If you're not familiar with cash flow, here's a key point you need to know about it:
Positive cash flow = Business survival
Cash flow buys time (if necessary), builds assets and profits, and keeps suppliers, bankers, creditors and investors smiling. Without positive cash flow, business survival becomes questionable. Negative or feebly positive cash flow is painful and, unless corrected, will either kill a business or damage it so seriously that it never lives up to its potential.
Although short periods of negative cash flow occur in almost every business, cash flow has to be positive at least on an annual basis. For instance, some farmers do very well with cash flow that is strongly negative for 11 months of the year. So do some manufacturers (especially in the garment industry). The key is that they know what their cash flow patterns are—and take steps to finance the negative periods, offsetting that cost against the occasional strong positive cash influx from operations.
Unfortunately, the smaller and more thinly capitalized the company is, the less able it is to survive extended negative cash flow. This is one reason why so many startups fail -- the business idea may be terrific, but sales always come much more slowly than expected while cash goes out twice as fast. And the initial investment is rarely enough to tide the business along until cash flow turns and stays positive.
How can a small business attain positive cash flow? Discipline. A cash flow budget is an unbeatable tool if followed carefully. If there's to be just one financial statement, make sure it’s the cash flow pro forma. It acts at once as a cash flow budget and as a benchmark for sales.
Some people have trouble differentiating the cash flow pro forma from the projected profit & loss (P&L) statement. The concept “profit” is so pervasive that it poses a barrier to understanding that positive cash flow doesn't equal profit (or vice versa). The example of a profitable growing company with negative cash flow succumbing to illiquidity and tumbling into Chapter 11 bankruptcy is commonly cited to disprove the identity. If the sales don’t turn to cash soon enough, the company goes broke. Revenues are up, receivables are up, expenses are up, even profits are up. Yet the company runs out of cash, can’t pay its bills and becomes another cash flow victim.
Another conceptual problem is equating P&L losses with negative cash flow. A loss on the P&L can reflect a negative cash flow, but it doesn’t have to. For example, publishing companies enjoy some accounting foibles such as deferred income (which suppresses sales by deferring revenues to a later period). The cash comes in December, but because the revenue isn't earned until the following year, the company can show a nice loss for tax purposes, while enjoying strongly positive cash flow.
Here are a few ways to help you understand cash flow (as distinct from P&L categories):
Students are adept at managing skinny cash flows. They postpone bill paying, share space to lower costs, use secondhand books whenever possible (if they have to pay the bill, that is), minimize food costs and so forth. Few of them think of this as cash flow management, but it is—and of a very high order. If they want a ticket to a concert or a ball game, they find a way to scrape up the cash. Very few companies are as carefully managed.
Emphasize timing. Timing is everything for cash flow—the transfers of cash, even the dates that bills fall due or when discounts can or can't be taken. Although timing is always important in business, it's especially important in managing cash flow. A P&L can stand a bit of looseness—it doesn’t matter whether a bill is received January 31 or February 10. But that 10 days can make a big difference in cash flow if the bill falls due before you have the cash in hand to pay it.
Compare cash flow to a checking account. Cash is deposited (cash inflow). Checks are written (cash outflow). The aim is to always have some cash on hand (positive cash flow).
For the literate, recall Charles Dickens’s character Micawber and his definition of happiness: “Income of £20.00.00, expenses of £19.19.19. Result: happiness. Expenses of £20.00.01. Result: misery.” Micawber was right; he understood cash flow. Cash flow deals with the ebb and flow of cash. If the flow is positive, it's good. If it's negative, do something to change it.