The ultimate goal of a small business is to become a profitable venture for a small business owner. Ideally, small business owners can run a business that they love while simultaneously being able to make a nice profit off of their business. If a small business does not turn a profit, this can create financial problems and strain for not just the small business but also the small business owner.
The key metric for determining profitability is cash flow. At the end of the day, cash flow shows how much money a business is generating after every expense in real terms. Assessing this cash flow and understanding how to improve cash flow management is fundamental for the improvement of the cash position of a small business.
Small business owners are faced with challenges related to running their small businesses every day. Often, small business owners do not have time to sift through financial statements and understand how each component affects the profitability of their business. However, it is important that small business owners understand the fundamental determinants of their profitability and cash position. As a result, you might be interested in how you can analyze cash flow from your business assets.
There is no need to worry. In this blog post, we will cover everything you need to know about cash flow, its importance for your small business, calculating cash flow, interpreting your cash flow broadly, as well as specifically, and fixing your cash flow problems while breaking down cash flow into a categorization of cash flows from assets. This will provide you with a template to start your own cash flow from assets analysis on your small business. We’ll cover the following in this article:
What is Cash Flow?
It is good to get a fundamental understanding of cash flow before you get into analyzing the complex dynamics of your company’s cash flow. Put simply, cash flow is the change in cash of a company after all expenses are paid. It reflects all of the cash inflows and cash outflows of a company in a given period. It is distinct from net income because it deals with non-cash expenses like depreciation to arrive at the actual change in the cash position of the small business.
It is important to remember that cash flow is not the same as the bottom line of a business. It is instead the change in the cash balance of your small business over time. It is a helpful measurement of whether you have enough cash in your business for possible future expenses.
Why is Cash Flow Important for a Small Business?
Cash flow is vital for a small business for a variety of reasons. Cash flow is not simply a bookkeeping measure. Cash flow shows how your business is really doing in terms of its cash position in a given period. It demonstrates your small business’s ability to make future purchases in cash or take on certain debt repayments. Overall, it is a very important metric of financial health in your business.
Your free cash flow is a metric that both investors and lenders can use to determine how efficiently your business is operating in a given period of time or accounting period. The net cash change helps determine the potential returns for an investor as well as the capability of your small business to repay different amounts of money in terms of business loans. Based on your current cash flow and recent cash flow history, investors and lenders will conduct cash flow forecasting. From this, they will create cash flow projections. Thus, your past and current cash flow performance means a lot in the way of what financing and funding your small business can get. It also potentially shows where your business needs to improve its cash flow.
Chances are that your small business will need financing at one point or another. If you need to do repairs, remodel, renovate, order new equipment, inventory, or other expenses, you may need to take out a loan. It does not really matter what the size of the loan will be. Your cash flow will affect your eligibility for loans, including those with lower interest rates. With a larger cash flow, your small business will find it easier to get cheaper financing because you will be able to handle additional financial obligations. Moreover, if you are planning on expanding your small business to an additional location, having a greater cash flow will make this decision a lot easier, happen sooner, and be much cheaper for your business.
Alternatively, if you are planning on raising equity or selling your small business one day, investors will be interested in their projected returns. One of the best ways that they can project returns is from your statement of cash flows. This statement gives information about your small business’s cash flow. If you have better cash flow, you are likely to get better offers when it comes to investors seeking to buy some or all of your business. This is because investors may be more certain of acquiring a better return in the short term.
Your cash flow is also a metric you can understand and use in the context of your own small business’s prospective expenses. For example, the cheapest way of buying new goods or equipment for your small business may be to simply buy them outright. This is especially true if you have a lot of cash. If your small business is saving up to make a large purchase, you can project this out with cash flow.
For these reasons, understanding your small business’s cash flow is very important. In addition, analyzing your small business’s cash flow from assets can help you determine where your business may be able to improve its cash flow. In improving your small business’s cash flow, you are setting up your business to be in a better and more profitable position. Some of these improvements can be made by increasing your sales revenue or operating income, but other changes simply focus on logistical improvements you can make with your business operations.
Understanding a Cash Flow Statement and Cash Flow from Assets
Before you can analyze your cash flow, you need to understand how your cash flow is reported. Cash flow is reported on a cash flow statement. The cash flow statement shows the inflows and outflows of cash based on the activities of your small business in a given period of time. The demarcation of different categories on the cash flow statement allows you to understand the breakdown of cash flow by activity. This includes the operations of a business, the investments of a business, and the financing activities of a business.
Overall, a cash flow statement shows the sources of cash inflows as well as the expenses that cash is being spent on. In doing so, the cash flow statement shows the liquidity of a business. This is important for lenders because, in the event of a default, a lender will want to know how to recover their money. They can be surer of their money being recovered if the cash flow is being managed better. Moreover, lenders can be sure of the increased likelihood of a business paying back their loans since businesses with higher cash flows have greater flexibility in their management of cash. This concern is especially important with long-term debt.
Importantly, a cash flow statement starts with a line called net income. Net income is the last line on the income statement. To explain cash flow thoroughly, it is best to start with the income statement.
