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Cash flow | What is it, how does it work, and how do you measure it

Cash flow | What is it, how does it work, and how do you measure it

Cash flow is one of the most vital contributors to the survival of any business. In fact, 82% of companies cited a failure to obtain consistent cash flow as the primary reason for their failure.

A lack of cash flow can be crippling to a business. A study from Intuit found that 61% of small companies worldwide struggle to stay on top of their cash flow, leading to delays in paying suppliers, themselves, and even staff.

Given that SMEs make up 99% of OECD businesses and 70% of all jobs, it's clear that effective cash flow management is crucial for both individual enterprises and the global economy.

Knowing how to anticipate, calculate, manage, and optimize cash flow is an essential skill for all business owners, so read on to find out how to improve your cash flow and ensure the long-term success of your business.


Table of contents

  1. What is cash flow? 

  2. Key points

  3. How cash flow works

  4. The critical factors in cash flow analysis

  5. How to analyze your cash flow

  6. Example of cash flow analysis

  7. The difference between cash flow and profitability

  8. Why is cash flow important?

  9. Cash flow: a summary


What is cash flow?

The term cash flow refers to the movement of money in and out of a business. It is widely recognized as one of the most critical aspects of financial health, affecting both short-term operations and long-term strategic plans.



Cash flow can come from several different sources, such as sales revenue, investments, loans, and other forms of financing. It can be used to pay operational expenses, fund investments in capital assets, and build cash reserves.

Positive cash flow is essential for businesses to meet their obligations, pay employees and suppliers on time, and invest in growth opportunities. Negative cash flow disrupts operations, increases liquidity risk, and can even lead to insolvency if left unchecked.

Cash flow is usually reported regularly (often monthly), with an indication of whether the business has enough money coming in to cover its debts.

Cash flow is often calculated using the equation below:

Operating cash flow = operating income + non-cash expenses – taxes + changes in working capital

A cash flow example might look something like this:

Operating cash flow = $100,000 + $3,000 (non-cash expenses) – $10,000 (taxes) + ($2,000) (changes in working capital). The resulting operating cash flow would be $91,000.


Key points

  • Cash flow represents the movement of money into and out of a business

  • Cash inflows are sources of cash, such as sales revenue or loans. Cash outflows are uses of cash, such as expenses or payments on debt

  • A cash flow statement tracks inflows and outflows over a given period

  • Operating, investing, and financing cash flows are the three categories of cash flows found on a cash flow statement

  • Cash flow analysis can help businesses understand their financial health and make decisions on how to optimize cash flow


How cash flow works

Understanding how cash flow works is one of the most critical aspects of business financial planning.

The first step is understanding where your cash flow comes from and how it is used. This means examining the sources of income, such as sales, investments, and loans, as well as expenses like inventory costs, wages, taxes, rent, utilities, and loan payments.

Keeping your cash flow positive is vital for the long-term success of your business. Positive cash flow means that you have more money coming in than going out, and it is essential to pay bills on time and maintain a healthy financial position.

Cash flow analysis lets you understand the timing and amount of your cash inflows and outflows, so you can plan for future expenses and identify opportunities to increase incoming funds.

A cash flow statement is the best way to analyze your business's cash flow. This statement provides a detailed overview of the cash entering and leaving your business, allowing you to make more informed decisions on managing your finances.

An accurate cash flow statement also helps you identify any financial problems or risks, such as cash shortages and upcoming late payments. It provides the information needed to make timely decisions so your business can remain solvent and operational.

What does positive cash flow mean?

Positive cash flow, simply put, means more cash is coming into your business than going out. This indicates a healthy operating environment and allows you to reinvest in new projects, hire additional staff, or pay down debt.

However, just because you have positive cash flow does not mean you can be complacent. It is essential to monitor your cash flow statement and adjust spending decisions as needed.

An accurate assessment of your business’s financial health through a cash flow statement helps you understand the short-term and long-term effects of various management decisions. This type of analysis can put you in a better position to make educated and informed decisions about your business.

Creating a cash flow forecast is an essential part of financial planning. By predicting your future cash flow, you can adjust spending and business strategy to ensure your business stays on track financially.

Once you understand your current and future cash flow, you can make more detailed plans for moving toward your long-term financial goals.

Positive cash flow allows you to invest in your business and take advantage of new opportunities. Having a clear picture of your cash flow enables you to make better use of available capital and minimize costly debt.

An accurate assessment of economic risk can also be conducted with the help of cash flow analysis. By understanding the potential risks associated with different management decisions, you can make informed choices that will help protect your business from economic downturns.

What does negative cash flow mean?

Negative cash flow occurs when the cash inflow is less than the outflow. This can happen if expenses exceed income or a business takes on too much debt. Inefficiencies, such as high inventory levels or slow-paying customers, could also cause negative cash flow.

