When someone starts a new business for the first time in their life, it’s like venturing into a no man’s land. One simply cannot fathom its vastness. Managing cash flow for small business owners is one such uncharted, hostile territory.
It’s obvious, managing cash flow for small businesses is comparatively more challenging than a big corporation. And therefore understanding cash flow is vital for the survival and growth of a small business.
What is cash flow?
Cash flow is the net of the cash or cash equivalent that is coming into and going out of your business. If for a period of time your account receivable is more than the account payable, it’s a positive cash flow. If the account payable is more than the account receivable then you’re looking at a negative cash flow.
Learn more about Cash Flow Management from here – The ultimate guide to cash flow management.
What is a cash flow analysis?
Cash flow analysis is the periodical study of several business components such as accounts payable, accounts receivable, inventory, credit terms et cetera to keep a check on cash flow.
How is cash flow analysis performed?
Cash flow statements can be generated either using free or paid accounting software or a free cash flow worksheet template. Cash flow statements consisting of operating cash flow, financing cash flow, and investing cash flow shall be generated in order to perform cash flow analysis.
The operating cash flow statement comprises recurring expenses such as rent, salaries, supplies, and utilities.
The investing cash flow statement consists of funds spent on financial instruments and fixed assets which could include assets in a plant, property, the purchase of stock, or securities of another company.
A financing cash flow statement consists of the funding that comes into a business from investors, a company’s owners, and creditors and is classified as dividend transactions, debt, and equity.
Methods to prepare a cash flow statement
Let’s begin with preparing the operating cash flow statement. Two commonly practiced methods include the cash flow statement direct method and the cash flow statement indirect method.
In the Direct Method, net income is calculated taking into consideration all cash collections from operating activities and then subtracting all of the cash disbursements from the operating activities.
In the Indirect Method, one begins with the net income and then deducts or adds from that amount for the expense items and non-cash revenue.
A small business operating cash flow statement includes but is not limited to:
- The purchase of inventory or supplies
- Payments to contractors
- Amount of cash received from sales of goods or services
- Fines or cash settlements from lawsuits
- Employees’ wages and cash bonuses
- Utility bills, rent or lease payments
- Interest received on loans
- Interest paid on loans and long-term debt, if any
After preparing the operating cash flow statement, you shall move on to prepare the investing cash flow statement and the financing cash flow statement.
Interpreting a cash flow statement
1) When cash flow is positive, it is good news. With more cash coming into the business than going out on a regular basis, you can pay your employees and suppliers on time, invest in machinery and innovation.
2) When cash flow is negative, it could be a sign of trouble. A single-time negative cash flow might not be a threat but if that is something happening in a row then it is definitely a sign of danger.
While doing your regular cash flow analysis, whenever you find yourself in a negative cash flow situation, be prepared to immediately inject cash into the business with the help of invoice factoring, invoice funding, and sales invoice discounting to fulfill short-term operational needs. If possible, refrain from selling off company assets to pay its operating expenses. Take this step only when you are in dire need and have no other options left.
3) When investing cash flow statement’s net is negative, it necessarily might not be a bad situation. A negative investing cash flow could be due to certain investments in purchasing certain assets and property, while the company is making good money and in turn using it to grow.
4) Your free cash flow reserve determines what you are left with after operating and capital expenditures. Free cash can be used to acquire another company, buy back stocks, pay down principal or interest amounts on loans.
Summing up
While doing a cash flow analysis for your business, it is very important to understand when a negative cash flow in certain areas might not necessarily be a bad sign and when a positive cash flow might not be a good sign. Weekly or monthly cash flow analysis will make you more aware of the intricacies of cash flow management.
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In conclusion, growth of a business is not achievable without analysing the actual data, and analysing business data is incomplete without analysing cash flow of your SME.