What is Cash Flow and How Can You Effectively Manage It?

Learn better from videos? You can jump straight to our overview of cash flow statements.

Consider this an anatomy lesson for your business. First, we’ll explain what cash flow is and how to read a cash flow statement. Then we’ll get into the specifics of managing cash flow and cures you can use if poor cash flow has your business feeling under the weather.

What is cash flow?

Cash flow is a measurement of the amount of cash that comes into and out of your business in a particular period of time. When you have positive cash flow, you have more cash coming into your business than you have leaving it—so you can pay your bills and cover other expenses. When you have negative cash flow, you can’t afford to make those payments. The concept of having “enough money to meet your financial obligations” is also known as working capital.

Cash flow vs. revenue

Revenue measures how much money is coming into your business, while cash flow measures both how much comes in and how much is going out. Cash flow also takes into account things like financing activities: did the bank just deposit a $10,000 loan into your account? It’s cash, so it counts!

Why does cash flow matter?

There’s a famous saying in business: “Revenue is vanity, profit is sanity, cash is reality.”

Simply put, financial management begins and ends with cash. If you don’t actually have cash on hand for your business needs, you start hitting blockers in your operations. Managing your cash flow is all about figuring out when you’re going to have cash in your hands, figuring out how to get more of it in your hands faster, and how to manage your spending so you don’t run into cash flow problems.

Learning to manage cash flow is a foundational building block for managing your business finances. If you’ve got that down, then you can start thinking about how to really grow your business and improve your margins and profit.

Cash accounting vs. accrual accounting

If your business uses the cash accounting method, then your books will pretty closely match the cash reality of your business. But if you use the accrual accounting method, then measuring your cash flow is doubly important.

Why? Because accrual accounting is more of a long-term, big-picture way of understanding your finances.

Let’s say you run a design agency, and you just wrapped up two huge projects with a company. All the work in the contract is complete, and you just sent the invoices. Under the accrual method, you’d put that revenue in your books as soon as you send the invoice, even if it takes the client six months to actually pay you, and your bookkeeping will not match the cash reality of your business. That’s why understanding cash flow matters.

How do you manage cash flow?

If you’re looking to improve your cash flow management, follow these seven steps:

1. Stay on top of bookkeeping. Yes, bookkeeping matters! It’s the single best way to understand all the financial transactions in your business, and you can’t do the rest of the steps without it.
2. Generate cash flow statements. If you have an accountant, they can do this for you. Otherwise, you can use software—or calculate it yourself using spreadsheets. You can up your analysis with cash flow projections to see how your decisions are impacting your future financial health.
3. Analyze your cash flow. Take the info from your cash flow statements and use it to understand how money is moving through your business.
4. Figure out whether you need to increase cash flow. Relying on your credit card or line of credit to make ends meet? These are signs you need to free up more cash flow.
5. Cut spending where you need to. Overspending can result from either covering unnecessary expenses or paying for expenses at unstrategic times. Cut overspending to increase cash flow.
6. Speed up your accounts receivable. Whether you’re waiting on invoice payments from clients or deposits from payment processors, the faster you get money in your pocket, the more cash flow you’ll have.
7. Rinse and repeat. Make analyzing your statements a regular part of your back office routine. The more you do it, the better you’ll get at spotting opportunities to increase cash flow—and nip shortages in the bud.

Cash flow in action

Here’s an example of cash flow in action. Let’s say you’re a starving poet in post-WWI Paris. You just sold your first two poems to the New Yorker and received a check for a whopping $30 in the mail.

Now, you’d like to buy a new sweater because the garret you live in doesn’t have heating. That’s going to cost $12. Also, you want to buy everyone a celebratory round of absinthe down at your favorite watering hole, Les Deux Magots. That’ll be $4. Finally, you owe Gertrude Stein $2.

That’s an $18 shopping bill. Your $30 should cover it easily, right?

Wrong. The bank doesn’t open until Monday, so you can’t cash your check. And until you have the money in your pocket, you can’t spend any of it. So you’ve got a cash flow problem—hefty revenue, but no liquidity.

