Most entrepreneurs hear a lot about cash flow from their bankers, financial advisors, and accountants, but how many of us really understand what this term means? More importantly, many business owners don’t recognise the importance of healthy cash flow in their businesses, leading to financial problems and even failure. Let’s unpack the concept of cash flow and see how vital it is to the success of any business.
What is cash flow, anyway?
Wordy definitions are seldom useful to hands-on entrepreneurs, so let’s keep it simple – cash flow is a way of understanding the amount of revenue your business takes in, and how much cash is on hand at a given time. Revenue can be understood as all money paid to your business when you sell goods and services, and having enough of it is extremely important for every business.
Cash flow vs. profit
A common mistake that many entrepreneurs make is to keep both eyes firmly fixed on making profits without taking cash flow into consideration. Profitability is the end goal of every business owner – there is no doubt about that – but without cash flow even a profitable business can land up in serious financial trouble. Here is an example that should make this concept clearer:
Let’s take the example of John, the owner of a small manufacturing company. John’s products are high-quality, well-priced, and popular with the market. He has many loyal customers, who give him repeat business, and his list of new customers is growing at a healthy pace – but just a few months ago John was on the verge of bankruptcy. How is this possible?
Although John’s products were selling well at a good profit, he found that most of his revenue was going back into manufacturing more products to meet his growing list of orders. While he waited for clients to pay, John was caught out by monthly overheads and salaries – at one stage he had no way of paying these expenses and was on the verge of losing members of his staff.
The solution to John’s problem was a credit facility. Because his business was serving so many customers he needed a source of funding to tide the company over until payments came in. With a low-interest facility from his bank he was able to keep the wheels rolling while his cash flow was weak, and by reducing monthly overheads he was able to slowly accumulate a cash reserve during times of strong cash flow.
Today John doesn’t make use of his credit facility too often, but keeps it active as a back-up source of funding.