Last editedOct 20212 min read
Understanding cash flow is one of the cornerstones to building a successful business. This essential metric tells you a lot about the health of your company, and can be an important analytic in terms of building future business plans. Essentially, a healthy cash flow allows you to cover all your business expenses so that you can continue running at maximum capacity. Even if you have plenty of orders and business, a poor business cash flow can limit your growth and cause a number of problems. Read this simple guide for a better understanding of cash flow and how you can make it more predictable.
What is cash flow and why is a cash flow statement important?
In short, cash flow refers to the rate at which money passes into, through and out of your business over a specified time period. This can be defined in terms of inflow, which is money going into the business from sources such as investment and sales, and outflow which refers to any money going out of the business. A company’s ability to create a positive and predictable cash flow is a key metric for shareholders, which is why cash flow statements are so important.
What cash flow problems can occur?
The definition of cash flow problems is simple: when a company’s debt payments outweigh the money that is coming in. These problems can be fairly serious, and in the worst case scenario may lead to company insolvency. There are a number of causes that can lead to this situation:
Low profits or losses. The logic here is straightforward – a business that is making losses will eventually run out of cash.
Overinvestment in capacity. If a company is spending too much money on production, then there will likely be factory equipment that is unused, not generating revenue and therefore a waste of money.
Buildup of stock can result in obsolete products that can no longer be used. For example, any products that expire may have to be disposed of, causing a loss for the company and impacting business cash flow.
Changes in seasonal demand can create cash flow problems, but these can also be predicted and therefore this problem is easy to avoid.
Overtrading or expansion that happens too quickly can create further issues. This puts pressure on short-term finance; for example, a retail business may open too many stores before they begin to generate profits.
How to predict future cash flows
It’s clear that a predictable cash flow is essential to a healthy business model, but how can you achieve this? Well, it’s essential to build a sustainable model that can also be scaled up. In other words, you should not try to produce over your capacity, and there should be room for the business to grow. In addition to this, try to incentivize your customers to pay on time to create a healthy cash flow.
One strategy that can teach you how to predict future cash flows is a 120-day forecast. Take a look at your profits and losses for a previous year and use these to make a prediction for the same period in the current year. There’s a degree of trial and error in this, but if you keep a rolling forecast then you’ll be able to build a fairly reliable model of your business cash flow.
It’s also important to recognize the seasonal fluctuations in your business. The same period of 120 days may be different depending on the time of year. For example, jewelry companies might expect to make more sales in the run-up to Christmas, whereas an ice cream shop will make many more sales in the summer. Be aware of these changes and incorporate them into your models, and try to find ways to boost sales in the low seasons.
With these techniques, you can create a more predictable cash flow. Remember the key is to keep a close record of inflow and outflow, as well as trying to maximize the former and minimize the latter.
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