Negative cash flow can cause severe financial distress for businesses. Without adequate cash flow, companies may struggle to pay employees and suppliers, purchase inventory, and cover operating expenses.

It can also lead to difficulty accessing financing or borrowing capital from lenders. Even if a business has sufficient profits, negative cash flow can make it difficult to access the capital needed to grow and become profitable.

As mentioned earlier, just over 80% of small businesses fail due to cash flow issues, making it critical for companies to closely monitor their cash flow and take steps to ensure that their inflows are higher than outflows. In addition, late payments can have a significant impact on a business’ ability to maintain positive cash flow. The FSB found that in the UK alone, 50,000 small businesses close down each year due to late payments and their negative impact on cash flow. 

Companies should also strive to improve operational efficiency and create policies that will help them manage their cash flow more effectively.

The critical factors in cash flow analysis

Now that you have a clearer picture of what cash flow is, why it's essential, and what positive and negative cash flow is, let’s take a closer look at the components of cash flow analysis and how they can be used to help you manage your company's finances.

Cash flow from operations

Cash flow from operations represents the cash a business generates from its day-to-day operating activities. It can be calculated by taking net income and adding back items such as depreciation, amortization, non-cash expenses, and other non-cash charges.

For example, if a business sells goods or services and collects cash payments, the cash flow from operations would include those proceeds. If a company purchases inventory on credit, that cash outflow is also included in this calculation.

As part of a cash flow statement, this metric reveals how much cash is actually being generated from a company's core operations. Reported on an accrual basis, it excludes one-time items such as the proceeds from the sale of a long-term asset or debt-reduction activities.

Cash flow from investing

Cash flow from investing activities measures a business's cash generated or used to acquire assets that produce income. Common investments include purchasing stocks, bonds, other securities, and fixed assets such as buildings or land. It also takes into account money spent on research and development projects.

Cash outflow from investing activities occurs when a business uses cash to invest in long-term assets or acquire other companies. Cash inflow from investing activities is generated when a company sells securities, land, buildings, or equipment.

When recording cash flow from investing on a cash flow statement, businesses will subtract the cash outflow from investing activities from the total cash flow. This gives an unlimited amount of net cash flow from investing activities.

A positive outcome is desirable since it indicates that a company's investments are generating more money than they cost. The higher this number, the better it is for the business.

Cash flow from financing

Cash flow from financing activities is cash flow related to borrowing or repaying money and issuing or repurchasing equity. Examples of these activities include paying dividends to shareholders, taking out loans, or repaying debt.  

This type of cash flow can come from banks, investors, and other companies and can take the form of loans, bonds, and other investments.

When recording cash flow from financing on a cash flow statement, businesses will add the cash inflow from financing activities to the total cash balance and subtract outflows from financing activities.

A positive outcome indicates that a company has enough money to pay back its debts or invest in new projects. On the other hand, a negative outcome could indicate financial distress and require additional funds to resolve the issue.

How to analyze your cash flow

Now that we've covered the critical factors in cash flow analysis, let's take a more detailed look at how you analyze them:

Analyzing your cash flow from operating activities

The first step in analyzing your cash flow from operating activities is to compare it to profit from operations. Your profit from operations should be listed on your statement of profit or loss.

The closer these two figures are, the better it is for your business. If there is a big difference between these two figures, you must consider why you cannot turn profit into cash flow.

An inability to turn profit into cash flow can lead to severe liquidity problems. Since liquidity is intrinsically linked to the success of your business, you must be aware of this problem and take steps to address it quickly.

The next step is to look at the components of your cash flow from operating activities more closely.

This includes examining how much you spend on fixed costs like rent, salaries, taxes, and utilities and how these amounts have changed over time. It also involves analyzing the impact of any changes in inventory levels, accounts receivable, accounts payable and other changes that affect cash flow.

Look for significant increases in payables or accounts receivables that could be potential warning signs of cash flow problems. For example, if accounts payable have gone up significantly and your sales have not increased correspondingly, it is an indication that you may be having difficulty paying vendors.

Examining how much of the income generated from operations goes toward debt servicing is also essential. If debt servicing amounts are too high, it could indicate that the business is not generating enough income to cover its expenses and other debts.

Any cash left over after paying all the bills can be used to invest in new products, grow the business, hire additional staff, or pay down existing debts.

Analyzing your cash flow from investing activities

When it comes to investing activities, it’s crucial to understand how the business is using its money. Is it being invested in new products or services? Is it used to purchase long-term assets such as land, equipment, vehicles, or buildings?

Knowing where the money is going can help you plan for future investments and better manage your cash flow. It can also be used to measure the success of your current assets so you know which ones are working and which ones need improvement.

