Every business, no matter how large or small it may be, depends on its cash flow. Cash is the most important business asset because it’s the most liquid asset as well. Having cash means you can pay for every expense immediately. It also means you can make investments when an opportunity presents itself. Without cash, a company would start having financial difficulties and eventually go bankrupt, even if that same company is generating good revenue and profits.
That’s why cash is considered king in the business world, at least from a financial point of view. It’s of the utmost importance for companies to track their operating cash flow. Operating cash flow is cash generated by a company’s everyday operations and not the cash gained from external resources, such as private reserves or investor funds. In other words, the cash a company can generate in order to sustain its business operations. Here are a few reasons why operating cash flow is important for small businesses.
A company’s liquidity determines its chances of long-term success. Basically, what liquidity means is the ability of a company to cover its immediate and short-term liabilities, i.e. its obligations or debts using its own assets. The liquidity ratio is determined by a company’s ability to pay its dues on time within a one-year time span. That’s where cash flow and cash-on-hand come into play. To calculate the ratio, companies must assess their liquid assets. The number of liquid assets a company possesses can usually be found in their balance sheet.
For instance, an emergency savings account is considered a liquid asset. Simply put, how fast can you turn your asset into cash determines the liquidity of an asset, and since a savings account is basically cash stored up, it’s one of the most liquid assets a company has. On the other hand, a building is also a liquid asset, but it takes time to sell it and turn it into cash. What’s more, you can rarely get the right price quickly for the building’s true worth, which means this asset is less liquid than the cash itself.
Balancing the cash flow
Positive cash flow is crucial for companies. It means you have more money coming in from accounts receivable than going out through accounts payable. However, too much cash can be almost as bad as not having enough cash. Primarily because if you have a surplus of cash, it means your company is missing out on potential investment opportunities where it can generate even more income and profit.
On the other hand, lacking cash means your company is most likely unable to collect payments from clients or customers on time. That can be solved by implementing a direct debit system for your recurring incoming payments and repeat customers, which will automatically collect funds. In other words, you balance the cash flow by ensuring payments are collected on time and surplus funds are invested wisely.. However, you cannot do that if you don’t track your operating cash flow.
Avoiding a financial crisis
As mentioned before, companies that generate good revenue can still go bankrupt without a positive cash flow. As you already know, cash is the most liquid asset. That means that you can use it to pay urgent expenses, such as bills, taxes, salaries and so on. However, a lot of small business owners confuse revenue and profits with cash, which is a huge mistake.
- Revenue is a total sum of money your company has obtained by conducting business operations over a specific period of time. Simply put, revenue is the entire income of your company, which was generated from sources such as sales, borrowed capital and interest rates among other things.
- On the other hand, your profit is the total sum of money your company has after you subtract your business expenses, i.e. operating costs and taxes from your total revenue. That profit is also called Net Profit.
Revenue nor profit is actual cash.
For instance, payments from invoices are considered sales profits and revenue but you don’t get cash until invoices are due, which is anywhere between 30 and 120 days. Conversely, you still have expenses to pay during that time, such as salaries and bills but you can’t do that without cash, which means you either find funds elsewhere or declare bankruptcy. That’s an example of going bankrupt even when your company generates revenue.
Operating cash flow is essential for small business success, as well as for financial stability. Having positive operating cash flow means your company is self-sustainable. In other words, your revenue, profits and cash can maintain optimal business operations without you having to pour external funds into your company, such as taking out a loan or asking an investor for financial aid.