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If your small business reports £100,000 as earnings, this hardly ever means that you have this much cash to spend and it might not even mean you are making a profit at all. In order to provide an accurate picture of the health of a business, financial statements always take into account non-cash items. Although this is more accurate overall, it does not make it possible for you to see how much cash the business has. In order to do this, you must conduct a cashflow forecast.
Because business is a very cash intensive process, none can survive in the long-run without generating a positive cashflow. To achieve positive cashflow, a business needs a long-term cash inflow that will exceed its long-term cash outflow. Cash inflow refers to money from customers, lenders and investors that comes into the business. Cash outflow is the exact opposite and refers to money that exits the business to pay employees or suppliers and creditors, or to cover legal settlements. Purchases made on credit are not recorded as cash outflows until the money actually exits the business.
One thing that is extremely important to note is that profitability is something completely different to having a positive cashflow. A company with a high cashflow is not necessarily even making a profit (and vice versa). If a company has large levels of cashflow, they are likely to be producing a lot of products or purchasing high levels of stock to meet demand. This will have a huge impact on their overall profitability.
An example of cashflow being a poor indicator of business performance would be a manufacturer experiencing low levels of demand and selling some of their production machinery to make enough cash to pay their bills. They will have had to sell their equipment at a lower cost than when it was originally purchased, so they will already have lost money on the sale. The sale will improve their cashflow in the short-term, but the lack of equipment will likely have a serious impact on their long-term earning potential.
The important lesson to learn is that being cashflow positive is often a good indicator of business health, it can also hide major long-term problems. Make sure that you know your business is profitable and this profit-making can be sustained into the future.
Disclaimer: Stefan Töpfer is CEO and Chairman of WinWeb.com
Image courtesy of WinWeb.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
