What Is Cash Flow In Business And Why Is It Important?

A little bit more about cash flow: real-life examples

Obviously, businesses need a consistent flow of cash for various reasons. There are suppliers and vendors to pay, rent and utility bills, accountant fees, employee salaries, and much more. But cash flow is much more than just how much cash you have.

Let’s explore what cash flow looks like with a real-world scenario:

Brian owns a car dealership in Seattle. He sells new and used cars, offers financing options, and has a service department. Because he must purchase vehicles before he can sell them, he needs big cash reserves or relies on loans.

Right now, the market could be better, and people buy new cars less often. This means Brian has an excessive number of unsold cars. As he continues to incur expenses for the purchased inventory but struggles to generate enough sales revenue, he is now facing negative cash flow—meaning he spent more money than he earned.

But wait, Brian is owed some money from customers. As he also provides financing options, he is expecting to receive more money in the next few months—including interest on cars already sold. If the cash expected to come in is higher than what he spent, that means Brian is profitable—even though his cash flow is negative. That’s great news.

What about positive cash flow, and what would that look like?

Katy is a franchise owner who operates a branch of “Gourmet Burgers” in Austin. Katy needs to pay monthly fees to the franchisor. These add up, but being a part of a well-known franchise provides an established brand and customer base. This means she has very high sales and a lot of regular customers. So, the fees end up being a small percentage of the total revenue.

She also needs to pay different vendors, rent, other bills, and payroll. By being a part of a franchise, she gets help with the budget. This enables her to keep expenses lower, meaning she has enough cash for other things she needs—like a new coffee machine that recently broke.

This last scenario highlights an important, and perhaps overlooked, aspect of cash flow: positive cash flow means you have enough money not only to pay your day to day expenses but to see the business you’re dreaming of come to life. It means you have extra cash (and peace of mind) to cover unexpected expenses or to innovate, develop, and grow your business.

Can your business be profitable and have negative cash flow?

Yes. It’s possible to have negative cash flow while being a profitable business, and vice versa. Let’s look at some real-life examples of how this works:

Imagine you’re opening a coffee shop. You take a small business loan from a local bank for $50,000. That loan represents money flowing into the business, producing a positive cash flow. But if you don’t have any customers in your first two months, you’re not generating revenue, which means your profitability is nil. Positive cash flow, without being profitable.

The reverse is also true. Let’s say you sell musical instruments, and most of your customers use the “buy now, pay later” option. You pay $3,000 for a piano, then resell it for $5,000, with the customer paying $2,000 now and $3,000 due in six months. Your cash reserves have actually gone down by $1,000 even though you netted a profit from the sale. If you are asking, what is negative cash flow, this is what it looks like, even while the business is profitable. Keep in mind though, that this scenario is quite rare.

How can negative cash flow affect a business?

Having sufficient liquid cash on hand to pay vendors and meet financial obligations is absolutely essential. Businesses that fall into negative cash flow and cannot cover expenses and payments are in a very tough spot.

It’s no surprise then that cash flow problems are among the most common reasons small businesses struggle. In fact, the Federal Reserve’s 2024 Small Business Credit Survey found that 44% of US small businesses faced a cash flow problem severe enough to keep them from paying expenses on time. Having a negative cash flow also makes it harder to forecast expenses and prepare for slow months.

Profit alone is not enough, you need positive cash flow to ensure you are keeping your business healthy.

How to calculate cash flow

There are two different types of cash flow that you’ll need to calculate in order to assess your business’s financial health: free cash flow and operating cash flow.

Free cash flow

This represents the money that remains after paying for things like payroll, rent, and taxes. This is the cash a company can use as it pleases.

Operating cash flow

Operating cash flow indicates whether or not a company can generate sufficient positive cash flow to maintain and grow its operations.

How to prepare a cash flow statement

There are several types of financial statements every business should regularly review to understand its health. A cash flow statement is a financial report that shows how much money is moving in and out of your business during a given period. Using this report, you’ll be able to see how much cash is available to your business.

