When you own a small business, it’s vital you understand how money flows into and out of it. At a basic level, you need to know where your income comes from and what your expenses are.
At a deeper level, knowing how money moves through your business can help you make strategic decisions about growth, invoicing, and debt management. The consequences of not understanding money can be drastic—poor financial management is one of the main reasons businesses fail.
That’s why you need to understand cash flow.
1. What is cash flow?
Before you can start to understand your cash flow, you need to know what cash flow is. Cash flow refers to the movement of money into and out of your business. It’s essentially understanding how much money is coming into your business (your income, loans and transfers of personal money into the business) versus how much is leaving (your expenses, taxes, and loan payments).
2. How do I conduct a cash flow analysis?
Some accounting software programs allow you to conduct a cash flow analysis through the platform itself or possibly via an addon. Open the program and often a cash flow statement can be found under a “Reports” tab or something similar. So if you’re already using accounting software, you can have a cash flow statement with minimal effort.
If you don’t use accounting software, you’ll have to conduct the analysis manually. Here is a very basic cash flow analysis (This can easily be done using a spreadsheet):
First enter the amount of cash your business actually had in the bank at the start of a financial period (say a month). Second, add up all the money that came into your business in the month. Include only money that actually came in, not money still owing from clients. Third, add this to the cash from the start of the month (in Step 1). Fourth, add up the cash that went out for the month, including rent, cost of goods, fixed costs and loan payments. Fifth, subtract the total in Step 4 from the total in Step 3. This gives you your cash at the end of the month, which is also your starting balance for the next month.
If the cash in your account is lower at the start of each month from the previous month, you have a cash flow problem that requires further analysis.
3. Why is cash flow important?
Not making enough money to cover debts is a major reason small businesses fail. Understanding your cash flow can help you take the steps you need to identify and address issues before they threaten your business.
A cash flow analysis can tell you if you’re allowing clients too long to pay their invoices, making you financially vulnerable. You can then determine if you need to charge a deposit for your services or shorten the payment terms. It can also tell you if you’re spending too much in areas that are not profitable for you. This can help you figure out where you need to cut back on spending—or charge your customers more.
Regular cash flow analysis can also show you what times of the year your business drops off – such as if you have a seasonal business. That can help you plan for those times to make sure you have enough money to cover a loss in revenue.
Final thoughts
Understanding your cash flow and making strategic decisions about your company’s future is vital for business survival. Unfortunately, many small business owners make the mistake of not understanding or, even worse, ignoring the importance of cash flow and that often results in losing their business.
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