Cash flow definition: Cash flow measures the money—the actual dollars or pesos or yen—that is moving in and out of your bank accounts.
Cash that you pay out is negative cash flow and cash that comes into your business is positive cash flow. Simply put, it is the cash you receive minus the cash you pay out.
Understanding cash flow helps you keep your doors open
Cash is critical to running a business. Without money in your bank account, you can’t pay your bills, buy more inventory, or expand your business.
You can always look at your bank account balance to see how much cash you have at any given time. But, that one number from your bank doesn’t tell you much about how money is moving in and out of your account or help you see a projection of how your bank account might look in one month or six months.
That’s where cash flow comes in. Cash flow is the measure of how much cash is moving in or out of your business in a given period of time. For example, during one month, you might pay $5,000 in bills and receive $8,000 in cash from your customers. In this case, your total cash flow would be $3,000. Cash flow calculations are simple:
Cash Received – Cash Paid Out = Cash Flow
In some months, you may have negative cash flow. Don’t worry, this is common during slower seasons for some businesses. It’s also really common if you are growing your business. You may be investing in growth, knowing that sales will come later.
The key to staying in business is not running out of cash. Banks don’t like it when you bounce checks! So, if you have money from investors to grow your business, you may be able to support negative cash flow for some time while you grow your business. Negative cash flow during startup is often called burn rate. Burn rate is simply the measure of how much cash you are using, or “burning,” every month.
The difference between cash flow and profits
The most important thing to know about cash flow is that it isn’t the same as profits. Profits and cash aren’t the same thing.
Here’s a quick explanation:
When you sell a product to a customer and send that customer an invoice, you often don’t get paid right away. Instead, you get paid in 30 days, maybe more. When you make this sale, however, you will show that sale on your profit and loss statement, which will help you calculate profits.
But, this sale won’t show up in your cash flow until you actually get the money from your customer. You track sales that you’ve made but haven’t been paid for yet with accounts receivable.
For a much more detailed explanation of the differences between cash and profits, read our explanation on Bplans.
Why is cash flow important?
At the most basic level, you need to understand and analyze your cash flow so that you know if your business bank accounts are growing or shrinking over time.
After all, you can’t run out of cash. If you do, you’re headed for bankruptcy.
Forecasting your cash flow is critical for running a healthy business. You’ll want to know how much cash you need to keep on hand to pay your bills You can also use a cash flow forecast to figure out when the best time will be to buy new equipment or when you can buy more inventory. With a cash flow forecast, you will even be able to see how fast growth can actually hurt your cash position.
Fast growth can be bad for your bank account (really?!?)
That’s right; fast growth can actually put your business in a challenging cash situation. That seems odd, but it’s true—especially for businesses that invoice their customers and get paid after they deliver their products.
So, how does this happen? Think about a business that sells widgets. In order to sell the widgets, the business needs to buy the materials for the widgets, pay employees to put the widgets together and package them, and finally ship them to the customer.
This business has paid for the widgets, paid salaries, and even paid shipping at this point, but the customer hasn’t paid yet. Since the customer’s invoice says “net-30” on the top of it, the customer might take up to 30 days to pay the bill. The business has paid out cash to deliver their widgets but won’t receive cash payments until much later.
If your business is growing and large orders are coming in quickly, you will most likely need to have a good amount of cash in your bank accounts to fulfill orders and support this growth.
What’s better? Positive or negative cash flow?
Positive cash flow is almost always better. This means that you are bringing money in the doors and accumulating cash that you can later invest in the business.
However, there are cases where a business may be expected to have negative cash flow. New startup companies and companies that are investing heavily in growth will often have negative cash flow.
Startups need to build their products, invest in initial marketing, and pay salaries before the first customer payments start rolling in. Companies that are investing in growth might have negative cash flow as they buy new equipment or expand their operations. These companies are hoping that their investment now will pay off with more customers and more cash coming into the business over the long term.
How to improve your cash flow:
There are lots of ways to improve your cash flow and I’ll cover a few of them here.
- Get your customers to pay you faster. The faster your customers pay you, the faster you get cash in the bank. I covered a few options you have to get customers to pay you faster in my article on accounts receivable.
- Convince customers to pay upfront in cash. Instead of invoicing customers and waiting for them to pay you, you could try and have some of your customers pay upfront. Some companies offer customers a discount when they pay part or all of their bill before products and services are delivered.
- Pay your bills a little slower. Sometimes you don’t have to pay all your bills right away. The longer you can hold on to your cash, the better cash position you will have. I covered a few options for this in my article on accounts payable.
- Get a line of credit. If your business regularly goes through a cash crunch and a period of negative cash flow, you may want to consider a line of credit for your business. This is basically a short-term loan that you can draw from as you need it. Many businesses use lines of credit to help them through periods of low cash.
- Purchase less inventory. Some businesses make the mistake of buying too much inventory. All of that inventory can tie up a lot of cash. Instead, see if it makes sense for your business to carry less inventory on hand and only order inventory when needed.
Of all metrics in your business, cash flow is almost certainly the most important number to watch. Cash is the lifeblood of all businesses and is necessary for business survival. Understanding if you are losing cash or piling it up is critical to understanding the health of your business.
Beyond just keeping an eye on your cash flow, consider creating a cash flow forecast so you can predict when you might run low on cash and when you should expand. This cash flow statement template for Excel can help you get started.
After all, as they say, “cash is king.”
For more business concepts made simple, check out these articles on direct costs, cash burn rate, net profit, operating margin, accounts payable, accounts receivable, profit and loss statement, balance sheet, and expense budgeting.
Editor’s note: This article was originally posted in 2015. It was updated in 2019.