How to manage your cash flow – for small business owners

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Is your small business running smoothly like clockwork, or is it continually an uphill struggle? If it’s the latter, then our guess is that it may be your cash flow giving you trouble. That’s because Quickbooks did a study where it was found the most common problem shared between 57% of small businesses was cash flow issues and Xero reported that over 90% of small businesses faced at least 1 month a year of negative cash flow, with UK businesses on average experiencing 4.5 months of negative cash flow. These are definitely concerning figures and it just goes to show how it’s important to learn how to manage your cash flow.

What is cash flow?

Cash flow is the term used to describe the movement of money that comes into your business as income and goes out of your business as expenditure across a certain period such as a month or a quarter. Cash in or inflow refers to all the money that enters your business as a result of customers purchasing your goods or services, as well as from proceeds on investments, funding, loans, or assets, among other sources. Contrarily, cash outflow, also known as cash out, is the total amount of money that leaves your business as a result of payments for costs like rent for an office, interest on a loan, taxes, and other payables. To calculate cash flow or net cash flow, you simply subtract the total cash outflow from the total cash inflow: Net Cash flow = Total Cash Inflow -Total Cash Outflow.

Why is understanding cash flow important?

Understanding your cash flow is so important as it will enable you to effectively manage it; this is crucial for small business survival. If you are not managing your cash flow well, it can affect your personal finances (especially if you are operating as a sole trader), or could even mean your business goes bust due to not having enough cash to sustain it. Learning to understand your cash flow will allow you to see when and where you are overspending, recognise seasonal trends or fluxes so that you can plan around low cash flow periods, as well as help you project cash flow when you’re seeking investment or planning to grow.

What are the different types of cash flow?

To manage your cash flow, you may need to understand the three different categories of cash flow. These three main streams are; operating, investing and financing. Which of those types you will predominantly use as a business metric will be dependent on what types of activities your business is involved in. For some businesses, all three will be relevant but at varying degrees, and for other businesses, some types of cash flow will be irrelevant.

• Cash flow from operating activities (CFO)

Your cash flow from operating activities is the movement of money coming in and out of your business due to core day-to-day activities. This can include generating income from the sale of goods or services, expenses such as purchasing inventory, other expenditure ranging from paying bills and utilities, paying off loans, and paying for employee salaries. The CFO is generally regarded as one of the key figures in any business’ financial reports as it shows how much cash is available to spend, whether that’s to invest, pay dividends (if you run your business as a limited company), or to settle financial liabilities such as taxes. Therefore, if you have a positive figure, it usually means your business is profitable and has surplus cash; whereas if the figure is negative, it means that you have spent more than the cash you have available.  

To calculate cash flow from operating activities, you use the following formula:

net income + non-cash expenses + changes in working capital = operating cash flow

To explain: non-cash expenses cover four accounting principles of depreciation, depletion, amortization, and deferred charges. A change in working capital is the value it takes to operate your business and is calculated simply by subtracting current liabilities from current assets on your balance sheet.

• Cash flow from investing activities (CFI)

This type of cash flow shows the movement of money due to investment activities specifically. This includes purchases of assets such as machinery or property which may change in value over time, business acquisitions or mergers, requested loans or debt repayments, and investments in marketable securities like bonds, cryptocurrencies, or stocks. It may be a more significant indicator for businesses in certain industries, such as manufacturing as they will invest much bigger sums of money on equipment and commercial space. 

To calculate cash flow from operating activities, you use the following formula:

money received from asset sales and any loan payments – money spent to purchase assets and loans = investing cash flow

• Cash flow from financing activities (CFF)

The third type of cash flow shows how money moves due to the financing of the business. For sole traders, it could be through putting in your own personal finances as capital to fund your business or perhaps you received a bank loan. For limited companies, your cash flow from financing activities could involve selling equity in exchange for investment. Generally speaking, this type of cash flow will be more useful for those businesses which are limited companies.

To calculate cash flow from operating activities, you use the following formula:

Cash earned on equity – (Dividend payments+ equity repurchases) = Financing cash flow

What is free cash flow?