There are three main financial statements that are standard in accounting which can help you analyze cash flow from assets for your small business. These three main financial statements at the income statement, the balance sheet, and the cash flow statement. The income statement starts with revenue and works through a business’s cash and non-cash expenses to arrive at a number for net income, also known as the bottom line. The balance sheet reflects a snapshot of a business’s balance of assets, such as cash and cash equivalents, with liabilities, including debt and shareholder’s equity. The cash flow statement starts with net income and adjusts for non-cash expenses to get the actual change in cash position.
Therefore, a cash flow statement starts with net income and makes adjustments to net income to arrive at free cash flow after three categories known as cash flow from assets. The first of these categories is known as cash flows from operating activities. Cash flows from operating activities adjust from the sale of goods and services of a business. The next category is cash flows from investing activities, which involves the need to adjust based on the income from investments that a business is making, such as with capital expenditures. The final category is cash flows from financing activities, which involves the need to adjust based on the income a business is making or losing from debt or other interest-based financing activities.
After adding the subsequent changes in cash from these three categories to net income, you arrive at cash flow. This cash flow number is the complete summary of your cash flow from assets. To support your analysis, the adjustment which is made to net income in each of the categories are usually broken down into which exact expenses are causing these adjustments. This can assist in better understanding your cash flow.
Calculating Cash Flow
Part of being able to critically analyze the cash flow from your assets is being able to calculate cash flow for yourself. Understanding the calculation of cash flow can help you project out different figures by modifying the strategies which your business pursues related to cash flow.
When you go to calculate or understand your cash flow, you will need to first understand the type of accounting that your business uses. Your accountant, you, or your accounting software will likely be able to tell you which accounting method you use. There are two primary methods of accounting: cash basis and accrual basis.
Cash basis accounting is usually used by very small businesses with not very complicated setups or structures which would necessitate finite accounting. If you use cash basis accounting, you record cash only when you receive money from customers in a period. This allows you to use a direct method of cash flow calculation, which means that your cash flow is calculated by taking all cash inflows and subtracting all cash outflows from cash inflows. This allows you to calculate your cash flow for a given period.
Accrual accounting is likely used by your small business if you have a lot of revenue, employees, or generally have a difficult structure to keep track of cash constantly. It is used by most businesses. Accrual accounting is also more helpful to understand the cash in the business when it is reasonably earned. This means that you can more accurately get an idea of when sales are happening versus when cash is hitting your bank account.
If your small business uses accrual accounting, you will use the indirect method to calculate the cash flow for your small business. Net income is the top line of the cash flow calculation, where each of the three categories is added to show the change in the amount of cash in the business to determine the net cash in the business at the end of the period.
Interpreting Cash Flow Generally
In analyzing your cash flow from assets, you need to first interpret the cash flow generally. From this level, a deeper analysis can then be made. Since cash flow is a general determinant of the success of a business during a certain period, a quick look at cash flow can give a general sense of whether a small business is performing well.
Positive cash flow is a good sign for a small business. If your small business is turning a positive cash flow from its business assets, you can already say that a business is producing more cash through its operation. The extent of the positive cash flow will demonstrate how successful your small business is currently with its operations. It can show that your business is ready to take on future expenses or payout distributions.
On the other hand, negative cash flow is often a bad sign for a small business. Negative cash flow is indicative that your small business is having a hard time managing cash in a good way during a certain period. You may have expenses that are too high or not enough revenue. However, it may not always be a negative sign in that you might have made a large investment in a given period. Yet, sustained negative cash flow is likely a bad sign for a small business. In any case, negative cash flows should make you scrutinize your financial statements and spending decisions to determine how to better your cash flow. You may need to modify your business plan or make alterations to your business operations, strategy, or structure.
Performing Cash Flow Analysis on Cash Flow from Assets
Now, it is time for your cash flow analysis to get specific. There are a few common areas that affect your cash flow from assets that you can see if they are affecting your cash flow positively or negatively. You can then determine what methods are best to remedy your cash flow issues from assets. A deep understanding of cash flow problems and how to fix them will help you find success as an entrepreneur. Separating your cash flow into cash flow from assets can help you determine how to best fix your small business’s cash flow problems.
Cash Flow from Operating Activities
Cash flow from operating activities essentially deals with the operating activities of the business. In other words, these are the general sales and expenses of the business. You should watch this part of the cash flow statement to understand where some of your cash flow problems might be originating.
Accounts receivable is an example of a very large influencer of cash flow in your small business. Accounts receivable is defined as the outstanding payments that your business will receive from customers who you have already served and delivered the good or service. Although you have already provided your customers with the good, you have yet to receive the funds from this sale. As a result, this money is known as accounts receivable and represents a current asset of your business.
While accounts receivable sales are recognized as revenue in the income statement, they will not be recognized in the same way on the cash flow statement. Accounts receivable will have to be subtracted from the net income number because the cash from accounts receivable has not reached your small business. Since this is an operating activity, accounts receivable will negatively affect your cash flow from assets for cash flow from operating activities.