If assets are being sold to finance the operating side of the business, pay down debts, or pay dividends, then it's a good indication that the company is not generating enough profit from its investments or daily operating activities.

Analyzing your cash flow from financing activities

Ideally, the cash flow from operations and investments would be enough to cover any increases in costs associated with the business. However, particularly for newer businesses, that's sometimes not an option.

Long-term finance activities such as taking out loans can help a business obtain the necessary capital for expansion or other projects. 

However, if you rely too heavily on financing activities, there is a danger that you will accrue too much debt, which can put your cash flow at risk. Higher debt levels also raise your perceived risk level in the eyes of potential lenders. This can make it more challenging to obtain additional financing in the future.

The appropriate level of debt for your business depends on the nature of your operations and the availability of other sources of capital. It's essential to strike a balance between taking on too little and too much debt so that you can ensure long-term financial stability while still having the capital necessary to fuel growth.

Example of cash flow analysis 

Let's take what we've discussed about the factors involved in cash flow analysis, how to analyze them properly, and their potential effect on cash flow and apply them to a hypothetical business.

In this cash flow example, we'll use a small business that operates on the construction model and call it Casey’s Construction.

We will assume a starting net income of $75,000 and add a monthly additional cash inflow of $95,000. This monthly inflow is generated by $45,000 in accounts receivable, $20,000 in loans, and $30,000 in sales.

From that, we deduct the monthly cash outflows, which total $25,925 and are made up of $150 in marketing expenses, $75 in fees, $800 in insurance, $1500 in inventory, $7500 in payroll, $900 in rent, and $15,000 in taxes.

This leaves an ending cash balance of $144,075.

The difference between cash flow and profitability

While both cash flow and profitability are essential metrics for assessing the financial health of your business, they don’t necessarily measure the same thing. Higher sales, revenue, and profits don’t always mean better cash flow. Understanding how they are different and how they work together can help you make sound financial decisions for your business.

Profits refer to the overall profit generated by a business over a certain period of time, which is typically measured on an annual basis. After accounting for all income and expenses, this number indicates how much you’ve earned.

In contrast, cash flow looks at the movement of funds in and out of your business during a given period. It tracks all the cash coming in, such as your income, and all the cash going out, such as supplier payments.

A profitable company may not have positive cash flow, while a company with negative profitability may still have positive cash flow.

For example, if a company cannot collect on its invoices, it may show a profit because it has recorded the income but cannot actually receive the cash. In this case, the company would have positive profitability but negative cash flow.

Why is cash flow important?

According to research by Hiscox and Bloomberg, 8 out of 10 businesses fail in the first 18 months of trading. An inability to maintain consistent cash flow is the primary reason for these insolvencies.

Without a well-managed cash flow, a business may struggle to pay its bills or employees. It cannot invest in new products, services, or tools to help it grow. As such, cash flow is critical for businesses to stay afloat and remain competitive.

Cash flow is also crucial for a company’s long-term success. Companies need cash reserves to absorb costs when unexpected expenses occur, during times of economic downturn, or when sales are low. Healthy cash flow allows businesses to invest in research and development, expand operations, and explore new markets.

Finally, cash flow can indicate a company’s overall health. Poor cash flow may indicate that the business is struggling financially and could reduce investment chances from creditors or other entities.

It may also be a sign of poor management and a lack of strategic planning, in which case management needs to take corrective action quickly to improve cash flow and the business's overall financial health.

Overall, the old axiom that 'cash is king' holds true today. A business that can properly analyze and understand its cash flow is better equipped to set meaningful goals, make informed decisions, and ensure the company's long-term financial health.

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Cash flow: a summary

To summarize what we've learned so far, cash flow represents the movement of money in and out of a business over time. Companies take in money from sales, investments, loans, and other sources but also spend money on operational expenses, taxes, loan repayments, and more.

A healthy cash flow allows businesses to expand and grow, pay down debt, and invest in new revenue-generating projects. On the other hand, poor cash flow can lead to a lack of liquidity, increased debt levels, and even bankruptcy.

Cash flow can be positive or negative, depending on the company's performance, but positive cash flow is always preferable. It should not be confused with profitability, which measures the difference between revenue and expenses.

To accurately measure cash flow, businesses must consider all cash inflows and outflows. Cash inflows include income from sales, investments, loans, and other sources of revenue. On the other hand, cash outflows are expenses for operational costs such as salaries and wages, taxes, loan repayments, utility bills, supplier costs, and more.

Proper cash flow management is critical to a business's success. Companies can struggle to pay bills and creditors on time or maintain operations without enough cash. Poor cash flow management can also lead to an increased risk of insolvency.

On the other hand, positive cash flow enables businesses to pay suppliers, employees, and creditors on time. It also provides a financial cushion for unexpected expenses or future investments in the business, empowering them to take advantage of growth opportunities.

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