Ask any business owner to name the number one requirement for financial stability. It’s not revenue, capitalization, or even access to affordable financing. You can hit the jackpot in all of these areas but still drive your business into the ground. While obtaining as much working capital as possible seems like the logical answer, it’s your ability to manage cash flow that ultimately plays the biggest role in your business’s financial health.
This segues into one of your primary responsibilities as an entrepreneur: balancing the amount of money flowing into your business with the amount of money flowing out. Of all the financial metrics to keep an eye on, cash flow deserves the most attention. Determining whether or not your business is cash flow positive will tell you if your finances are in generally good shape or in need of serious help. Arguably even more difficult than becoming cash flow positive, however, is maintaining healthy cash flow throughout the inevitable ups and downs.
In this guide, we’ll explain what it means to be cash flow positive, why cash flow is so important, and which obstacles are most likely restricting your cash flow.
What is Cash Flow?
Cash flow refers to the net amount of cash moving in and out of your business throughout a given period. The time frame is crucial for monitoring cash flow, since this metric tends to change quite frequently and dramatically. For this reason, most businesses measure cash flow with monthly data.
What Does It Mean to Be Cash Flow Positive?
Operational businesses must always have money in the bank to cover payroll, vendor bills, rent, Internet, and other recurring costs. The money used for these expenses usually comes from at least two sources: working capital that the company has built up over time or recent earnings from sales, receivables, and other forms of revenue.
But having enough money to cover your monthly expenses doesn’t guarantee healthy cash flow. You must time those expenses in accordance with your sales, and make sure to only spend certain amounts in certain time frames. Plenty of companies earn more money than they spend in general but spend more money than they earn within short-term intervals (i.e. one month). They end up running out of cash simply because they failed to coordinate sales or receivables with expenses.
Why You Might Not Be Cash Flow Positive: An Example
Let’s say your company does $20,000 in sales in one month. Your monthly costs amount to approximately $15,000, most of which comes from payroll and inventory. At first, it seems like your company has just made $5,000 in profit.
But then you realize that some of your bigger clients – who make up the bulk of those sales – still haven’t paid their invoices. A few of your other sales were paid via credit card, and those payments haven’t been processed by the credit card company yet. When the month ends, your actual revenue amounts to just $13,000, with $7,000 in outstanding receivables. So, despite your strong sales, you really spent $2,000 more than you earned. In this case, your business would be cash flow negative.
One month of negative cash flow will not spell your business’s demise. If this trend persists for several consecutive months, however, the company could lose upwards of $15,000, or the amount of money it usually spends in one month. When that new client places an order the following month, you might not have enough working capital to pay your employees and purchase the required inventory. The revenue from this large order would only stop the bleeding temporarily.
Cash Flow Positive vs. Profitable
New entrepreneurs often make the mistake of assuming that “cash flow positive” means the same thing as “profitable.” The two terms have similar definitions, yes, but contrary to popular belief, a business can in fact be profitable without being cash flow positive, and vice versa.
Let’s clear the air on what differentiates each term.
Cash flow positive means having more money going into your business than going out within a specific time frame.
Your profit, on the other hand, refers to the amount of money you have left over after covering all expenses, both short-term and long-term. A business can only be technically classified as “profitable” if it has more money on-hand than it spent by the end of the fiscal year. It’s entirely feasible to achieve this status without consecutively maintaining profitability at all times.
In other words, you don’t have to turn a profit every month in order to turn a profit when the year comes to a close and therefore declare your business as “profitable.” The opposite holds true as well: You can turn a profit during one really successful month but find yourself on the brink of bankruptcy at the end of the year.
Chances are, if you don’t turn a profit at the end of one month, you’re probably cash flow negative. Thus, a technically profitable business can be cash flow negative at several points throughout the year.
How to Determine If You’re Cash Flow Positive
To determine the status of your cash flow, start by figuring out how much cash you have on-hand at the beginning of the month. This includes the cash from all of your business bank accounts. You can probably find your bank balances from the beginning of the month on the last bank statement from the month prior.
