What Is Cash Flow in Business?

Last Updated October 8, 2024

Many business owners believe that the profits they make is what sustains their businesses. While this is true in some respect, consistent cash flow is essential to maintain and grow business operations as strong cash inflows help you pay your bills on time, purchase equipment and inventory, and turn a profit in a scalable manner.

Simply having funds in the pipeline is not enough, as the money may not be readily available when you need it. This is why you need to understand how cash flow works in order to properly manage your funds and run your business efficiently.

What Is Cash Flow?

Cash flow is simply the movement of cash and cash-equivalents in and out of a business. Analyzing how much cash a business generates and how much it spends is the basis of cash flow, and this data is tracked by a document known as a cash flow statement.

Tracking the cash flow of your business helps you to better understand your business’ financial health. A great place to start is by understanding if you have positive or negative cash flow.

Positive Cash Flow vs. Negative Cash Flow

A positive cash flow occurs when the cash inflows are higher than the cash outflows of a business, and a negative cash flow occurs when the cash outflows are higher than the cash inflows. Having a positive cash flow is a good financial signal for your company as it shows that you have the means to reinvest in the business, increase business operations, make payments to shareholders, and pay your expenses.

Types of Cash Flow

Since cash flow can either be positive or negative, it is essential to understand the different types of cash flow and how they impact the business as a whole. Below are the three types of cash flow:

• Operating Cash Flow
• Investing Cash Flow
• Financing Cash Flow

Operating Cash Flow

Operating cash flow is the flow of cash from operations. Cash inflows from operating activities include revenue generated from sales, while cash outflows from operating activities include payroll, payments made to vendors, and interest payments.

Operating cash flow can indicate a company’s ability to maintain and scale its operations. If a business has positive operating cash flow, then it is typically in a better position to grow because it has the cash on-hand to make investments in company growth. However, a if business has negative operating cash flow, it may need to seek forms of financing, such as invoice factoring, to ensure it can make payments to vendors, purchase inventory, and maintain operations.

Related: How to Calculate Cash Flow Margin

Investing Cash Flow

Investing cash flow is the flow of cash from investing activities, which can include the purchase or sale of physical assets and marketable securities. While many people may not think of the purchase of property or equipment as an investing activity, this action contributes to investing cash flow because they are considered long-term investments.

Positive investing cash flow can indicate the sale of physical assets (like a piece of machinery) or marketable securities. On the other hand, negative investing cash flow can indicate a long-term investment made by the company, such as an acquisition of another business.

Financing Cash Flow

Financing cash flow is the flow of cash for financing-related matters of a business, including the purchase or sale of stock, paying out dividends to shareholders, and borrowing and paying down debt.

Financing cash inflows and outflows are typically driven by debt and equity financing. Negative financing cash flow is often related to the repayment of debt or the distribution of dividends to investors, while positive financing cash flow can indicate the borrowing of debt, such as a loan, or the buyback of company stock.

Net Cash Flow

Net cash flow is the difference between your cash outflow and your cash inflow. It can be either positive or negative, depending on if your company had more inflows or outflows for the evaluated time period. Understanding your business’ net cash flow can help you identify potential issues with your cash flow before they become detrimental to the company.

Free Cash Flow

Free cash flow (FCF) is the cash that is left from operations after all operating expenses and capital expenditures have been taken into account. Free cash flow is often used to evaluate a company’s flexibility and ability to repay its debts and distribute dividends to investors.

Free cash flow can easily be confused with profit, but FCF does not take into consideration noncash expenses. Looking at profit and free cash flow side-by-side can give you a better understanding of your company’s financial health because free cash flow is more difficult to manipulate. However, while it can be more difficult to obscure key pieces of financial information using FCF, it is best to evaluate it from a trended view as single data points may not be reflective of long-term financial health.

Discounted Cash Flow

Discounted cash flow (DCF) is the difference in value between the purchase of an investment now and the revenue it generates in the future. DCF is used to evaluate if an investment is worth the cost based on its future cash flows. This value is calculated based on a discount rate, which assumes the value of a dollar will be less in the future than it is today. The weighted average cost of capital (WACC) is often used as the discount rate when calculating DCF.

What Is a Cash Flow Statement?

