Cash flow measures how much cash is flowing in and out of a business. A positive cash flow is one of the strongest determinants of a business’s success. It shows that a company can fund its debts and pay for immediate needs such as equipment and staffing, and also that it has enough money in reserve to invest or survive a downturn.
Profit is important in business, but focusing solely on profits can be misleading. A company can be profitable and not have a positive cash flow. And a company is more likely to fail because of cash flow issues than poor profitability.
Business owners who do not understand cash flow statements might have mistaken ideas about their company’s health. This can cause financial problems down the road, including the inability to grow, to secure financing, or to attract investors. It might even lead to insolvency and failure.
Cash Flow Issues and Business Failure
Entrepreneurs are undoubtedly familiar with the dismal statistics about how often new businesses fail. In case you have forgotten, more than one-fifth of businesses fail in their first year, nearly one-third fail within two years, and more than half fail within five years.[1] It is important for business owners to understand why businesses fail and how they can avoid common mistakes that lead to failure.
Many small businesses fail because of cash flow problems. Poor cash flow management skills and a poor understanding of cash flow rank ahead of other common cash-related reasons for business failure, including too little start-up money and running out of cash. It also tops being outcompeted, lack of market for a business’s products or services, and not having the right team.[2]
What Is Cash Flow?
Business owners are understandably concerned about profits. Businesses that do not have enough money coming in may be forced to cut costs or borrow more money. Over time, businesses that do not make enough money do not succeed.
However, profit only tells part of the story. Cash flow indicates how much money a business has on hand. It is what is left over after cash and cash equivalents come into a company and money goes out to pay a company’s bills. A business with high profits can still have negative cash flow, while a business with low profits can have positive cash flow. When expenses exceed existing cash, that is a sign of trouble.
A business cannot pay its bills with profits. It needs money on hand. That is why looking solely at income and revenue—or just at liability and losses—can provide a false impression of a business’s financial health. For a truer picture of financial health, the movement of cash in and out of a company must be measured using a cash flow statement.
Cash Flow and Liquidity
A cash flow statement provides an overview of the amount of cash and cash equivalents entering and leaving a company. Cash means the funds in an account available for immediate use. Cash equivalents are assets that can quickly and easily be converted to cash. Cash and cash equivalents are liquid assets.
Liquidity is closely related to cash flow. Both liquidity and a positive cash flow are signs of healthy finances. A liquid company can meet immediate and short-term obligations using its current assets (i.e., without having to raise outside capital). Having a positive cash flow indicates that a company is increasing its liquid assets. The more liquidity a company has, the more able it is to cover its obligations, reinvest in growth, have emergency funding, obtain loans, and take advantage of investment opportunities.
Measuring Cash Flow
Cash flow statements cover the amount of cash entering and exiting a company from three main types of business activities: operating activities, investment activities, and financing activities.
- Operating activities are traditional business activities. The operating activities section of a cash flow statement shows how much revenue is generated by the company’s goods or services, as well as operating expenses such as office costs and wages.
- Investment activities reflect money gained or lost through short- and long-term investments—such as the purchase or sale of equipment, intellectual property, and other assets—as well as payments related to mergers and acquisitions.
- Financing activities are transactions involving debt and equity financing. Inflow financing activities may include money borrowed, while outflows may include debt servicing, distributions, or dividends.
These categories comprise the cash flow statement, which is prepared using a direct or indirect accounting method. Both methods calculate a business’s total cash received, minus the total amount it spends, over a given period. The main difference between the two involves calculating cash flow from operating activities.
QuickBooks notes that the indirect method is easier to use and is generally preferred by business owners, but the direct method, although more labor-intensive, can give a more complete picture of cash inflows and outflows.[3]
Investors and stakeholders may prefer a cash flow statement prepared with the direct method. This method can also be beneficial for companies that operate in highly regulated industries that require maximum transparency.
In addition, the detailed accounting provided by the direct method may be more useful for long-term business planning. While burdensome for larger businesses, the direct method is less so for smaller businesses with simpler income streams.
How to Use a Cash Flow Statement
You have completed your business cash flow statement. Now what?
To start, it can let you know whether you have a cash flow problem. Hint: if your money going out exceeds your money coming in, you have a cash flow problem. Identifying that you have a problem is a crucial first step for taking corrective action.
A cash flow statement is also useful for achieving growth. If you have sufficient cash and cash equivalents to maintain daily operations, you can turn your attention to growing the company. The cash flow statement can inform growth strategies and let lenders and investors know a company is a good bet.
Need the Help of a Professional? Talk to Our Business Lawyers
Alongside your balance sheet and income statement, a cash flow statement is a critical measure of where your business stands. It pays to ensure that you not only get cash flow calculations right but also know how to adjust your business in response to cash flow statements.
Another top reason businesses fail is that they do not get help from professionals when they need it. It is a sound business strategy to invest resources where they can do the most good. Often, that means knowing what you do and do not do well. If you want to discuss the legal aspects of long-term planning for your business, get in touch to schedule a consultation with one of our experienced business attorneys.
[1] Business Employment Dynamics: Entrepreneurship and the U.S. Economy, U.S. Bureau Lab. Stats. (Apr. 28, 2016), https://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm.
[2] Jeff Desjardins, Why Do Businesses Fail?, Visual Capitalist (Aug. 1, 2017), https://www.visualcapitalist.com/why-do-businesses-fail/.
[3] Direct or Indirect Cash Flow: Which Is the Right Fit for Your Business?, Intuit QuickBooks (Aug. 15, 2021), https://quickbooks.intuit.com/au/blog/running-a-business/direct-vs-indirect-cash-flow/.
