What is cash flow?

In finance, cash flow refers to the net amount of cash that is transferred in and out of a business, an account or investment. If you have more cash coming in than what is going out, your business is considered to be in good financial health.

For example, Njeri is a small business owner who runs a hair salon. She relies on the money from her customers to pay her two employees, herself, rent and her utilities in order to keep the business going. If within a month, her expenses exceeded the cash she receives, she would not be able to meet her financial obligations and would therefore have a negative cash flow.

On the other hand, if Njeri is able to meet these obligations and even have cash left over, then she has a positive cash flow. Positive cash flow is when a business is continuously generating more revenue than its expenses, enabling it to settle its debts, reinvest in its business, pay dividends to its shareholders, pay its expenses and have a financial buffer to meet any unexpected future financial challenges. Positive cash flow allows a business to have financial flexibility which can be useful especially if the money is invested in profitable activities.

Types of cash flow

There are three types of cash flows:

1. Operational cash flow

This refers to cash received or spent as a result of business activities. For example, Njeri’s cash flow is dependent on her hair salon business. At a personal level, what Njeri pays herself covers her house rent, school fees, food and other personal expenses. This still fits in under operational cash flow.

2. Investment cash flows

This is cash received or spent through investing activities. This is essentially purchasing and selling of assets that will grow the business. For example, Daudi is a kiosk owner who owns several assets including three properties, a car and the kiosk inventory or stock. If he decided to sell these assets, the cash he makes from the sales will increase his net worth.

3. Financing cash flow

This is cash received through debt or paid out as debt repayments. For a company issuing shares, paying debt from creditors such as a bank or repurchasing shares would fall into this category. For Njeri, this would mean paying back loans from the bank or money she has borrowed from family and friends.

When a business runs out of money to meet its financial obligations, it will experience something called a “cash flow crunch”. This can happen whether the business is paying for recurrent expenditure or repaying debt. This may lead it to selling off its fixed assets (land, motor vehicles etc) to finance its operations or getting additional debt. Worst case scenario is insolvency which can lead to bankruptcy. Hence it is important to set aside emergency reserves to mitigate any unexpected events.

Cash flow break-even

Cash flow break-even is one of the most important financial tools for managing cash flow. It enables a business to know the amount of money they need to meet its financial obligations. More than this, it allows a business to predict or forecast when they should collect the money they have received from sales before their own bills are due. For example, Diana runs a car sales business where she imports second hand cars from Japan and sells them to customers on hire purchase. This means customers pay an upfront deposit and clear the rest within 3 months. In order to keep the business going, Diana has to calculate how much money she needs in a given month to pay all her expenses. Therefore for each sales Diana makes or credit she extends to her customers, she calculates her break even point.

Cash flow break-even point balances the amount of money needed and when it is needed. It can shift depending on the operating expenses of a business. Hence, it is possible to lower the cash flow break-even point by minimizing the recurring expenses. For example, finding better and cheaper suppliers, reducing the cost of production and minimizing overhead costs. In such a situation, the amount of money needed is less than the expenses and break-even is achieved.

From a time perspective, the cash flow break-even point allows businesses with long sales cycles to predict when to collect outstanding invoices and to diversify their products and services to ensure they have money coming in from different sources.

Is it better to be cash-positive or profitable?

This is one of the most important questions I received early in my career as an entrepreneur. I have come to appreciate it more when managing my business finances ever since.

While profitability and cash positive affect the financial health of a business, they often refer to two different situations. Profitability (or simply profit) refers to the amount of money a business makes minus all the expenses at the end of a financial year. One of the key financial documents derived from this is the profit and loss statement. This clearly states whether a profit or a loss was made. Diversely, positive cash flow refers to whether a business has enough cash to meet its current financial obligations. The document that is used to reflect this is called a cash flow statement.

So can a business be profitable and cash flow negative? Yes. In financial terms, any money you invoice or any expected income, such as your monthly salary or money guaranteed from customers for services rendered, contributes to your profitability. For example, if Daudi, the kiosk owner, sold 10 cartoons of milk this month and made a profit of Kes 2000 minus expenses, then we would say he has made a profit. The catch is, if the customer did not pay Daudi immediately and the goods were sold on credit, then Daudi would be profitable but cash negative since he wouldn’t have enough cash to meet his financial obligations that month.

This is a situation many profitable businesses face where they fail to meet their operating activities since they cannot generate enough cash to stay liquid. Hence it is important to ensure that as an entrepreneur, you have enough cash to settle current liabilities (short and long term debts) and control how much you spend on long term assets such as property, machinery etc which cannot easily be converted into cash.