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Cash Flow Explained | What is it, Why it Matters, and How to Calculate

Noah Parsons

9 min. read

Updated November 23, 2024

What is cash flow?

Cash flow measures the money—the actual dollars—moving in and out of your business bank account during a specific period of time.

Cash flows into your business when you receive payments from customers, sell an asset such as a vehicle or other property, or receive money from a lender or investor.

Cash flows out when you spend money on payroll, supplies and services, utilities, taxes, loan payments, asset and inventory purchases, and other bills.

Your cash flow is measured by subtracting the cash outflow from the inflow during a specific period of time—resulting in either positive or negative cash flow. 

How to calculate cash flow

Cash flow calculations are simple:

Cash Received – Cash Paid Out = Cash Flow

For example, during one month, you might receive $8,000 in cash from your customers and pay $5,000 on bills. In this case, your total cash flow would be $3,000. 

Why is cash flow important?

At the most basic level, you need to understand and analyze your cash flow to know if your business bank accounts are growing or shrinking over time.

After all, you can’t run out of cash. If you do, you’ll be unable to pay your bills, and you’re headed for bankruptcy.

You can always look at your bank account balance to see how much cash you have at any given time. But, that one number from your bank doesn’t tell you much about how and why money is moving in and out of your account or how your bank account will look in one month or six months.

That’s why you also need to forecast your cash flow. 

By looking ahead, you’ll know: 

• •How much cash you need at different times in the future
• •If you’re burning through too much cash
• •How long your business will survive in its current state
• •The best time to make a large purchase, hire an employee, or buy more inventory

With a cash flow forecast, you can even see how fast growth can actually hurt your cash position.

Fast growth can be bad for your cash flow (really?!?)

That’s right; fast growth can put your business in a challenging cash situation. That may seem odd, but it’s true—especially for businesses that invoice their customers and get paid after they deliver their products.

So, how does this happen? Think about a business that sells widgets. To sell the widgets, the business needs to: 

• •Buy the materials for the widgets.
• •Pay employees to put the widgets together.
• •Package and finally ship them to the customer.

This business has paid to build the widgets, salaries, and even shipping at this point, but the customer hasn’t paid yet. Since the customer’s invoice says “net-30” on the top of it, the customer might take up to 30 days to pay the bill. The business has paid cash to deliver their widgets but won’t receive cash payments until much later.

If your business is growing and large orders are coming in quickly, you will most likely need a good amount of cash in your bank accounts to fulfill and support this growth. A good cash flow forecast will help you predict this type of problem so you can plan ahead and control your growth.

What is the difference between cash flow and profits?

What really gets high-growth businesses in trouble is confusing cash for profits. Well, profits and cash flow aren’t the same thing. And it mainly comes down to timing.

Here’s a quick explanation:

When you sell a product to a customer and send that customer an invoice, you often don’t get paid right away. Instead, you get paid in 30 days, maybe more. 

When you make this sale, you will show that sale on your profit and loss statement, which will help you calculate profits. However, this sale will not appear in your cash flow until you actually get the money from your customer. 

So, while your profit and loss statement shows the sales that you’ve made and the expenses that have occurred, your cash flow statement (and your bank account) won’t show the money from your sales until you actually get paid by your customers.

This means you look profitable on paper but may still be struggling financially if you aren’t bringing in cash quickly enough.

As a side note, you keep track of all the sales you’ve made but haven’t been paid for yet with accounts receivable.

Is positive or negative cash flow better?

Positive cash flow is almost always better. This means you are bringing money in the doors and accumulating cash to later invest in your business.

In some months, you may have negative cash flow. Don’t worry; this is common during slower seasons for some businesses. It’s also really common for new startup companies or if you are investing heavily in growth.

Startups need to build their products, invest in initial marketing, and pay salaries before the first customer payments start rolling in. Companies that are investing in growth might have negative cash flow as they buy new equipment or expand their operations. 

These companies hope that their investment now will pay off in the long term, with more customers and cash flowing into the business.

The key to staying in business is not running out of cash. So, if you have money from investors to grow your business, you may be able to support negative cash flow for some time while you grow your business. 

Negative cash flow during the startup phase is often called burn rate. Burn rate is simply the measure of how much cash you are using, or “burning,” every month.