A cash flow statement (CFS) is a financial report that outlines the total movement of money in and out of a business either for operations, investments, or financing-related matters. This document shows cash and cash-equivalent transactions of a company, and a business owner needs to create a cash flow statement to monitor these transactions. The statement of cash flows reveals if cash flow is positive or negative, and it has a section for each type of cash flow listed above.

Because the cash flow statement highlights a business’ cash management, it can reveal a lot about the financial health of a company. For example, consistent negative cash flow can show that a company has issues generating cash and could show a mismanagement of business funds. A company should analyze its cash flow statement to better understand its cash flow health and to help budget for the future.

Net Cash Flow vs. Profit

Net cash flow (the balance left after you subtract the cash outflows from the cash inflows) is sometimes mistaken for profit (also known as net income), and while they are similar and vital for a business to succeed, they have a few key differences. Net cash flow is the movement of cash into and out of a business, while profit is the amount of money left after all expenses have been paid. A company can be profitable while having a negative cash flow and vice versa.

But how does this happen? Let’s use the formulas for each and consider the following example:

Net Cash Flow Formula

Cash Inflows – Cash Outflows = Net Cash Flow

Profit (Net Income) Formula

Total Revenue – Total Expenses = Net Income

Example

For the month of February, a bicycle shop generates $100,000 in revenue, pays its employees $50,000, and spends $40,000 on raw materials. Based on this, we can calculate the bicycle shop’s net cash flow:

$100,000 – $50,000 – $40,000 = $10,000

As seen using the net cash flow formula, the bicycle shop has a positive cash flow for the month of February of $10,000.

If we were to calculate profit, we would need to consider the bicycle shop’s noncash expenses, such as depreciation. For this example, let’s say the bicycle shop had a depreciation expense of $15,000 along with the cash inflows and outflows that were previously listed. Using this data, we can calculate the profit as follows:

$100,000 – $50,000 – $40,000 – $15,000 = ($5,000)

As you can see in the example above, taking into account noncash expenses gives the bicycle shop a negative profit, even though it had a positive cash flow for February.

While both cash flow and profit can be used to evaluate a company’s financial health, they have different indications. Accordingly to Gates Little, President of the Southern Bank Company, the difference and importance of cash flow and profit “can be a tough subject, as the two things seem so similar.” He goes on to explain, “A company with positive cash flow can stay open, almost regardless of profit. That’s because each week, we pay our bills and our employees with cash flow. We simply can’t operate without it. Profit is important, but it can come and go. Vendors and employees might not care if you’re profitable, but they care if you can pay them.”

At the end of the day, both cash flow and profit are vital to the long-term success of a business, and they should be evaluated jointly to get a better picture of a company’s financial health.

How to Manage Cash Flow

As you build your business and look for ways to improve, consider the following cash flow management tips:

1. Track All Cash Inflows and Outflows: The first step to effectively managing your cash flow? Making sure you are keeping track of it. Recording all inflows and outflows will make it even easier to put together your cash flow statement and review the financial condition of your company.
2. Perform a Cash Flow Analysis: Performing a cash flow analysis on a regular basis ensures you are familiar with your cash budget and the financial health of your business. Analyzing your cash flow helps you identify opportunities to improve your company finances before they become a problem.
3. Increase Speed of Collection: You can increase your speed of invoice payment collection (and improve your cash flow) by offering electronic payment options, shortening your invoice payment terms, or providing early payment discounts.
4. Decrease Speed of Payments: If you have slow cash inflows, it may be better to avoid paying your invoices early to reserve cash. Waiting for the invoice due date to pay can help you have more working capital on-hand and avoid unnecessary cash constraints.
5. Factor Your Invoices: You can also sell your invoices to obtain quick cash and keep your business afloat. It is ideal to use factoring companies with low fees so that you can keep a larger chunk of your profit margin.

In-Summary: Cash Flow

“Cash flow” is one of the most commonly heard terms in the business world, and for good reason. There’s arguably no better indicator of a business’s financial stability than cash flow.

Obviously, striving towards positive cash flow should be the main focus of every business owner. However, it’s highly likely that at some point—especially during a company’s early stages or in the midst of a growth phase—negative cash flow will be encountered. The difference between successful and unsuccessful businesses is often how these periods are managed. It’s pivotal to have a plan in place to steer your finances back in the right direction, whether it be through cost-cutting, other strategic business decisions, or perhaps looking into alternative lending solutions tailored for improving cash flow.