Most small businesses aren’t run by starving poets, but many of them have trouble managing cash flow. That’s why cash flow statements are important.

Cash flow statements

You can keep an eye on cash flow by consulting cash flow statements. They’re one of three essential statements for running your business—the other two are income statements and balance sheets.

Cash flow statements have one main functionality: seeing where your cash has moved during a set reporting period. Here’s an example:

(If you want to plug your own numbers in, you can download our free cash flow statement template.)

Cool table. What does it mean?

Okay, let’s break down Big Tex’s company’s cash flow into three sections so he can understand the financial health of his business.

• Cash Flow from Operations is the amount of money moving in and out of the business in relation to what Big Tex does—renting and servicing mechanical bulls.
• Cash Flow from Investing is the amount of money moving in and out of Big Tex’s business due to gains and losses investing. In Tex’s case, that involves buying equipment.
• Cash Flow from Financing is the amount of money moving in and out of the business due to financing from lenders such as loans or lines of credit.

Each of these categories contains different accounts. Think of these categories as envelopes into which your cash is organized.

Your income statements and balance sheets show money in different accounts, even if the cash isn’t actually there. Your cash flow statements reverse that information.

For instance, “Accounts Receivable” is where you track the money owed to you. If you were to look at Tex’s income statement for July, you’d see he invoiced clients $3,000—hence the “Increase in Accounts Receivable” above.

But Tex doesn’t have the cash yet. So the cash flow statement takes that $3,000 and turns it into ($3,000). That means $3,000 is being taken back out of Accounts Receivable.

In accounting, when a number is black, that means it’s being added to an account. When it’s in (brackets) or red, the money is being subtracted. That’s why business people say it’s good to be “in the black.”

The indirect vs. the direct method

Cash flow statements are generated using two different methods—the direct and the indirect.

Most small- and medium-sized businesses favor the indirect method. That’s because it’s relatively simple. Using this method, you start with your net income for a period and then make changes in order to see how much cash you have on hand. Big Tex uses the indirect method.

The direct method is typical for larger businesses. With this method, you list out all your cash income and expenses for the given period. This means really digging into your financial records and figuring out what was paid with cash and what wasn’t. It takes more time to do.

How to get cash flow statements

If you’ve already got balance sheets and income statements on hand, you can try to do the math yourself and create your own cash flow statement.

If you’d like to save time and energy, though, you have other options.

• Use accounting software. It can usually generate cash flow statements for you. However, the statement won’t be accurate unless the info you’ve entered is, too. Prices vary for different software suites or cloud-based services.
• Hire a bookkeeper. Charging $20 – 50 per hour, a bookkeeper will use your transaction history to generate cash flow statements—and other financial statements—for your business.
• Let Bench do it for you. Your Bench team will do your bookkeeping monthly and create cash flow statements for you upon request.

How to calculate your operating cash flow (OCF)

Cash flow statements are by far the most effective tool for analyzing your business’s cash flow. That being said, by calculating your OCF—also called cash flow from operations—you can quickly see how much cash you have to work with.

Simply put, you calculate OCF using the following formula:

OCF = Total Revenue – Operating Expenses

Let’s say we’re calculating cash flow for the prior month. Your total revenue is how much money has come into your bank account—via accounts receivable, direct sales, or a mixture of the two. Total revenue does not include money you make from investments. Your operating expenses are everything you’ve spent in order to keep your business running and produce your product or service.

Calculating OCF doesn’t just prevent you from overdrawing your bank account. Tracking it over time can also tell you whether it’s increasing or decreasing and help you plan how to change that.

Keep in mind that, unlike cash flow statements, OCF won’t tell you exactly where your money is going to or coming from.

Managing cash flow

Let’s go back to Tex and his mechanical bull rentals and servicing business. Tex has expanded to dominate the mechanical bull market in the state of Oregon—business is going well.

But Tex’s accountant, Pearl, has been on his case lately. Pearl says Tex needs to spend more time on “cash flow analysis” instead of just throwing his statements in a filing cabinet. According to her, cash flow is the lifeblood of small businesses—and if Tex isn’t proactive about his cash flow management, things could start to go south.

