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Home>Business Resource Center >Financial Articles >Taxes and Accounting

Cash Flow - The Life Blood of Your Business

Earnings are good, and profits are great – but if you don't have sufficient cash flow, your business could still fail. If a customer is late on payments or if you have to pay a huge invoice for supplies before you have sales to generate cash… an otherwise healthy business could be forced to close its doors.

What is cash flow? Cash flow is the money that moves in and out of your business:

Cash in: Money received from sales of goods and services. Money you receive from loans or from outside investment can also be considered cash flow. Just keep in mind that if you extend credit to customers, while you may have made a sale, no cash has flowed in until payments are received.

In other words, an Account Receivable – a payment owed to you by a customer – is a sale but is not cash flow until the payment is actually received and deposited.

Cash out: Cash out is the money you pay for salaries, supplies, inventory, expenses, etc. Aside from salaries, the largest source of cash out is due to purchasing inventory; in manufacturing, the purchase of raw materials, supplies, and components. Payments made on loans or to purchase assets are also forms of cash out.

For example, to determine your cash flow for a month,:

Starting Cash: The amount of cash on hand at the beginning of the month

Cash In: All cash received from sales, receivables, interest, sales of assets, sales of stock, etc

Cash Out: All cash paid in salaries, expenses, supplies, to purchase inventory, etc

Ending Cash: Add Starting Cash to Cash In, subtract Cash Out, and the remainder is Ending Cash.

Cash flow can be positive or negative. Hopefully your Ending Cash is greater than your Starting Cash, meaning your cash flow is positive, but depending on your business activity that may not be the case. For example, you may have decided to purchase additional inventory in anticipation of a heavy seasonal sales period.

Here's a simple example.

• Say your Starting Cash was $10,000. You received $9,000 in sales and $9,000 in receivables from a customer to whom you extended credit. Your total Cash In was $18,000.
• You paid $6,000 in salaries, $2,000 in expenses, and $4,000 to purchase inventory. Your total Cash Out was $12,000.
• Your Ending Cash is $16,000; $6,000 of that total was positive cash flow.

It is possible to have negative cash flow. Say the customer who purchased product on credit did not pay during the month; that would reduce your Cash In by $9,000. In that case your total Cash In would be $9,000, while your Cash Out was $12,000 – your cash flow would be -$3,000. Your Ending Cash would then be $7,000.

It's easy to see that any business survives on positive cash flow (unless you continue to receive funds from investors to finance operations).

In the article How to Manage Accounts Receivable we'll look at ways to keep cash flowing into your business. For now, let's look at some of the more common cash flow terms; if you deal with bankers and accountants, you'll want to know:

• Cash: Money in your bank accounts, investments you can quickly turn into cash, etc
• Current assets: Items that are expected to be turned into cash within a short period of time as a normal operating process. Current assets include inventory, accounts receivable, and even cash (cash is considered both cash and a current asset).
• Current liability: Obligations the business is required to pay within a specific operating cycle. Items like salaries, loan payments, utility payments, and taxes are current liabilities.
• Long-term assets and long-term liabilities: Assets and liabilities not expected to be converted into cash or paid within a specific operating cycle. A building or piece of manufacturing equipment is a long-term asset. The balance on a ten-year loan to purchase an asset is a long-term liability; the monthly payment to service that loan is a current liability.
• Net working capital: The total of current assets minus current liabilities. If your business is healthy, the number should be positive; otherwise, you owe more than you are (at least currently) earning.
• Current ratio: The ratio of current assets to current liabilities. For example, if your current assets are $15,000 and your current liabilities are $10,000, your current ratio is 1.5. A current ratio over 1.0 signifies positive cash flow. A current ratio trending downwards over a period of months indicates your cash flow is deteriorating.
• Quick ratio: The ratio of current assets (after subtracting inventory) divided by current liabilities. Selling inventory in a short time period could be difficult; the quick ratio lets you know how readily you could pay off liabilities. Lenders often use the quick ratio to get a bottom-line sense of the health of a business, because including inventory in current assets could artificially inflate a company's current assets.
• Accounts receivable: Money owed by your customers for goods or services.
• Accounts receivable aging: Status of accounts receivable, analyzed by due date. Most businesses analyze accounts receivable by time period, showing how many accounts are "past due 30 days," "past due 60 days," etc. In effect accounts receivable aging shows how many – and how much – accounts receivable are past due.
• Accounts receivable turnover: Shows how quickly you collect on accounts receivable; indicates the frequency of payment on accounts receivable. The higher the ratio the more quickly the company is being paid. Calculated by dividing total sales by average value of accounts receivable.
• Inventory: Cost (to you) of products you have purchased to sell to customers. Can include work in progress, raw materials, and finished goods (if you manufacture or assemble products).
• Slow moving stock: Inventory selling at lower than expected rates. If your typical inventory turnover is thirty days, products in inventory for longer periods are considered slow moving stock.
• Stock out rate: If a customer order cannot be filled or a sale cannot be made due to insufficient inventory, the event is considered a "stock out." Stock out rate is based on the number of occurrences per one hundred orders. Stock outs due to insufficient cash flow obviously hinder your business's ability to operate effectively.

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