Free cash flow is not a different type of cash flow but a way to calculate how much money is left in the business after all business expenses are paid for. It basically shows how much money is left in the business to spend as you wish. You’ll likely look at your free cash flow before making big financial decisions such as if you’re wanting to purchase large assets e.g. company vans, cars or equipment, considering taking on new employees, or expanding your business in other ways. Free cash flow is a good indicator of your company’s liquidity which is synonymous with financial health and ability to continue staying in business.

To calculate free cash flow, you use the following formula:

Operating cash flow – capital expenditures = free cash flow

What is the difference between cash flow and profit?

Often, cash flow is confused with profit because they both consider the difference in value between expenditure and revenue. However, it is important to be aware that they are two distinctly different financial metrics that should be used in different situations.

Profit is a static metric that will give you a picture of your business’ finances over the last period of time because the calculation is simply revenue minus expenses. You can choose to use either the cash accounting method or accruals accounting method when calculating profit, but they will give different results.

The cash accounting method focuses on the movement of cash. It will show how much money is coming into the business and leaving it, but it will not show if the business is profitable. This is because you may have a month where you receive a high volume of orders, but until you are paid, your cash flow report may show negative cash flow.

How to manage your cash flow

To manage your cash flow, you should create a cash flow forecast. This is a plan which predicts when you expect money to come in and when you forecast expect money to go out. A cash flow forecast is not intended to be perfect or completely accurate but is based on reasonable assumptions.

You can start with either your expenditure or your sales first – whichever is more stable for your business. For expenditure, you can plot fairly anticipated outgoings such as staff salaries and rent. You may then move on to plot planned expenditure such as upgrading new equipment before the summer or the launch of a new product or service.

Sales can be trickier to predict unless you have a regular and stable customer base, but it may be sensible to predict volume of sales depending on seasons or key events. For example, if you’re a florist, it will be fair to assume an influx of orders for events such as Valentine’s Day and Mothers’ Day.

Once you have plotted out key times of money coming in and out you can start to ensure you have sufficient reserves for when money needs to go out. It may not be wise to buy expensive new equipment just before you need to pay staff salaries if there is not enough money in the business. On the other hand, you may want to invest more in stock of swimsuits in the winter when it’s cheaper to purchase with the prediction that you’ll be able to sell all the stock by the beginning of the summer.

A cash flow forecast is a report that should be reviewed regularly as well as adjusted when you have new information on your business. It will allow you to manage your cash flow by helping you see when you will need to have sufficient money in the business to pay for upcoming expenditure (whether that involves saving up for it in advance or boosting marketing to increase sales) as well as inform you of when you may have a window of opportunity to invest or pay out dividends where you predict high cash inflow.

How to improve your cash flow

If you’re having trouble with managing your cash flow, then here are five strategies you can use to improve your cash flow:

1. Review your payment terms. If you normally allow your customers 60 days to pay their invoices, considering shortening this time frame. Alternatively, you may even want to change your payment model and ask for a deposit upfront to improve your cash flow.
2. Assess whether it would be beneficial to enter into a lease or payment plan. Periodic payments for high value assets may be more manageable than purchasing an asset outright in one go, especially if your buffer of cash is low.
3. Use contractors or temp staff if you’re not ready to hire full-time employees. Sometimes you need an extra pair of hands to help you during busy periods, but if your business has not yet established a need for permanent hires, then temporary hires may be more suitable as it means you do not have to commit to annual salaries. Alternatively, if you are able to use contractors, it may mean that you can save on NI contributions also.
4. Monitor stock closely. Stock/inventory is one of the most common business expenditures, but they can cause cash flow issues when you’re unable to shift it as quickly as you expect to. Regularly evaluating your stock and replacing slow moving goods for more popular inventory lines will help improve your cash flow.
5. Create a surplus buffer. Whilst using profits to invest in your business may help it grow, it is also wise to save cash in order to ride out negative cash flow periods. Business experts suggest having between three to six months’ worth of operating expenses available in the bank so save where you can for rainy days.

Get help with understanding your cash flow

If cash flow is an issue for your business, it can be difficult to understand why, especially if you’re not used to interpreting cash flow reports or forecasts. Our Management Accounts service not only provides you with the key numbers for your business, but we’ll also explain and discuss them with you as well so that you have full understanding to make better business decisions. To find out more about our Management Accounts service, use our contact form to book a consultation call. Our accountants are keen to hear about your business goals and see how we can help.