Understanding cash flow basics, key terms and concepts
Most businesses understand the basic concept of cash flow. It is simple after all. Cash comes into a business from your clients, and cash goes out when you pay your expenses and suppliers. But is it really that easy?
If we use the ultra-popular iceberg analogy, there’s a lot more to cash flow than you think. In this article, we’re going to explore cash flow to see what lies beneath the surface. We’ll be looking at the following cash flow basics:
- Everywhere the cash goes, you must follow: a basic definition of the term cash flow
- Cash flow statement: what it is and what it does
- Monitor and manage your cash flow: why this is important and how to do it
- Cash flow versus profit: understanding the difference
- Liquidity versus solvency: the long and short terms of cash flow
1. Everywhere the cash goes, you must follow
The term cash flow is rather self-explanatory. Put simply, cash flows in and cash flows out. Monitoring how its flowing in and out can tell you how efficiently your business is running.
At a glance, you can see whether you can pay your bills, keep the lights on and even when it’s time to take your business to the next level. Ultimately, it’s the tell-all indicator that every business needs to keep a close eye on. The first step in getting to know your cash flow is to follow the money. Understand where it’s coming from and where it’s going.
2. Cash flow statement
If you’re tracking your business’ financial health, you’ll undoubtedly be looking at a few financial statements. Profit and loss statements, balance sheets and cash flow statements.
Profit and loss statements are true to their name; showing you whether or not your business is profitable. Balance sheets are there to indicate how much working capital you have. Cash flow statements marry the two to show you a more comprehensive view of how cash is flowing through your business.
Your cash flow statement also comes with the added bonus of showing you some important patterns. Patterns that tell you where you can improve your business and your profit margins. For example, where money is being spent unnecessarily or where you could spread out your expenses. It will also show you where your cash flow is constricted through long payment terms with your clients. This can help you see where external finance such as invoice finance or a business loan could be necessary to bridge any gaps in cash flow.
3. Monitor and manage your cash flow
Many small businesses underestimate the importance of this step. Tracking your income and expenses is vital to not only knowing your cash flow, but knowing your business.
Cash flow management is the process of monitoring your cash flow. And it’s easier than you think. To begin tracking your cash flow, you need to start with making cash flow statements on a weekly or monthly basis. We recommend that you start with weekly. Cloud-based accounting software like Xero, Quickbooks, and Sage all have helpful tools that will help you monitor your cash flow with ease.
4. Cash flow versus profitability
We say a business is profitable when there’s money left over after you subtract all your business expenses from your total income. Profit is a sure indicator that your business is a success, but cash flow shows you whether or not you’re running an efficient operation. Cash flow will not only be the ticket to keeping our doors open, but it will show you where you can improve to make the best of your business.
5. Liquidity versus solvency
These two terms can be a little confusing but the key thing to understand here is that it all comes down to timing. Liquidity is your ability to cover your current liabilities with your current assets. Can you cover all your expenses right now? If so, you’re considered liquid.
Solvency, on the other hand, is how well you manage your business and prepare for the future. If your creditors all come knocking at once, solvency asks if you’d be able to cover these costs. In other words, liquidity is looking at your business in the short term and solvency is having a glance at the future and your business in the long term.
Both aspects are crucial when it comes to cash flow. They help you answer these questions: Is your cash flow enough for right now? Is your cash going to be flowing enough in the future?
Now that you’ve got the basics covered, check out these seven effective strategies to help you improve your cash flow.
At MarketFinance we understand how important your business is to you, and that you need cash flow to make it a success. That’s why we offer seamless invoice finance and business loan solutions that get your cash flowing when you need it.