.
With a stable cash flow, your cash flow projections are also likely to be more accurate. Based on accurate predictions, you should be able to develop a more realistic budget. Reliable cash flow projections are likely to improve the trust of your stakeholders, while improved budget-making should help you achieve better control over expenses and realize greater profits.
Moreover, when you have strong control over cash flow, your inventory-related decisions also improve. Your inventory planning should get healthier and you should be able to manage your stock efficiently. Proper inventory management helps improve your eCommerce business operations and streamlines the internal processes.
Get a Competitive Edge
One of the most critical reasons why small or medium-sized businesses are forced out of business is poor cash flow. They fail to realize that maintaining a positive cash flow provides them with a pool of working capital to fund operations, and thus, achieve that highly-sought competitive advantage.
A higher rate of cash inflow than outflow boosts the funding available to the business. Your buying power improves, so you’re able to secure bulk discounts or early settlement discounts.
Stable cash flow ensures quick access to money. This in turn makes your business agile, that is, your ability to promptly respond to market opportunities improves. Based on the latest trends, agility is among the most critical characteristics that help a business outflank its peers in the industry. The business happens to be more responsive than its competitors in making important decisions, such as pursuing a lucrative contract, acquiring a competitor, or delivering a project. This helps the firm achieve an edge over the competition.
Similarly, innovation and R&D is at the heart of business success. In today’s fiercely competitive business world, you need to be on the constant lookout for ways to improve customer experiences and maximize value for clients. Any improvements you choose to pursue depend on whether or not you have readily available cash. Efficient cash flow allows businesses to invest in research into innovative products and processes. They set aside a proportion of revenue for novel initiatives. This helps them discover and exploit new market opportunities, seeking a competitive advantage over slow-moving rivals.
Based on the factors discussed above, maintaining a stable and healthy cash flow position helps overpower competition and keep maximizing your market share.
Easy Access to Credit
Regardless of what your business goals are, access to credit is crucial to pursuing important decisions and in many cases, to keep the business running. When you approach lenders for loans or vendors for supplies, they’ll require concrete proof of your ability to repay the loan or pay suppliers at a later date.
If your cash flow statement demonstrates a healthy cash flow position, your chances of obtaining credit should be much greater. You’ll find yourself in a better position to negotiate terms with lenders.
Likewise, suppliers would be willing to grant credit for extended periods. These factors should further improve your cash flow position, leaving more money to invest in critical business areas.
Stable cash flow and ease of credit are particularly important if you’re looking to expand your business. It can require new staff members, more physical space, better equipment, and penetration into new markets. However, if you choose to expand at the wrong time, you’re likely to face serious issues down the road.
Hiring employees, renting buildings, purchasing stock, etc. are tasks that have to be done before the projected revenue starts flowing in. Maintaining the cash flow helps you know when you should pursue business growth. Because it also improves your chances of obtaining credit from lenders and suppliers, you should have readily available cash to go for expansion.
However, when you acquire money to purchase property, equipment, or stock, you must be able to maintain a positive future cash flow to pay the debt as well. Whether you obtain short-term credit accounts from suppliers or long term loans from banks, you’ll be required to make monthly payments.
In the drive to invest in key business areas, you should never ignore these debt obligations. Defaulting on these can lead to serious trouble. In the case of loans, the interest will keep on building up, and in the worst-case scenario, you may need to sell off your business assets to pay the debt. Also, you may lose or hurt your relationship with vendors if you fail to make payments on time.
To wrap things up, your cash flow is critical for your business’s very survival. The importance of cash flow can be judged from the fact that a Cash Flow Statement forms a mandatory part of annual financial statements reported by firms.
In the earliest stages of a business, maintaining cash flow might be simple but as the business expands, preparing proper accounts, including your Cash flow Statement, can become quite complicated. In that case, Fully Accountable can help you manage your accounts while you can focus on scaling your business operations to facilitate business growth.