Because maintaining a steady cash flow can be a major challenge for any business, entrepreneurs and small-business owners should understand the mechanics of cash flow and its role in influencing financial health.

Measuring cash flow can be a useful way to gauge certain aspects of a business’s financial health. It can serve as an indicator for the rate of return or value of a product, help in evaluating risks involved in a new project and determine a company’s liquidity. Given the financial volatility caused by the economic downturn, many companies have had to re-evaluate and improve their cash flow situation.

It is important to understand the distinction between cash flow and profits. A business’s profits are determined by the difference between its revenues and its expenses, while cash flow is based on the amount of money a business produces or consumes over a specific period, usually based on monthly, quarterly or yearly changes. A profitable business may have negative cash flow, and vice versa.

“[I]f you have a business with significant hardware requirements, like a hosting business for example, you might be generating a profit on paper but the cash outlays you are making to buy servers may mean your business is cash flow negative,” venture capital expert Fred Wilson explains at his blog A VC.

“Another example in the opposite direction would be a software as a service business where your company gets paid a year in advance for your software subscription revenues. You collect the revenue upfront but recognize it over the course of the year. So in the month you collect the revenue from a big customer, you might be cash flow positive, but your Income Statement would show the business operating at a loss,” Wilson adds.

To determine cash flow, you must calculate the difference between the cash balance at the start of a measuring period versus the end of the period. Preparing a simplified cash flow statement for accounting purposes involves comparing the company’s current assets (less cash) at the start of a year with the current assets (less cash) at the end of a year, and if they have gone up, subtracting that amount from the net income. The same is done with non-current assets, while liabilities function in reverse (a gain should be added to the income and a loss subtracted).

If a cash flow problem is found, what can a company do about it?

According to Inc.com:

[C]ash-flow problems are common in business, and people often have a hard time figuring out what’s behind them, but there are actually just a few potential causes. You could have too much cash tied up in receivables or — if you have a product-based business — in inventory. Or you could have too many deadbeat customers. Or you could be spending too much on overhead.

If these issues are under control, narrow gross margins may be responsible for troubled cash flow. This means that prices for the business’s products or services may be too low or that direct costs are too high.

Aside from adjusting margins and pricing structures, there are several supply chain strategies that can be used to improve cash flow efficiency, such as targeting markets that provide quicker access to cash.

“The credit freeze of 2009 prompted other CFOs to lessen their need or broaden their search for cash beyond banks or capital markets. When credit was more readily available, companies would tap it ‘in anticipation of needing it later,’” CFO Magazine reports. “Now, with debt hard to come by, money wrung from supply chains has become a highly desirable commodity.”

In some cases, making cash-efficient acquisitions within a supply chain and finding ways to free up more capital — such as targeting new customers, cutting costs by more closely linking shipments to demand or squeezing more revenue from existing revenue streams — can be an effective way to improve cash flow.

Although credit availability may be more constrained, especially compared to pre-recession levels, an excess of loans may be more detrimental to cash flow than previously thought.

“Comparing credit availability to that which prevailed in the 2003-07 period is misleading. Underwriting standards were very weak, producing massive overextensions relative to cash flow and assets, a macro mistake we do not want to repeat,” the National Federation of Independent Business notes in a March report.

Nevertheless, business credit conditions appear to be gradually improving, meaning that careful lending may enable companies to generate additional capital and free up more cash as credit availability continues to increase.

According to a February survey from the Federal Reserve Board, “commercial banks generally ceased tightening standards on many loan types in the fourth quarter of last year but have yet to unwind the considerable tightening that has occurred over the past two years. The net percentages of banks reporting tighter loan terms continued to trend lower.”

Resolving cash flow problems is a key step in building a company’s financial strength. Ongoing cash problems can hobble an otherwise sound business strategy, making it critical for employers to address these issues by evaluating their pricing, margins, payment rates and considering ways to leverage supply chain opportunities into better cash flow.

Earlier

Surviving the Credit Crunch

Resources

Cash Flow
by Fred Wilson
A VC, March 29, 2010

How to Fix Cash Flow Problems
by Norm Brodsky
Inc.com, May 1, 2009

The Shortest Distance to Cash
by David Katz
CFO Magazine, March 1, 2010

Small Business Economic Trends
by William Dunkelberg and Holly Wade
The National Federation of Independent Business, March 2010

The January 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices
The Federal Reserve Board, Feb. 1, 2010