Next, it’s time to compile the month’s cash inflows and outflows. But remember, this only includes the earning or spending of cash, as opposed to every time you make sales, purchases, or send invoices.
For example, if you send an invoice in August but the client doesn’t pay you until September, the revenue does not belong on August’s cash flow statement. The same concept applies to business credit card transactions. If you pay for something with your credit card in August but don’t pay the credit card statement until September, the expense goes on your cash flow statement for September.
Finally, subtract your total cash outflows from your inflows and compare this number with your balance from the beginning of the month. If that number is higher than your opening balance, you are officially cash flow positive.
How to Determine Your Profitability
Businesses have two kinds of profit margins: net profit margin and gross profit margin.
To calculate net profit margin, subtract your revenue throughout a certain time period from the amount of money you spent in that same period. Then, divide that number by total revenue.
Let’s say your company earned $20 million in sales in a year and spent $15 million in the same time period. Your net profit margin would be 25%.
Gross profit margin represents the profitability of a single product or service. To calculate gross profit margin, subtract the cost of producing a product or service from its retail price. This includes the cost of materials along with labor. Then, divide that number by the retail price.
For example, if you sell a product for $10 that costs $5 to make, the gross profit margin is 50%.
Why Profitability Can Be Misleading
Earlier, we mentioned that it’s possible for a profitable business to be cash flow negative at some points of the year. If your business has a profitable month, this doesn’t mean the next month will show the same results. Unlike cash flow, profitability cannot tell you when your cash inflows and outflows transpired. You may have made payroll last month, but what about next month? How much of last month’s profits have actually reached your bank account?
In order to achieve true financial stability, you must develop sales and spending strategies that ensure positive cash flow month-to-month. Only cash flow data can show how much working capital you’ll have on-hand in the immediate future.
For these reasons, profitability can actually mislead you into thinking you have control of your finances. If anything, you should only look at monthly profitability when gauging the actual success of your recent sales, as opposed to gauging the long-term success of your business.
Why Should You Focus On Becoming Cash Flow Positive?
As you can see, monitoring cash flow gives you an incomparably informal picture of your financial health. Your income statement can reveal the extent of your profitability, but not how much money you have on-hand to cover regular expenses. Let’s go over some of the more specific benefits of good cash flow management:
1. Cash flow data gives you exact figures.
Without cash flow analysis, you’d essentially have to rely on your budget to assess your spending patterns. Most businesses do not calculate exact, to-the-dollar monthly budgets. They merely create estimations of their cash inflows and outflows to get an idea of how much they can afford to spend that month. As your business grows, you begin to see the flaws in relying on rough estimations.
Having exact cash inflows and outflows at your disposal allows you understand exactly how much money you need to earn and spend in order to maintain stability. You won’t start or end each month wondering if you have enough money to continue your usual strategies.
2. You can prepare for cyclical slow periods.
All businesses experience ups and downs. External factors like seasonality, outdated equipment, and expiring business relationships prevent your cash flow from staying the same every month. It’s simply not possible to eliminate occasional dips in revenue. So, rather than wasting time and money trying to avoid the unavoidable, it makes more sense to just focus on being prepared. Examining cash flow data can show you the exact points of the year when revenue begins to slow down.
Your business’s slow months will become infinitely less stressful when they no longer catch you off guard. You can figure out the right time to start gathering the requirements for business loans or the right time to start putting in some extra hours. Several strategies can help you save more money in anticipation for dips in revenue. Accurate cash flow data can tell you when to launch each one, instead of getting overwhelmed by trying to launch them all simultaneously.
3. Knowing your cash flow frees up your concentration.
No business owner can deny the connection between anxiety and uncertainty. The less you know, the more you worry about the future. These fears will decrease significantly, however, when you can safely say you have your cash flow under control. When you aren’t constantly worrying about your financial health, you can finally direct your full attention to what you do
best: growing your business. Just think of how much more you could get done each day if your mind wasn’t burdened by anxiety.
Yes, it will likely take time to fix the holes in your cash flow and properly prepare for upcoming investments. But the sooner you identify your shortcomings, the sooner you can fix them and get back to generating revenue.
