What is Cash Flow and How it Affects Your Business
As a small business owner you may be familiar with something called a Profit and Loss Statement (a.k.a the “P&L”). In fact, you’ve probably been asked to supply one each year to your tax accountant. These reports tell you how much you made in sales, and how much you had in expenses. They tell you whether or not you were profitable, or if you lost money. But here’s what these reports don’t tell you…
They don’t tell you how much money actually went out the door. Here’s why – the profit and loss statement includes expenses (things you spent money on like rent, office supplies, travel etc.), but it doesn’t include money you used to pay down debt (credit cards, loans) or to purchase assets (things like computers, refrigerators, vehicles). Also, if you’re a solopreneur and taking money out of the business to pay yourself (not through payroll, but as owner’s draw), the profit and loss statement doesn’t show that amount, either.
Here’s why it matters. Imagine your business earned $100k in profit last year. This came from having $250k in sales revenue and $150k in expenses, leaving $100k in profit. At first glance, this sounds pretty good, right?
However, from that $100k profit you had to pay yourself, pay your taxes, and make payments on loans (if you had any). That amount may actually be greater than the $100k you earned in profit.
This is why you need to be looking at more than just your profit and loss statement to understand your true financial situation. This report can show you that your business is profitable, but the amount you’re making in profit might not be enough to cover your personal salary, or your debt.
Understanding and analyzing cash flow is necessary if you want to be able to make smart decisions for moving your business forward. Whether it’s giving yourself a raise or hiring an employee, you need to know how much money you have available to you at any given time in order to make these types of decisions.
The Difference Between Cash Flow and Revenue
Imagine you run a marketing agency (maybe you really do!) and you get an inquiry from a potential client who could be your highest paying client yet. They want to retain your services throughout the year, and these services include the full package. Social media marketing, email campaigns, digital advertising,… the works.
You’ve never worked with a company of this size before, and you’re unsure how much work is really involved. Yet, you need to create a proposal and come up with an amount to charge them for your services.
So you look at the work you do for other clients, see what you’ve charged them, then try to estimate how much more work is involved for this new opportunity. It’s the highest amount you’ve pitched in your business, ever.
The client accepts the proposal and you are stoked. Your revenue for the year just increased by $120k.
Once you start working, however, you quickly realize that you need help. You can’t do all of this work on your own. You hire a contractor to take on some of the tasks.
At the end of the month you discover you have no money in your bank account. In fact, you have an outstanding bill that you can’t afford to pay. You just increased your revenue by $10k per month, how could this happen?
Because while your revenue went up, your costs also went up. And this led to having negative cash flow. Your revenue from this new client is $10k per month, but the costs of hiring an additional person, plus the costs associated with the services you provide (advertising, design materials, etc.), and the costs of your own labor, added up to more than $10k.
When I work with my clients, I help them see the difference between their revenue and their cash flow. And if there are cash flow concerns, we come up with a strategy to get them back on track. Sometimes the solution is to have more accurate pricing.
When Your Business is Profitable, But Cash Flow is Negative
It’s possible to have a profitable business, but negative cash flow.
Profit is the difference between your sales and your expenses. Cash flow, however, is the flow of money coming into your business (from all sources) and the money going out, which includes expenses, but also includes things like credit card payments, loan payments, and money you take out of the business as a solopreneur.
There are several reasons why cash flow may be negative at any given time. If your profit and loss statement shows that you’re profitable, but you struggle with having enough cash in your business, here are a few questions to ask yourself to determine the “why” behind negative cash flow…
- Are sales slower than usual?
- Are clients paying you inconsistently? – In other words, do your clients pay in lump sum amounts, pay large retainers, or not pay until the work is complete?
- Do you have a lot of debt that you’re paying off?
- Did you make a big investment recently that’s outside of your usual spending?
- Are you taking too much money out of the business to pay yourself?
These are just a few of the reasons you might be struggling with cash flow. To help alleviate the issue, first find the cause, then create a plan to alleviate it.
For example, cash flow may be negative for many months because your clients aren’t paying you until a project is complete. Yet that project could take several months. That’s a long time to work without getting paid!
Instead, consider charging an up-front retainer, followed by a few payments along the way. Perhaps a 6-month project has a retainer, and then 2 or 3 progress payments, followed by a final payment. Small changes like this can make a big difference in cash flow.
This is just one of many examples.
Managing Cash Flow in a Seasonal Business
I work with a lot of clients in the hospitality industry. Whether it be corporate events, luxury weddings, farm-to-table eateries, or local coffee shops. One of the reasons I love working with this industry is because my clients use their artistic talents (and attention to detail!) to create amazing experiences for others.
However, the hospitality industry comes with its challenges. Namely, it is highly dependent on the state of the economy, consumer buying trends, and the weather! Want a beautiful outdoor wedding in Maine? Your choice of months is limited. Have a coffee shop with an amazing view from the deck? It needs to be warm and dry enough for people to want to sit out there.
With fluctuations in sales throughout the year, it can be difficult to manage cash flow. When it’s the height of your busy season you’re thinking you really need to hire an assistant (or two!). But then January rolls around and you’re not sure you can afford to have someone on the payroll. Next it’s July and you’re really needing that extra person again.
It can easily feel like one month you’re “raking in the dough,” and four months later you have zero cash coming in the door. Despite having high revenue months, you question if you are making enough revenue overall. During the low cash flow months, you worry how long the dry spell will last. You may need to hire help, but with such ups and downs in cash flow, you don’t know that you can afford it.
Tracking cash flow is an extremely important part of building financial security, however it is not something that most small business owners know how to do. Without knowing what to expect when it comes to cash flow, making big decisions in your business (like hiring) can be very risky.
One of the many services I provide for my clients is creating a cash flow analysis for their business. I help them see the patterns in their cash flow, and show them how to use this information to make decisions as they move their business forward.
Three Ways to Improve Cash Flow
There are many ways to improve cash flow in your business. Here are just a few suggestions…
1. Create better consistency with regards to receiving client payments. Whether you work with clients on a project-basis or on a monthly basis, collect payments on a consistent basis. The more frequently your clients pay you, the more consistent your cash flow will be.
2. Revisit your pricing. When was the last time you updated your prices? Have your expenses gone up since the last price change? Having up-to-date pricing can give your cash flow the boost it needs.
3. Reduce costs. Yup, I said it. Take a look at your monthly expenses and find ways to cut back a bit. Are you paying for software you don’t use? Do you have three products that can be replaced by one? Are you paying for office space you don’t really need and/or use?
Cut back on unnecessary costs, but remember this – Spending isn’t the same as investing! Reduced spending may help your cash flow in the short term, but not investing in your business may negatively impact it in the long term.
The key to creating consistent cash flow in a business is to plan ahead. Create both sales projections and cash flow projections for the next 12 months and use these projections to help you create a budget (and stick to it!), monitor spending, pay yourself consistently, and plan for future investment (like that assistant you need!).
Have you been thinking about investing in your business, but cash flow fluctuations got you wondering if it’s the right time to do so? Would you like to have more consistent cash flow in your business? I love helping clients get a better handle on their finances, so they can pay themselves more, hire help, and continue to invest in their business.
Interested in learning how I can help you in YOUR business? Schedule a no-obligation Discovery Call with me and let’s talk.