Cash Flow Basics: What It Is and Best Practices

As a small business owner, effective cash flow management is necessary for the success of your business. Knowing how to set up and understand your cash flow statement helps you stay on top of strategic decision making and growth. 

Read on for everything you need to know about cash flow, how to set up your own cash flow statement, and which mistakes to avoid to ensure you’re able to manage your business effectively. 

What is a cash flow statement?

Your cash flow statement is a financial report that tracks the actual cash moving into and out of your business over a period of time, usually every month, quarter and/or year. It provides insight into how much money you have on hand to fund different aspects of your business. 

Cash flow statements differ from an income statement, which shows your company’s total income and expenses over a period of time. They’re also different from a balance sheet, which gives a snapshot of your assets and liabilities at one point in time.

Low cash flow may signal the need for financing and adjustments to your expenses. Strong cash savings gives you the capacity to adapt to unforeseen changes. These aspects of your cash flow statement indicate whether your business has enough money readily available cash to cover operating costs, inventory, marketing campaigns, and other areas of your business that incur expenses. It’s important to regularly monitor your cash flow to ensure your business is in good standing.

How to set up a cash flow statement

Setting up your cash flow statement is an easy process. While this is a task you can complete manually, you can simplify the process by using a cloud-based accounting software. This makes it easier to check in on your cash flow from anywhere or share it with an accountant as needed.

Accounting software, after you’ve entered in all transactions, will generate a cash flow statement based on the dates you input. Before getting started, it’s important to understand the three parts to the cash flow statement.

1. Operating: Cash flow that comes from revenue sources, like sales.

2. Investing: Cash flow that comes from cash gained or loss from investments, such as physical property.

3. Financing: Cash flow that comes from debts, interest payments, selling stocks, etc. 

Cash can flow in or out of these categories, depending on the status of your business. When calculating your cash flow there are two methods you can use: the direct and indirect methods. 

Direct vs. indirect cash flow accounting

The indirect method of tracking cash flow uses your income statement and balance sheet to calculate cash flow. If you were to create an indirect cash flow statement manually, you would: 

1. Calculate your cash inflow. Add your total revenue for the period to any changes in accounts receivable (money due to you but not yet received) and payable (money you owe to others but have not yet paid). 

2. Calculate your cash outflow. Add together any payments like salaries, supplies, and taxes. 

3. Calculate your total cash from operations. Subtract your cash outflow from your inflow.

With the direct method, you calculate your cash flow based on the actual cash you received from customers and cash paid for expenses. You can get these amounts from your bank statements and expense receipts. Add together the cash inflows and outflows to find your total cash from operations. 

Indirect and direct accounting will both give you a clear picture of your finances, so which method you choose is up to your comfort level. Direct cash flow accounting can give you a more stripped back picture, for example, because it doesn’t include money that’s not yet paid. But indirect accounting might make sense for someone who wants to include their net profit in their cash flow calculations.

Accounting software defaults to the indirect method when automatically generating a cash flow statement for you. Update and review your cash flow statement on a monthly basis to ensure sufficient cash is available to cover your expenses.

Cash flow statement example 

Below is an example of a cash flow statement using the indirect method. The example follows a fictional business, Hannah’s Closet, from her first year of business selling handmade fashion pieces on Squarespace. 

Hannah’s Closet — Cash flow statement — End of year December 2022 

In the example cash flow statement, Hannah used the indirect method of accounting. First, she noted down key revenue-generating activities. The net income is pulled from her income statement and current assets and liabilities are pulled from her balance sheet. After that, she included any changes to investment activities, such as long-term assets. Then, she recorded changes to financing activities such as capital or borrowing.

Finally, the net change in cash is calculated by adding up the cash inflows and outflows. The opening balance will be based on the closing balance from the last period. The closing balance for the current balance will take into account the net cash increase or decrease. Within your accounting software, you’ll be able to compare cash flows over multiple periods side-by-side. 

Common cash flow mistakes

It’s important to know the common mistakes business owners make when it comes to cash flow so that you can do your best to avoid them. Here are three common cash flow missteps.

1. Not anticipating sales fluctuations: This can happen seasonally or due to holidays or even if a product becomes incredibly popular unexpectedly.

2. Incorrectly forecasting cash flow: This is one reason it’s important to regularly analyze and understand your typical cash inflows and outflows. If you underestimate, you could find yourself in the red.

3. Taking on too much debt: While loans can help grow your business, too much debt puts you at risk of missing payments if your sales decline. 

This is where frequent cash flow forecasting becomes necessary. Cash flow forecasting is the process of estimating how much cash your business will have on hand in the future. It involves projecting upcoming cash inflows and outflows over a set period of time, usually monthly or quarterly. This helps ensure you have enough cash to cover months with lower revenue. 

If you’ve been in business for a year or so, analyze your historical financials and forecast future cash needs accurately. This can be harder to do if your business is newer, but you can stay cautious by regularly reviewing your operating costs to cut any non-essential expenses. If you find your projected cash flow is less than the forecasted amount, make adjustments as necessary.

Optimizing your cash flow comes down to strong financial management. Forecasting, planning, and consistent tracking is especially important in the early days of your business as it will help you minimize risks and plan for growth. 

Tips to improve your cash flow

Managing cash flow effectively takes consistent monitoring and strategic adjustments. To improve your cash flow it’s important to ensure you’re monitoring it consistently. Implementing technology and automation is a great place to start.

Accounting software allows you to automate important financial processes. Tasks that usually require hours of work can be completed in a matter of minutes. Accounting software gives you access to generated reports and financial statements.This gives you important insights into areas of your business, such as your inventory.

Accounting software has the capability to track whether your inventory is keeping up with your cash inflows. You can make adjustments if needed by reducing stock amount to preserve cash flow in anticipation of slower sales the following year. With this foresight, you’re able to manage your cash flow more simply.

When using an accounting software, you can also integrate it with a range of other tools. For example, to maintain continued accuracy in your financial data, consider an accounting integration. With Amaka’s Squarespace + Xero or Squarespace + MYOB Extensions, Squarespace sales are synced to your accounting software daily. This eliminates the need for manual data entry and reconciliation.

Additionally, you can integrate cash forecasting tools with your accounting software and export your data to create visual reports for your cash flow changes over time. Or, get on top of your inventory management so that you can better anticipate when to order materials and products.

With careful planning and the right tools in place to achieve cash flow oversight, you can avoid mistakes and run a financially healthy business.

Note: This Making It article was created in collaboration with Amaka. It is not meant to be construed as professional financial or legal advice. Refer to local regulations and a financial professional to understand your obligations.