4. Being cash flow positive helps you access business loans.
Most financial institutions prioritize cash flow when assessing applications for business loans. If your previous cash flow data denotes strong management, the institution will not attribute the current shortage to pure carelessness. Good cash flow management makes it easier for institutions to trust you, since you’ve already proven your ability to cover operational and growth-related expenses amid ups and downs in revenue. They don’t want to see that you can barely afford to make payroll when the slow months set in.
Institutions look for capitalization as well, or an extra cushion of cash in your bank account. Well, you will build up this cushion naturally if you continue to practice strong cash flow management. Unforeseen expenses can arise at any time, so institutions would like to get the idea that virtually nothing will stop you from paying off debt.
5. Cash flow data shows you when you can put money away.
We recently discussed the difference between profitability data and cash flow data. Your profit and loss statement might show a profitable month, but it can’t show you if that profit has actually reached your bank account. In order to invest in growth, you need to know exactly how much money gets added to your supply of working capital each month.
Monitoring cash flow puts precise timetables on growth-related initiatives like expanding your team, mass marketing campaigns, or the purchase of new equipment. When you know how much money flows in and out of your business, you can see exactly how much of the former you can afford to set aside for growth.
How to Become Cash Flow Positive: Three Strategies
Becoming cash flow positive essentially comes down to plugging more money into your business in shorter time frames. You can accomplish this by improving several key aspects of your business model, most of which deal with the coordination of spending, selling, and earning revenue.
Here are three ways to better manage your cash flow with the objective of becoming cash flow positive:
Don’t Order Too Much Inventory Too Early
In regards to inventory, businesses often end up spending more money than they make by letting items sit on their shelves. They place bulk orders (possibly for discounts) but don’t actually sell the items until months later. In the meantime, the business continues spending money on operational expenses and additional inventory while earning less money because of the unsold items. The more money you spend without selling an item, the less profitable that item becomes.
You can prevent this extremely common scenario by striving to order inventory shortly before you plan on selling the items. Popular solutions include improving forecasting of demand, or securing business lines of credit to purchase inventory at any time. If you’re unsure about an item, you could use your line of credit to place the order when demand becomes clearer.
Prevent Delinquent Payments
Unpaid invoices basically have the same effect as unsold inventory. You pay for the expenses needed to serve the customer, but the customer doesn’t pay you for months on end. So, how can you increase the likelihood of getting paid on time?
Well, you could send more than one invoice per month with the help of an automated invoice system. Many businesses offer discounts for clients who pay early or on time. Others only offer the traditional 30-day terms to customers with flawless payment histories.
Lower Your Monthly Expenses/Cost of Goods Sold
Okay, so you’ve gone over your monthly expenses and found nothing you can completely eliminate. But there’s probably at least one expense you can decrease or take better steps to eliminate.
Do you always pay your bills on time? If so, you should speak to your suppliers or credit card vendors about lowering monthly rates. It’s not inappropriate at all to ask longtime inventory suppliers for cheaper prices, especially if you regularly place orders and never pay late. If your supplier can’t offer a discount right now, you can ask about possibilities for the near future.
Speaking of credit card vendors, the debts with the highest monthly payments typically carry the highest interest rates. You should therefore focus on eliminating these debts as quickly as possible. So, instead of making minimum payments, see if you can afford to pay a little more each month.
You may find that payroll makes up your biggest expense, by far. From now on, consider doing more with less people. Instead of hiring new employees to handle additional tasks, see if you can train current employees to do a little more work. Yes, you’d have to increase their salaries, but hiring new employees would undoubtedly cost much more.
Becoming Cash Flow Positive Takes Time, But It’s Worth It
The importance of cash flow reflects the difficulty of mastering it, or becoming cash flow positive. It’s entirely feasible to completely restructure your cash flow, but it won’t happen overnight. Businesses usually have to experiment with several of the aforementioned strategies before finding out which one has the biggest impact on cash flow.
This epic journey begins with identifying what’s hurting your cash flow. Learning this information isn’t comforting but understanding the problem makes the solution much, much clearer. Trust the data; for it will eventually point you in the direction.