If you recognize that your accounts receivable are negatively affecting your cash flow at a substantial level, your small business may have a problem when it comes to collecting on sales it makes. You should consider improving the methods by which you collect payments from customers to ensure that your accounts receivable is brought back into an appropriate balance.
Accounts payable also have the potential to influence your cash flow positively. Accounts payable is defined as the payments that your small business still needs to make even though you have already received the products or services from another company. Since you have not paid those companies, the cash is still in your business. As a result, your cash flow is higher.
This artificial increase in cash flow may be a bad thing since accounts payable flow from your current liabilities. This is an expense that you will have to deal with at some point, and having accounts payable is normal for small businesses. However, having too many accounts payable can inflate your cash flow numbers. It is also important to note that accounts payable specifically affect cash flow from operating activities as part of your cash flow from assets.
Some businesses consider having larger accounts payable as a good thing since it inflates their cash flow from assets. However, it is still important to note the effect of accounts payable on cash flow when analyzing why your small business might have such high cash flow.
Inventory further impacts your cash flow. When you think about the inventory in your business, as you sell inventory, your cash flow theoretically increases due to the purchases of your goods. However, when you buy inventory, your cash flow decreases, as you use your cash to buy goods.
Inventory stems from cash flow from operating activities in terms of cash flow from assets. This is because buying and selling inventory is an operating activity of your small business.
When analyzing your cash flow from assets in cash flow from operating activities, you should look at your inventory purchase business expenses and your sales. This can help you tell a story with your cash flow. If you have had massive sales with comparatively fewer inventory purchases, your cash flow might be unusually high. Likewise, if you buy a lot of inventory, your cash flow might be decreased or go negative. This might be done to harness economies of scale. In any case, some instances of depressed cash flow may be explained by inventory movements. You can try to optimize these to improve your cash flow in a given period.
One of the ways you can increase your cash flow is to raise prices. This, of course, assumes that the price raise will not decrease your sales volume to the point that your overall sales decline. However, a price raise might contribute to a greater cash flow from operating activities. Having a good pricing strategy is important for this.
Another common fix to cash flow is to look for ways to reduce the production costs of your products and services. By reducing the costs of your goods and services in production, you are leaving more cash left over at the end of the day, increasing your cash flow from operating activities.
One of the other things you can do to increase the cash that your business will take in at the end of the day is to focus on how you might be able to reduce unnecessary labor costs and other operating expenses when it comes to general business operations. By reducing spending on operations, it might be possible to have more money reach the bottom line. In turn, this can create additional cash flow from the asset of operating activities, improving your operating cash flow.
Cash Flow from Investing Activities
Cash flow from investing activities is essentially the business activities which involve making capital expenditure investments or investments in external companies.
If your small business has recently made a large investment in some capital product, your small business might be experiencing an outflow of cash. As such, your cash flow may be reduced for a certain period.
Improving your working capital may also be able to improve your small business’s cash flow position. By investing less in investments outside of your company and reducing the amount of money that you need to pay in loans, your cash flow can be improved. This will improve your cash flow from assets in both financing activities and investing activities.
Cash Flow from Financing Activities
Cash flow from financing activities is essentially the debt and financing that a business receives and has to pay. If your business takes out a loan or another form of debt at the start of a period, it will show up as positive cash flow. If your business is making payments on the debt, this will represent negative cash flow.
Debt is very common for small businesses and debt payments contribute to decreasing the cash flow of a business through the monthly payments of principal and interest amortization every month taking cash away from the business. Your small business might take on debt for a variety of reasons. Whether you were expanding your business, buying new equipment, or repairing a part of your small business, you will have a monthly payment to accompany your loan. This monthly payment represents an outflow of cash from your small business.
Debt is part of the cash flow from financing activities as part of the cash flow from assets because debt is one of the ways that businesses get financing. As such, you should see debt on the cash flow statement as part of the cash flow from assets.
While debt payments decrease your cash flow, there may be reasons why this is not such a bad thing. For example, debt might be really cheap and a good way to invest in and harness future returns. In this case, decreased cash flow might not be a large problem. However, if debt payments start decreasing cash flow by too much or result in negative cash flow, this could be a sign of future problems for the operations of your business.
It is also important to note that when you get debt from a lender, the money coming from the loan will increase the cash flow on your cash flow statement. This can inflate your cash flow and is something to pay attention to if one of your cash flow statements is affected by cash from a loan going into your business.
Maintaining Good Cash Flow
While your business might be wildly successful and have great cash flow already, there might still be ways to improve the cash position of your small business. Whether your business is struggling or successful, cash flow analysis, understanding, and management is extremely important. By taking these tips in this post and implementing them in your small business, you are well on your way to creating great cash flow for your business. Make sure to do this analysis regularly too, as cash flow problems can change or develop over time.
At Biz2Credit, we are dedicated to small businesses and their owners. As part of this, we work diligently to provide them with the tools and resources they need to help their companies succeed. That’s why we run our Biz2Credit Blog, where we post new content each weekday. So, please continue to check back here to read our latest articles on everything small business and financing related.