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Cash Flow 101: Understanding Cash Flow for Your Business

Share current LOB: SmallBusiness

Successful business owners have a solid understanding of cash flow, their cash flow cycle and how efficiently they’re putting their working capital to use. But there’s always room for improvement. If you accelerate the cash flow cycle and make working capital more productive, you can improve your business finances immensely, which results in a healthier, more viable organization.

What is the Definition of Cash Flow?

Cash flow is the residual cash generated by your operations after you pay all expenses, loan payments and capital investments. If you’re like many small business owners and you self-fund your business, cash flow is the amount of cash available to spend after you collect from your customers and pay all bills, taxes, employees and interest payments.

Even if your firm is profitable on paper, you can still run out of cash since profits do not equal cash flow. Profits are “supposed” to be left over at the end of the month. Cash is how much money you actually have on hand to pay bills — including loans, capital and cash from operations. A profit and loss statement does not tell you how much cash you have because it doesn’t factor in hidden cash drains, including slow-paying customers, large seasonal swings in revenues, significant one-time expenses or increases in inventory due to growth.

What is the Cash Flow Cycle?

Time really is money when accelerating your cash flow. What matters most regarding your cash flow is how efficiently you can buy and deliver your goods and services, how fast customers pay you and how quickly you can put your cash to work. Many owners have been able to improve cash flow by focusing time and attention on these three principles. Cashconscious owners focus on accelerating the cash flow cycle, which is how long it takes to buy, build, sell and receive payment for your goods and services.

How Long is Your Cash Flow Cycle?

Your cash flow cycle is how long it takes to buy, build, sell and receive payment for your goods and services after you book an order. For example, if from the moment you sell a product, it takes you 10 days to buy parts, 10 days to build a product, and 10 days to collect cash from your customer, and then your cash flow cycle is 30 days. In this example, your business is capable of 12 cash flow cycles annually. Sometimes these cycles are called “turns.”

How Much Cash Flow Does Each Cycle Generate?

If your cash outlays are less than the cash you collect, your company will generate extra cash, or positive cash flow. For example, if you sold a part for $100 and it cost you $90 to manufacture, your profit margin is $10. In theory, you will generate $10 in extra cash from every turn of your cash flow cycle. The higher your profit margins, the more extra cash each cycle creates. You make your cash work harder by generating the highest positive profit from each cash flow cycle. If you can generate more cycles in a year, you generate more cash.

How Many Resources Does Your Cash Flow Cycle Tie Up?

Knowing the amount of cash and other resources tied to your cash flow cycle is important to the health of your business. For example, if you sell a product for $100, you assume a portion of that is used to buy materials and build the product. But you also need to be aware of hidden costs, such as the costs of carrying inventory, waiting for payment and financing your equipment. Non-product costs also might include time spent on collections, tracking employee expenses or idle time for workers waiting on raw materials. With tight margins, excessive inventory and slow delivery, costs can equal or even exceed the $100 sales price.

What is Working Capital?

Every business needs working capital to operate. Your business ties up cash because most employees, landlords and suppliers are not willing to provide their services for free and wait patiently to get paid until the cash comes in from the big sale or project. Before you begin to manage your cash flow, you should know where your cash goes. Some costs, such as labor, phones and materials, are relatively easy for most owners to track because they are on a standard profit and loss (P&L) statement. But other costs, such as inventory carrying costs, changes in customer financing and capital investment, are harder to manage because you have to look on your balance sheet to find them. There are six areas that tie up your money:

  • Materials for products: The cash you use to buy parts and raw materials for your products is called “cost of goods sold” on your P&L statement.
  • Labor to produce products: Cash that pays for the labor related to making products or servicing customers also is considered cost of goods sold. Allocate payroll costs to products, customers or jobs to identify waste and determine profitability.
  • Expenses and overhead: Non-product expenses — often called “sales,” “general” and “administrative expenses” on your P&L statement — include overhead costs, such as utilities and professional services, not allocated to specific products or jobs.
  • Financing customers and suppliers: If you give customers 60 days to pay, you are essentially extending a 60-day loan. If you pay cash on delivery for inventory instead of waiting to pay suppliers, you are extending them credit. Customer credit is called receivables, and vendor credit is called accounts payable, both of which appear on your balance statement. Manage these costs by aligning your customer and supplier payment terms, so you limit the amount of money tied up financing both.
  • Inventory carrying costs: Storing and handling raw materials, unfinished products or finished inventory ties up cash. How fast you deliver and how low you keep inventory levels does matter. If the inventory on your balance sheet is much larger than your sales in a given year or business cycle, you have a cash problem.
  • Financing equipment and plants: If you are in a capital-intensive industry that requires heavy machinery, specialized tools or expensive facilities, financing equipment or plants may tie up a big part of your cash. This is called capital investment or capital equipment on the balance sheet. Talk to your bankers to identify the best financing options for your cash situation.

Understanding the dynamics of these six areas will allow you to keep enough cash on hand to cover expenses, so you don’t risk running out. And, if you understand how each of these cash requirements work, you’ll be able to identify ways to make your working capital and cash flow more productive.

About SunTrust Business Owner Research: SunTrust surveys small business owners and advisors as part of its ongoing business seminars and symposiums. The small business owners attending these events include both SunTrust client and non-client business owners and are representative of the broad spectrum of businesses located in the SunTrust markets. The research cited in this report is extracted from these 5,425 small business owner surveys collected between 2007 and 2011.

This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.

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