How to improve your cash flow

If your cash flow is negative or you’re just looking for ways to improve it, there are plenty of options available. Here’s a quick list of things you can do:

• •Get your customers to pay you faster: The faster your customers pay you, the faster you get cash in the bank.
• •Convince customers to pay upfront in cash: Instead of invoicing customers and waiting for them to pay you, you could offer a discount to have them pay all or part of their bill before products and services are delivered.
• •Pay your bills a little slower: You don’t always have to pay all your bills right away. The longer you can hold on to your cash, the better cash position you will have.
• •Get a line of credit: If your business experiences regular periods of low cash and negative cash flow, you may want to consider a line of credit for your business. This is basically a short-term loan that you can draw from as you need it.
• •Purchase less inventory: Some businesses make the mistake of buying too much inventory. All of that inventory can tie up a lot of cash. Consider carrying less inventory on hand and only order inventory when needed.

Key cash flow terms you should know

I’ve already covered some of these terms throughout the article, but here is a quick cash flow cheat sheet that you can refer back to. Understanding these terms is critical for analyzing your cash flow and effectively communicating with stakeholders.

• •Cash position: The amount of cash your business has on hand (in the bank) at a given time.
• •Cash from operations: Cash generated or used for core business activities, including revenue from sales and payments for expenses like salaries and supplies.
• •Cash from investments: Cash generated or used to make investments, such as the purchase or sale of assets (like property or equipment), acquisitions of other businesses, and investments in marketable securities (stocks and bonds).
• •Cash from financing: Cash generated or used by a business from loans/investments, paying dividends, and obtaining or repaying short-term and long-term debt.
• •Positive cash flow: When your business’s cash inflows exceed its cash outflows during a specific period—indicating more cash is coming in than going out.
• •Negative cash flow: When your business’s cash outflows exceed its cash inflows during a specific period—indicating more cash is going out than coming in.
• •Burn rate: The rate at which your business is spending its cash reserves to cover operating expenses, typically expressed on a monthly basis.
• •Cash runway: The amount of time your business can operate with current cash reserves, spending rate, and generated revenue before you run out of money.
• •Accounts receivable: Money owed to your business by its customers for goods or services delivered but not yet paid for.
• •Accounts payable: Money your business owes to suppliers or vendors for goods or services received but not yet paid for.

Keep an eye on your cash flow

Of all the metrics in your business, cash flow is almost certainly the most important number to watch. After all, as they say, “cash is king,” and that’s because it’s the lifeblood of your business.

Cash is necessary for business survival and understanding whether you are losing it or piling it up is critical to running a healthy business.

To learn more about how you can measure the impact of cash flow on your business, check out these resources:

• •Cash flow statement template: Take your knowledge of cash burn rate and put it to work with this free cash flow forecast template.
• •Tips for more accurate cash flow forecasts: Follow these five recommendations to get more out of your cash flow projections.
• •How to review your cash flow statement: These are the five things to look for when performing a cash flow analysis.
• •Avoid cash flow problems with a monthly review: Learn how to make reviews of your cash performance and forecasts a regular exercise for your business.

FAQ

What can cash flow tell you?

Cash flow reveals the movement of money in and out of your business over a specific period, showing how well your business generates cash to meet its debt obligations and fund its operating expenses. It helps you understand if your business is financially healthy and sustainable.

What is considered a healthy cash flow?

Healthy cash flow is where your business’s cash inflows consistently exceed its outflows, resulting in positive cash flow. This ensures you have enough cash on hand to cover expenses, invest in growth, and weather financial challenges. 

There may be times when your cash flow decreases, or you begin burning through cash to reinvest in your business. This isn’t necessarily a sign of unhealthy cash flow. As long as this change is expected and you maintain a reasonable cash runway, it can lead to business growth and a long-term improvement in cash performance.

What are the types of cash flow?

There are three common types of cash flow:

• •Operating cash flow: Cash generated from the sales of your products or services and the associated expenses your business pays for to remain operational.
• •Investing cash flow: Cash used or generated from investment activities, including the purchase or sale of assets like property, equipment, or securities.
• •Financing cash flow: Cash transactions related to financing activities, such as borrowing money, repaying loans, issuing stock, or paying dividends.

Noah Parsons

Before joining Palo Alto Software, Noah Parsons was an early Internet marketing and product expert in the Silicon Valley. He joined Yahoo! in 1996 as one of its first 101 employees and become Producer of the Yahoo! Employment property as part of the Yahoo! Classifieds team before leaving to serve as Director of Production at Epinions.com. He is a graduate of Princeton University. Noah devotes most of his free time to his three young sons. In the winter you'll find him giving them lessons on the ski slopes, and in summer they're usually involved in a variety of outdoor pursuits. Noah is currently the COO at Palo Alto Software, makers of the online business plan app LivePlan.