Why It’s Important To Understand Your Cash Flow As A Business Owner
If you’re a non-accountant or non-finance person, you would imagine cash flow like a faucet with flowing money coming out of it. Well, you could think of it that way, only that something is missing in your imagination: Where is the money coming from?
Cash flow in business is basically the coming in and moving out of money. You need money to spend in order to keep your business operations running, and you need a steady inflow of cash to do it. It’s as simple as that.
Sources of Cash
Now, to answer where the money is coming from, here are the different sources of cash in business:
- Cash Sales – Cash from sales of the company’s inventory or main trade.
- Collections of Accounts Receivables – Payments received from customers upon the due date of the credit extended.
- Loan Proceeds – Cash received from loans granted by banks and other financial institutions.
- Sale of assets – Cash from selling property, plant, or equipment
- Owner’s investment – Cash entered into the business to be part of the owner’s equity
Importance of Understanding Cash Flow as A Business Owner
It’s easy to disregard cash flow statements, thinking that they’re not really that important, unlike Profit and Loss Statement and Balance Sheet. As a business owner, you might have the tendency to just be after the results of your operation and your financial position.
However, your cash flow serves as your supposed guide about whether it’s feasible for you to continue the same activities you are doing for your business or veer away from these and try some unexplored avenues, hoping for better results. So, cash flow is often as crucial as your net income.
Here are some of the reasons how understanding cash flow will benefit business owners:
1. Avoid Making Bad Decisions
Cash flow is what is left of your cash after deducting all your expenses for a specific period. On the other hand, net income is the overall profit from your business operations after deducting all costs and expenses, which doesn’t necessarily have to be cash.
In fact, it’s possible to have a net income without any cash left on your balance sheet, and to have a lot of cash without earning any profit. By knowing these, you can avoid making crucial financial decisions that your business actually couldn’t afford at the moment.
2. Improve Your Chances of Securing a Loan
Aside from looking at whether your business is profitable or not, typically, cash flow is another basis of lending institutions in granting loan applications. By understanding how cash flow works to your advantage, you’ll be able to verbally relay this to the financial institutions during interviews to match with the presented financial statements.
3. You Can Improve Your Cash Flow
When you understand how cash flow works, you can do everything in your ability to have a better one for each accounting period. By doing so, you give your business the flexibility in facing financial dilemmas that may occur, as well as the advantage in making critical decisions, something not a lot of business may have due to negative cash flow.
Improving your cash flow simply means improving your cash inflow or the money coming in. There are several things to accomplish this, namely:
- Forward invoices to customers as soon as possible. The sooner they get it, the sooner you get paid. In practice, the credit terms are based on the invoice date and not on the date the goods and services are received.
- Encourage early payments from customers by offering discounts for paying in advance. It’s always better than imposing penalties on late payments and tainting business relationships in the process.
- Just lease buildings and equipment instead of buying for business operations. This is especially beneficial if you are not going to use the assets year-round. Just opt to pay the monthly lease or rent, and you can use your budget on something more important and can produce more money.
- Dispose of your slow-moving inventory. Offer discounts even if it means offering it at the breakeven price. It’s better this way than having your money tied to it and not getting anything but occupied storage space.
- Do thorough credit investigations on potential customers. Ensuring that they will be able to pay on time reduces the risk of bad debt or credits that cannot be recovered.
- Pay bills using your business credit cards. This way, you can maximize your credit line, and the money that is supposedly used to pay will stay with you for an extended period. This is because even when you pay on the exact due date, you will still have around 21 days before your credit card bill falls due.
Having an excellent bottom line on your Profit and Loss statement is not all when it comes to business. You can have a nice looking revenue at the top and an even better income at the bottom, but it means nothing in the long run if your cash flow is deficient. Think about all your revenue coming from credit sales, and you’ll understand why.
In terms of longevity, business owners who are able to create excess cash have more opportunity to grow better businesses over those who only look at the profits. In the end, you have to look at both ways to succeed.