Here’s what Tex can do with his statements in order to manage cash flow.

Make sure there’s enough cash on hand

Tex’s cash flow statement for September doesn’t look so hot:

Even though net income for the month was decent, cash flow was low—just $1,000 to work with. How come?

Tex was feeling good—he invoiced clients for $8,000 (Increase in Accounts Receivable), so he knew money was on its way. Then, suddenly, there was an end-of-summer sale on novelty cowboy hats. Tex went a little crazy—he spent $7,000 (Increase in Inventory) on novelty hats to include as prizes with his mechanical bull rentals.

The problem is, even if Tex has $7,000 worth of cowboy hats sitting in his garage, that’s $7,000 that he can no longer spend. And even though he’s got $8,000 in Accounts Receivable, he hasn’t been paid yet. That’s why his cash flow for the month is a measly $1,000.

Luckily, Tex can look at his cash flow statement, see what’s up, and make changes in the future to ensure his cash balance stays healthy. For instance, he could refuse to let Accounts Receivable burn a hole in his pocket next time sequined Stetsons go on sale.

Tracking how you’ve spent your money

After the cowboy hat incident, Tex decides to dig through some past cash flow statements and review his past business activity.

His income statement for April shows lower revenue than usual, so he checks back at his cash flow statement for insight.

Now, Tex can see what happened. A big chunk of his cash flow—$7,000, out of a total cash flow of $13,000—came from Increase in Accounts Payable. Looking back at his transaction records, he sees he hired a bunch of contract workers to run mechanical bulls at a three-day “indoor rodeo” event.

It seems like the event had more cash outflow (contractors) than cash inflow (ticket sales). So maybe next year, when the indoor rodeo comes to town, Tex will lower his expenditures.

Keeping an eye on accounts receivable

Tex is still a little obsessed about the cowboy hat incident in September, so he has another look at the cash flow statement.

That’s $8,000 tied up in Accounts Receivable—$8,000 Tex didn’t have on hand to buy novelty items for his inventory. Maybe the problem isn’t that Tex has an addiction to glittery cowboy hats—maybe it’s that he didn’t forecast his clients not paying immediately.

He looks back and checks out Increase in Accounts Receivable for summer, his busy months.

• August: $7,000
• July: $3,000
• June: $8,000
• May: $9,000

Except for some especially time-sensitive clients who paid early in July, it seems like Tex spent a lot of his months waiting on money to land in his pocket. Now he knows he should take concrete steps to get paid faster.

Tracking debt payments

Tex’s cash flow statement includes the section Cash Flow from Financing, so he can see how much his debt is costing him every month in the form of Notes payable.

Notes payable for September was $2,000. Looking back to August, July, June, and May, he sees that Notes payable has stayed at a steady $2,000.

When Tex logs into his online banking, he can see that the minimum monthly payment on his small business loan is $1,500. So he’s only contributing an extra $500 per month to pay down his debt.

Now, given that business has been good, Tex reckons he should start paying down his loan. He makes an appointment with his accountant so she can help him put together a more accelerated payment plan.

How to improve your cash flow

Maybe reading about Tex’s sequined Stetson spending spree brought back tough memories for you. He wasn’t quite at $0 cash flow, but he came close. Has there ever been a time when you went to pay for a business expense but didn’t have the cash to cover it?

That’s a sign of poor cash flow. It’s also called not having enough liquidity. Luckily, there are steps you can take to increase liquidity and overcome any cash shortfalls.

Increase revenue

It sounds almost too simple, but the more money you have coming into your business, the more cash you have on hand to cover expenses.

Blogs, books, magazine articles, and your next-door neighbor all have ideas to help you make more money. But when you get down to it, there are only four ways to increase revenue.

1. Increase the number of customers
2. Increase the amount of the average sale
3. Increase how often customers buy from you
4. Raise prices

So, for instance, instead of asking yourself, “How can I increase revenue?” try asking, “How can I get more customers?” When you use these four categories as starting points, the big problem of increasing revenue is broken down into bite-size pieces, and you can start making actionable plans.

