What is Cash Flow?
Cash flow is a confusing and scary topic for business owners but it doesn’t have to be – here’s a simple example that will help you to manage your cash flow like a pro and avoid the rookie mistakes that could easily send you bankrupt.
Right now you have two imaginary employees that you will never see. The first is a woman – we’ll call her Penny – she gets her energy from spending. The second is a man – we’ll call him Ernest – he gets energy from earning.
Penny and Ernest love to flirt and chase each other. So before you opened, Penny, powered by start-up expenses, took off and ran a long way. The more you spent, the further she ran.
Penny playfully urged Ernest to chase her, but he couldn’t – not until you brought in some cash. Only after the first customer was invoiced and paid the bill, could Ernest take off in pursuit.
You see Penny and Ernest only get energy from spending and earning – which means cash must physically go in or out of your business. Penny doesn’t run when you buy supplies and pay later; she only runs when you pay the account. Ernest doesn’t get momentum when you give a customer 30 days to pay; he runs when your customer pays.
To put this into context, let’s revisit what happened when you started trading…
Recall the money you spent – fitting out your office, paying rent, designing a logo, buying business insurance, and launching a website? By drawing upon your savings and overdraft, you probably paid for these in cash. As a result, Penny ran a long way before opening day, giving her a good head-start on Ernest.
Yes, things changed when you got your first customer. If you were lucky, Ernest chased Penny immediately. However, if you offered credit to your customers, Ernest had to wait 30 days (maybe more) before he was able to chase Penny.
Now here’s the bit you didn’t see coming – combined with a good head-start from start-up spending, just as Penny’s stamina started to fade– your suppliers wanted payment, you owed rent, your advertising fell due and your employees wanted their wages. Just when you thought Ernest would surely catch Penny, more spending happened, and Penny was off again. Soon it became clear that, while Penny slowed down from time to time, she was never going to stop.
Thankfully, Ernest kept running too, but it was never enough to catch Penny. No sooner was one bill paid than another – often bigger one – took its place.
The only way to stay afloat was to operate close to the limit of your overdraft, with your credit card as backup. And you learingned, that credit is expensive – and you probably didn’t factor high interest rates into your initial budget.
Does any of this sound familiar?
Remember, money movements (represented by Ernest and Penny) are cash flow: real money moving in and out. When your cash earnings (represented by Ernest) catch up to and pass your spending (represented by Penny), the cash surplus is a real profit – one you can see in your bank account.
If your financial statements only recorded the amounts that Penny and Ernest ran, it would be easy to see your cash flow and understand why you don’t have enough money to pay your bills. Unfortunately, your Profit and Loss and Balance Sheet are not recorded on a cash basis. In addition to money spent and money collected, your financials also include money committed to be spent (payables, taxes, credit cards, loans) and money expected to be collected (debtors, inventory, prepaids, investment income) days or months from now.
What this means is that you cannot rely on [just] your financial statements to run your business safely and effectively.
You also need to know what your cash flow is. And in order to see it, so that you can ask better questions and make better decisions, you need to convert your Profit & Loss and Balance Sheet to cash accounting by making some adjustments.
But don’t worry, we do all the number crunching for you automatically each month – which saves time and allows you to focus on the 2-3 strategies that will have the biggest impact on your cash flow.
Your cash flow dashboard (represented by the distance Ernest and Penny ran – money in and money out) gives you a clear picture of the cash that has gone in and out of your business. And more importantly, it helps to highlight and reinforce the specific 2-3 steps you need to take today to boost your bank balance.