You’ll stumble upon different finance and accounting terms when you study business. Most of them would have something to do with financial reports. If you run a small, sole proprietorship business, the terms you’ll likely encounter the most are cash flow and income statement.
At first, the two terms seem alike. But there are key differences between the two. An income statement shows both cash and non-cash accounting, while a cash flow only focuses on, well, how much cash the business has.
When sales start pouring in, you will deal with cash flow. As such, the cash flow is something you monitor every day. Every small business owner needs to know exactly how their money comes and goes. That way, they can tell whether they need to reduce costs, make investments, and such.
Defining Cash Flow
To define cash flow, it is the net amount of cash and cash equivalents that a business receives and spends. “Net” refers to the amount you end up with after deducting the business’s total liabilities from its total cash.
Inflows refer to the cash you received, while outflows are the money spent. Your goal is to generate positive cash flows or, more specifically, to increase your long-term free cash flow (FCF). Your small business generates FCF from its normal operations after deducting any amount spent on capital expenditures (CapEx).
Other Terms You Need to Know
To create a cash flow statement, you should understand the following terms:
- Revenue – money from sales
- Expenses or disbursements – money spent
- Interest income – money earned from investments or lending
- Investment income – money earned from an investment’s maturity
- Royalties – money earned or spent from a contract, such as when another entity uses your copyrighted works, or vice-versa, for example
- Licensing agreements- sales from a branded or trademarked product or service
- Products or services sold on credit – sales in which the money will be received at a later date
Determining the amount, timing, and uncertainty of cash flows, along with their sources and destinations, is crucial in assessing your small business’s liquidity. Liquidity refers to how easily your assets or securities can be converted into cash without changing their market price. Cash itself is the most liquid asset.
Cash Flow Statement vs. Income Statement
The simplest way to differentiate a cash flow statement from an income statement is to describe both statements at the most fundamental level. A cash flow shows the exact amount of cash a business has. It also includes the business’s expenses. On the other hand, an income statement shows a business’s total revenue and expenses, as well as non-cash accounting such as asset depreciation.
Of the two, it’s the income statement shows how your small business is performing. That’s because it computes your profit and loss. A cash flow statement merely shows the circulation of money in your business, though it can also give you an idea of whether you’re profiting or not.
A cash flow statement and income statement co-exist. You can’t create a cash flow statement without computing your income because the cash flow starts with the net income or loss.
Improving Your Cash Flow
- Build Your Savings
While using all your available cash to grow your business sounds like a plan, you should also set aside a certain amount to build your savings. You can use that money in the future for investments or major expenses. Create your business’s bank savings so that you can make deposits consistently.
- Increase Revenue
You can increase your revenue in various ways. For example, raising your prices. The idea may sound infeasible, but you can make it work if you’d also improve the quality of your products or service. You can also release a new product or service line with higher prices.
- Reduce Expenses
If most of your outflows come from operational expenses, like utilities or printing costs, find ways to reduce them. For example, replace your traditional phone lines for a VoIP phone, or switch from fossil fuels to solar. It would generate high upfront costs, but your long-term savings would be great. Consider reducing your use of papers as well in favor of digital technology.
- Open a Credit Line
You can ask a bank to open a credit line for your business. It’s a fund you may borrow at once, but you don’t have to do it immediately. Your credit line will come in handy if an urgent need for cash arises.
Boosting your cash flow will not necessarily increase your profits. You need to receive the cash and have more revenue than expenses for your profits to increase. Hence, if most of your sales are paid later, you won’t profit as fast. Still, it’s better than getting a negative cash flow.