What Is Cash Flow and Why Is it Important?

by | Aug 18, 2021 | Accounting

The importance of cash flow can be summed up with one statistic: 82% of businesses that fail do so because of cash flow issues. Care about cash flow yet?

This article discusses the reasons why cash flow is critical to any business looking to stay afloat. With cash flow statements and cash flow analyses, you can clearly see where you stand and whether you’re actually turning a profit.

What Is Cash Flow?

Cash flow describes the net amount of cash and cash equivalents transferring to and from a business. Cash received, or a business’s accounts receivable, represents all the money flowing into a business. Cash paid or accounts payable represents all of the money outflowing from a company to other parties. 

A company’s ability to sustainably grow and provide value to shareholders depends on generating a positive cash flow. More specifically, if a company wants a healthy cash flow, it must capitalize on its long-term free cash flow (FCF). FCF describes the money companies generate from their normal business operations, also known as operating cash flow, after subtracting the money spent on capital expenditures (CapEx). 

Cash Flow Vs. Profit V. Petty Cash

Cash flow, profit, and petty cash are key financial indicators crucial to a business’s success, each with distinct roles and impacts. Cash flow represents the money a business spends and receives; positive cash flow indicates more income than expenses, while negative cash flow suggests spending exceeds earnings. It’s possible for a business to be profitable yet struggle with cash flow issues due to factors like overspending or excessive inventory. Especially in fast-growing businesses, maintaining a healthy cash flow is vital to keep up with increasing demand. 

Profit, on the other hand, is the residual amount after subtracting costs from revenue. High profits are desirable, but if costs exceed revenue, the business incurs losses, which are unsustainable in the long term. 

Petty cash covers minor expenditures such as employee lunches or client dinners. Despite being small, these transactions must be meticulously recorded for accurate financial management. 

These three elements — cash flow, profit, and petty cash—are interrelated yet independent. For instance, a business can have cash flow difficulties despite being profitable. Collectively, they are fundamental in assessing a company’s financial health and its capacity for sustainable expansion.

What Is a Cash Flow Statement?

Cash flow statements accurately display how a company spends its cash. Businesses often use it along with the Profit and Loss and the Balance sheet to assess the company’s financial health.

What Is Cash Flow Analysis?

Cash flow analysis determines your company’s working capital, which is the amount of money needed to run business operations and complete all transactions. You can calculate your cash flow analysis by accounting for your current assets and liabilities. Analyzing your working capital provides a snapshot of your liquidity and prepares you for other financial endeavors. Studying the cash flow cycle of your business and doing periodic cash flow forecasting can set you up for financial success. 

Why Is the Cash Flow Statement Important?

The cash flow statement is the most accurate method for displaying a company’s financial health. Without it, businesses don’t know where they’re spending cash. If a business neglects cash flow analysis, it can easily lose money and turn from profit to liability.

Cash flow statements display your expenses, loan payments, and tax requirements. These numbers help the leaders within a company strategize for the financial future. It is a key report that ensures a business’s solvency. Without it, the risk of bankruptcy is imminent. 

Cash flow reports are integral for larger businesses, particularly those that use non-cash transactions for a substantial amount of their revenue stream. Profit and Loss statements simply don’t utilize enough metrics to form a complete outlook. 

How Do You Perform Cash Flow Analysis and Why It’s Necessary

A cash flow statement clearly shows your financial standing, but it’s only a tool; it’s not a solution. For that, you need a cash flow analysis, which is a vital process for evaluating and optimizing a company’s financial inflows and outflows. 

It involves several key steps:

  • Managing accounts payable through effective software implementation and prioritizing invoices
  • Enhancing accounts receivable by encouraging prompt payments and offering various options
  • Utilizing idle cash in interest-bearing accounts or for revenue-generating investments
  • Ensuring financial security through stringent cybersecurity measures and controlled account access
  • Outsourcing non-core business functions like IT and accounting for cost efficiency
  • Regularly reviewing and renegotiating service contracts to reduce expenses
  • Maintaining rolling cash forecasts to monitor projected cash movements
  • Assessing operational expenses to identify and minimize unnecessary costs 
  • Evaluating spending efficiency to differentiate between essential and excessive expenses

This process is essential for maintaining financial health, optimizing cash flow, supporting strategic planning, preventing overspending, enhancing security, and facilitating sustainable growth. 

Profitable Businesses Can Go Bankrupt

The idea that a profitable business can go bankrupt may seem jarring at first, so let’s take a closer look. 

You may have loads of customers purchasing products off your shelves. That doesn’t necessarily mean you’ll be able to pay all of your bills. Let’s say you sell $300,000 dollars worth of products on credit, and you offer your customers 90-day terms. You also spend $70,000 on supplies that you have to repay within 60 days. 

Additionally, you have $50,000 on your lease, insurance payments, payroll, etc. You won’t be able to pay all your bills unless you have cash reserves. Even if you eventually pay off your debt, this process can take its toll on your reputation and credit, resulting in you sacrificing relationships with vendors, suppliers, and lenders. 

Why Is Tracking Cash Flow Important?

Keeping Up With Debt 

Maximizing cash flow management ensures your business stays ahead of all your debts. Debt can destroy businesses and individuals; when you run a business, you typically accrue more debt than individuals. 

Both long-term loans and short-term credit accounts can restrict free cash flow, meaning you lose the ability to invest in your business’s growth. Staying on top of these numbers ensures you can adequately plan for your financial future, choosing the right credit options.

Advised Decision Making

Accurate cash flow statements advise you so that you understand your financial health. When you look at an accurate cash flow statement, you immediately know your available funds. Any decision you make after that is made with accurate information. 

You may mistakenly believe your business is in a strong position to expand aggressively, while a cash flow statement says otherwise. It lets you gauge your purchases in the yearly, quarterly, monthly, and weekly time periods.

Protect Business Relationships 

Cash flow problems cause issues when it comes to paying your suppliers, harming business relationships and damaging your business’s overall reputation. Cash flow reports direct you to the correct finances available to pay suppliers. Without these reports, your business risks losing its reputation over time. 

Expand at the Right Time 

Growth and expansion is an exciting business proposition. New markets, new employees, more money- what’s not to like?

However, if done too hastily and without the correct logistics, expansion can kill businesses. Growth requires a hefty sum of cash. You need to consider increasing inventory, rent, and payroll. If your funds don’t match your growth, your growth will cause your demise. 

Managed Cash Flow Increases Opportunity

Cash flow is similar to debt management in the sense that it offers visibility into the areas of your business you can sustainably invest in for growth. 

Building new locations, investing in research and development, renovating infrastructure, and improving technology are all great ways to expand your business. However, if you expand these areas without the proper due diligence, they will hurt you more than help.

Outsource Your Accounting for Top-Tier Cash Flow Analysis 

Cash flow is an integral component of the success of every business. Without it, finances quickly become murky, making it difficult to decide whether business decisions are right or wrong. Thoroughly planned cash flow statements give you financial diagnostics that aid every facet of your business. They tell you when to expand and when to cut costs, protect your reputation and business relationships with vendors, and, most of all, make it clear where you’re spending your money.

The experts at Fully Accountable can keep track of all your finances so you can focus on your core business principles. We are your business partner on the road to your financial success and sustainable growth. 

Contact us today to learn what Fully Accountable can do for your business. 


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