Understanding Cash Flows: What is it and how to maintain a good flow

Do you often wonder where your money has gone, even if your business clearly makes a profit? The answer lies in your cash flow, and how well you manage it.

A recent survey by Xero shows that over 90% of small businesses will experience at least one cash flow crunch each year- a negative cash flow month that’s sufficient enough to negatively impact your business.

While it’s not impossible to get back on track after a negative cash flow, this is one of the most common pitfalls small business owners encounter especially when starting up their business. To beat this crunch, let’s discuss what cash flow is, its importance in your business, and how to create a cash flow statement together with Profit & Loss (P&L) as well as Balance sheet statements.

What is Cash Flow?

At its core, cash flow refers to the movement of money in and out your business. It’s not just about the revenue or the profit you make; it’s about the actual cash that comes into your business and the cash that goes out.

Think of cash flow as the lifeblood of your business. Why? A healthy cash flow ensures that you have the necessary funds to cover your expenses, invest in your business’ growth, and prepare for unexpected financial problems that may come your way. That includes missed payments, poor cash management that leads to a potential loss of your business and personal assets or worse, could lead you to bankruptcy.

Where Your Money Goes

To gain a better understanding of your cash flow, it’s important to identify where your money goes. Here are the three main activities that impacts your cash flow:

  1. Operating Activities: These are the day-to-day activities of your business, such as sales, purchases, and operating expenses. Cash flow from operating activities reflects the inflow and outflow of cash generated by your core business operations.
  2. Investing Activities: Investing activities involve the purchase or sale of assets, such as property, equipment, or investments. Cash flow from investing activities tracks the cash used or generated from these transactions.
  3. Financing Activities: Financing activities include activities related to raising capital or paying back loans. This could involve taking out loans, repaying debt, issuing shares, or distributing dividends. Cash flow from financing activities indicates the movement of cash in relation to your business’s financing activities.

Cash Flow vs Profit & Loss Vs Balance Sheet: What’s the difference?

The Cash Flow statement tracks the inflow and outflow of cash within a specified period. This statement is vital for evaluating liquidity, identifying potential cash flow issues, and making your financial decisions.

Profit and Loss statement, also known as P&L or Income Statement, shows the following over a given period:

  • Business revenues
  • Expenses
  • Net profit or loss

Think of it like a snapshot of your company’s financial performance and its ability to generate profits from core operations. P&L allows you to analyse revenue trends, cost structures, expense management, or even formulate your revenue growth strategies.

However, not all expenses might show up on your P&L, such as loan repayments, your ATO payments, so it’s still important that you have both your cash flow statement and balance sheet ready on a regular basis.

Talking about balance sheets, having one will show your business’ financial position at a specific point in time. It allows you to see how much you would have left over if you sold your assets and had all the liabilities settled, which is known as the equity.

As the name suggests, your equity must be balanced with assets and liabilities in this formula:

Equity = Assets – Liabilities

Preparing a Cash Flow Statement

The most common way to prepare a cash flow statement is the indirect method – using Profit & Loss (P&L) and Balance sheet as your starting point, also known as the indirect method.

  1. Determine the starting balance
    This value can be found by gathering your P&L statement and Balance sheet.
  2. Identify operating activities
    Focus on the revenue and expenses sections of the profit loss statement. Determine the net cash flow from operating activities by calculating the difference between cash inflows (such as sales revenue) and cash outflows (such as salaries and utility bills).
  3. Analyse Investing Activities
    Look at the asset-related transactions on your balance sheet. Calculate the net cash flow from investing activities by comparing cash inflows (such as proceeds from the sale of assets) and cash outflows (such as purchases of equipment or property).
  4. Assess Financing Activities
    Examine the financing-related transactions on your balance sheet. Calculate the net cash flow from financing activities by comparing cash inflows (such as loans or equity investments) and cash outflows (such as debt repayments or dividend payments).
  5. Summarise Cash Flows
    Combine the net cash flows from operating, investing, and financing activities to calculate the net change in cash during the reporting period.

Maintaining a Good Cash Flow

A healthy cash flow is more than just gaining high profits and revenues. It’s about planning how to prepare for the ups and downs of your business, and here are some tips to maintain a positive flow:

  1. Regularly monitor your cash flow
    Ideally, you should monitor your cash flow on a monthly basis. If you’re cash spending is high, identity which expenses are costing the most and determine whether they are truly necessary for your business. Remember to also check your online spending (subscriptions, direct debits, etc.) now that most transactions are done online.
  2. Separate personal and business expenses
    This is essential to provide financial clarity and helps you gain a clear understanding of the financial health of your business.  By keeping personal and business expenses separate, you can easily track and monitor your business’s income, expenses, profitability and cash available within the business. This information is valuable for making informed financial decisions.
  3. Build cash reserves
    Set aside a portion of your profits such as cash reserves for unforeseen expenses or major downturns. With a cash buffer, you’ll have a safety net to help enhance your business’s financial stability.
  4. Use a reliable accounting software
    If you want to forecast your cash flow or generate reports for your business metrics, using accounting software will help. Compared to manually tracking on spreadsheets, accounting software like Xero will save you hours and hours for generating your reports, and will also connect you directly to bank feeds and ATO to help manage your finances.
  5. Consider hiring a bookkeeper or an accountant for your business.
    Coupled with accounting software, finding yourself an excellent bookkeeper to help you to track your finances will give you more time to work on your business, remain compliant and keep your books up to date.

Need help with bookkeeping?

Accounts all sorted are Xero Platinum Partners, Registered BAS Agents and would love the opportunity to become your trusted bookkeeping partner by helping you stay on top of your bookkeeping, compliance, maintaining and optimising your cash flow. If you’re a sole trader, a business with employees, let’s have a chat and see how we can help

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