Reduce overhead

Similarly, spending less on operating activities sounds almost too simple to work. But it does—reducing the cost of goods sold or cost of services (COGS or COS, respectively) will grow your bottom line. That can mean more cash to work with each month.

How you reduce overhead will depend a lot on your business, but finding less expensive vendors, living with less, buying in bulk, or joining a buying cooperative are all steps in the right direction.

Further reading: The Small Business Owner’s Guide to Cutting Costs

Manage your inventory carefully

The more cash you have tied up in inventory, the less you have on hand to spend, but you need to maintain enough inventory, or else you’ll run out and won’t be able to make sales.

If you’re experiencing a short-term cash flow problem, consider running a sale. Sales can be used to inject cash into your business now and get rid of a surplus of product, solving two problems at once.

Inventory management is a fine art, and it can be affected by factors like business growth, your marketing plan, seasonality, and vendor prices. For a crash course, check out our article, Inventory Management 101.

Match receivables to payables

You should try to sync up the payments you receive (Accounts Receivable) with the payments you make (Accounts Payable). Remember, if Tex’s clients paid him soon enough, he would have been able to afford those novelty hats.

Let’s say your monthly loan repayments are due on the 15th. Meanwhile, when you invoice your clients, they have 30 days to pay. And for most of your clients, you send monthly invoices on the 1st of the month.

So, by the time you have to make a loan payment, you still don’t have your revenue for the month on hand—most clients don’t bother paying until the end of the month. As a result, for the second half of the month, cash is tight.

You can change this. One option is to change the due date on your invoices or start sending them out 30 days before each loan payment is due. Easier would be to call the bank—they’re typically able to change the date your loan payment comes out to one that works for you.

Speed up your invoice cycle

We touched on this under matching receivables to payables, but it bears repeating—the sooner you get paid, the sooner you can cover your expenses with cash.

There are a few ways to do this:

• Shorter payment terms. For instance, giving your clients 30 days to pay, instead of 60, will get you your money faster.
• More payment options. It’s possible your clients may also be waiting to get cash in their pockets before they pay you—and that’s slowing them down. Give them the option to pay via credit card, and you could see yourself receiving payments sooner.
• Offer incentives for paying earlier. It’s common for contractors to knock two or three percent off an invoice if the client pays in 10 days or less.
• Invoice factoring. Invoice factoring introduces a third party, called a factor, to the mix. They buy debt off you and give you a portion of the value upfront. You make less, but you get paid faster.

Further reading: How to Set Up (And Optimize) Your Accounts Receivable Process

Pay off debts faster

The more you pay off your debt now, the less you have to pay later in interest. That means less cash coming out of your account every month and lower Notes payable on your cash flow statement. Pay off chunks of debt when you can—during the busy season, or when sales are high, for instance—and you’ll benefit in the long term.

Before you start making early payments on a loan, check if there are prepayment penalties. Financial institutions have these fees to ensure they make up for the money they’ll no longer make on interest payments. These fees for paying down your debts early can offset any potential savings.

Sell your assets

The closer your assets are to being cash, the more liquid they are.

Take Tex as an example. There’s not much you can trade a mechanical bull for. You definitely can’t use it to repay debts or cover rent. Cash, on the other hand, works in almost every situation.

If you’re facing a serious cash flow crisis—you aren’t able to pay employees, cover your mortgage, or make debt repayments—you may be forced to sell your assets. It’s good to keep track of which assets you can afford to sell at any one time. Tex, for instance, knows that if things ever get really bad, he can offload one of his vintage mechanical bulls to a buyer on eBay and cover his essential payments.

Refinance your debt

Your accountant can help you with this one. If monthly debts are putting pressure on your cash flow, it may be possible to refinance some of your debt.

An example of this is working with a new lender to take out a small business loan at 10% APR and paying off your 14% APR business credit card debt. It won’t make a huge dent—but it’s one step towards improving monthly cash flow for your business.