The main components of a cash flow statement are:

1. Cash flow from operating activities: This is how much cash is generated from a company’s ongoing operating expenses, such as products or services.
2. Cash flow from investing activities: These include any sources and uses of cash from investments made by the company for the company. These include purchases or sales of assets like computers or desks for example.
3. Cash flow from financing activities: This represents the sources of cash from investors and banks, as well as the way cash is paid to shareholders.

When creating the cash flow statement, here are the steps you need to take:

1. Determine the starting balance of cash at the beginning of the reporting period.
2. Calculate cash flow from operating activities.
3. Calculate cash flow from investing activities.
4. Calculate cash flow from financing activities.
5. Determine the closing balance. Take the sum of cash flow from operating, investing, and financing activities to see your change in net cash for a given period.

Forecast expenses and earnings

A cash flow forecast is an estimate of your future sales and expenses. It shows how much money will come in and go out of your business over a particular period. It will also help you understand if you’re going to run out of cash or if you are looking at a cash surplus.

You can use accounting software, like QuickBooks or Xero, to create a cash flow example. You can also use a cash flow app to automate the process and reduce manual errors.

If you aren’t using accounting software, here’s what you need to do:

• Decide on your forecasting period: Choose a reporting timeframe that’s easy to predict and that’s correlated with what you want to know. It can be a week, a month, or a year, whatever you prefer.
• Add up your income: List all the cash coming into your bank account during the forecasting period. This includes sales, tax refunds, interest earned, investments from shareholders or owners, grants, and miscellaneous cash payments.
• Add up your expenses: List everything you’ll need to pay for during the forecasting period. That includes rent, wages, inventory, loans, fees and charges, marketing and advertising, and tax.
• Calculate your cash flow: For each week or month, subtract your total expenses from your total income.

Imagine a restaurant business that also provides catering services, and check out the example of a cash flow statement below. Note that while the first three months of the year are predicted to be slow, last year’s profit and investments keep the business at positive cash flow.

Inflation

When inflation rises, businesses with variable-rate loans can find themselves making larger installments. Higher loan payments mean that businesses may have predicted a certain cash flow, but are now dealing with less available cash on hand.

Supply chain issues

Supply chain disruptions—whether from labor gaps or price increases across industries—can raise the cost of goods. This means that downstream businesses have less free cash, making it harder to forecast cash flow.

Growing labor expenses

Labor shortages can lead to higher wages and less efficiency. As a result, businesses sometimes fail to deliver products and services to their customers, which can hurt revenue. Meeting those demands comes at a cost: hiring temporary staff or investing in upskilling existing employees.

Inventory management issues

Having too much stock is a problem. The larger your inventory, the less cash you have. Forgotten stock can also lead to cash flow issues down the road. You cannot sell it until you find it, and uncounted stock will continue to burden your cash flow until you do.

Should I take a loan if my cash flow is negative?

It makes sense that when you lack cash and are wondering how to increase cash flow, the first thing you might think of is taking a loan. And this is definitely one possible solution. However, there are safer steps to take before you resort to that. First, find out why your cash flow is negative. Once you have the answer to that question, the solution will be clearer.

Seek professional advice

Before you make any big decisions, consult a professional expert. An accountant will be able to help you decide how to solve your current issues and how to move forward. Plus, if you do end up taking a loan, an accountant can help you manage the whole process and get the best terms possible.

Cut down your expenses

Reducing expenses is one of the quickest ways to improve cash flow. These simple changes act as cash hacks—tactical shifts that can help you free up working capital quickly. When you spend less on payroll, rent, production, supplies, and other common expenses, the more cash you will have on hand.

This is an immediate step you can take, however, be very careful when cutting down staff. While reducing hires can be a short-term solution, rehiring new employees later may cost more in the long run.

Make sure you pay on time

Late payments often carry late fees. To avoid them, make sure you pay your bills on time. Some vendors even give discounts for early payments.

To make paying on time a regular habit, it is recommended to: