Learn about calculating your company’s operating income margin to master financial health, experience growth, and attract investors.
Looking at successful startups, you might assume they've had their money ducks in a row from the very beginning. That isn’t always the case.
When you’re struggling to get a handle on cash flow, it’s hard to imagine that those other businesses were ever where you are now. But most small, growing businesses need help managing where their cash is coming from and going during their early stages.
Unfortunately, many underestimate just how essential cash flow is and fail to take the necessary steps to secure a healthy financial future.
How can poor cash management affect a startup's success? Delayed payments, inability to invest in growth opportunities and difficulty meeting financial obligations are just a few obstacles that poor management can create.
This article will provide a comprehensive overview of what cash flow is and why it's crucial for startups, plus some tips for managing it effectively.
Simply put, cash flow is the money that a business has available to use. In other words, it's the money coming into your business (income) minus any money going out of your business (expenses).
Cash flow is essential for any business, but it's particularly important for startups. Unfortunately, startups often don't have the capital or resources to withstand any dips in income, so a reliable flow of cash helps pay bills and give your room to make investments towards growth.
Cash flow indicates how much money flows into and out of your business at any given time.
When analyzing it, it's important to understand both positive and negative cash flow. Startups need to strive for positive cash flow, as it will give you the financial flexibility you need to build your business.
If you’re in the negative, you must adjust your expenses and create a sustainable budget for the next month.
Positive cash flow occurs when the money coming into a business is greater than the money going out. You can then use this extra money to invest in growth opportunities, cover operational costs, or pay back any loans you took to start the business.
It's important to understand that profit and cash flow are different. Profit is the money that remains after subtracting business costs from your overall sales revenue, while cash flow measures how much available money a business has for use during a set period.
For example, a business may have made $1,000 in sales and spent $800 on expenses for that sale. That leaves $200 of profit for the company. However, if the company doesn't receive the money from those sales until the next month, then the cash flow for that month would be zero, as no money was available to use.
While profit and cash flow are different, they go hand in hand. Use them in conjunction when analyzing your business's financial health.
Having a positive or negative cash flow can impact your business's profit. With a positive cash flow, you'll have the money to make investments or pay back debts, potentially leading to higher profits.
Conversely, negative cash flow can make it difficult to cover essential costs or take advantage of growth opportunities, which may ultimately reduce profits. You’ll find yourself in the negative due to delayed payments or spending more money than you bring in.
There are three main types of cash flow: operating, investing, and financing. While each type is distinct, they all contribute to your ability to generate and manage cash.
1. Operating cash flow – The money generated from your startup’s day-to-day operations. This includes any customer payments, sales, interest earned on investments, and other sources of income. The operating cash flow formula is:
Operating cash flow = sales revenue – operational expenses
2. Investing cash flow – The money you receive from investments or spend on acquisitions. Money from selling stocks, bonds, or real estate and any money spent purchasing these items belong here.
3. Financing cash flow – Money you get from taking out loans or issuing equity. Cash from taking out a loan, issuing stock or bonds, and other forms of financing fall under this category.
You can utilize all three types of cash flow to fund your startup's operations. Awareness of each type and how it affects the financial health of your business will help you make better decisions to maintain positive cash balances.
There are three key formulas that startups need to know: net cash flow (NCF), free cash flow (FCF), and unlevered free cash flow (UFCF). These formulas will help you analyze and understand the ups and downs of your business.
1. Net cash flow formula – Determines the total amount of money coming into and out of a business over a given period. You can calculate it by adding all cash inflows (revenue, interest, investments) and subtracting all cash outflows (expenses, debt payments).
Net cash flow = total inflows – total outflows
2. Free cash flow formula – determines how much money a business has available for use. You can calculate it by subtracting capital expenditures from operating capital.
Free cash flow = operating capital – capital expenditures
3. Unlevered free cash flow formula –Determines how much money a business has to invest and cover other expenses without considering debt.
Unlevered free cash flow = net income + depreciation/amortization – working capital – capital expenditures
Managing your cash and where it’s going isn’t always a straight path, especially if you have plans to grow. Your business will always be changing, as will the factors affecting your finances. Here are a few to look out for.
While all businesses must deal with cash flow management, startups often have to manage their finances more carefully. Startups typically don't have the same cash reserves as established businesses, so it's crucial to stay on top of your finances and ensure you're spending appropriately. Below are some of the most important things you must do to keep your startup's financials healthy.
Reading and understanding cash flow statements is integral to managing your business's finances. These statements provide information about the sources and uses of your cash over a period.
They have three categories: operating activities, investing activities, and financing activities. Each category can help you track different types of expenditures and revenue so you can better understand your where your money is coming from and going.
Your cash flow statement is a roadmap to the financial health of your business. However, these statements are only one piece of the puzzle when evaluating your business's finances. You should also consider other financial statements, such as income and balance sheets, to get a complete picture of where your business stands.
Another critical tool for analysis is the debt service coverage ratio. This ratio measures your company's ability to meet its financial obligations. It looks at how much money is available to pay off debts compared to how much money you'll need. The higher the ratio, the more likely you'll be able to pay off your debts.
A cash flow forecast uses your cash inflow and outflow numbers to anticipate issues and plan accordingly. With this forecast, you can set goals, identify risks, and take proactive steps to ensure that your business has enough money coming in to meet financial obligations.
To create a direct cash flow forecast, you'll use your cash inflow and outflow to find out your net cash flow. Then, you'll add this to your opening balance from the previous period. This will show how much money you have available to spend during the next financial period.
Closing balance = opening balance + net cash flow
You can also use the indirect method (explained in detail here), which includes revenue from credit sales and other non-cash sales and expenses.
When deciding which method to use, start by considering this:
However, this is just the starting point of understanding and deciding between which forecasting method is best for your startup. Take a deep dive in weighing these methods here.
At a high level, your business is in the green if it has enough money to pay its bills and stay operational. It also means the company has enough cash for investments, expansion, or other opportunities.
But a healthy flow extends past the ability to pay your bills, too. Things can change in the blink of an eye. One day your machine is working perfectly fine for production then suddenly you have to hire someone to fix thousands of dollars of damage. A company with healthy reserves would be able to easily cover this expense without negative fallout on their budget.
For startups, growth is often the main focus. However, expanding too quickly can be a detriment to your company’s future. If you spend an enormous amount of money on expansion and hiring by acquiring loans or more debt you’re essentially spending money before it hits the bank.
Startups that are able to balance growth while having cash to jump on lucrative investments shows investors that they have a firm grip on money coming in.
With the right cash flow management strategies, you're in a better position to keep your startup competitive and achieve your long-term goals.
Startups looking to improve cash flow can start with a few simple steps. Below are the main actions you can take.
If you don't track your money, you may be unable to properly manage your financials or make informed decisions about how to grow your business. Recent studies show it takes two to three years for a business to turn a profit, so you must keep a close eye on your cash flow during this period to ensure your business has enough money to stay afloat.
By tracking accurately and consistently, you can ensure that you're aware of your startup's current financial situation and upcoming expenses. Not only will this tell you if your business is running efficiently, but it will also prepare you for any surprises or changes in the market.
Frequent reporting also keeps you informed about any changes that could affect your business. When you can identify potential issues early, you can take action quickly and stay on track for success.
You can avoid common pitfalls that lead to startup failure by mastering your cash flow. By controlling this aspect of your finances, you ensure that your startup can mitigate risks and capitalize on opportunities.
While some business owners may be hesitant to get professional help, it's important to remember that having an experienced CPA or part-time CFO can be invaluable in helping startups succeed. They can provide guidance and advice on the best ways to manage cash, maximize profits, and minimize losses.
With the right knowledge, approach, and support, you can use cash flow to your advantage and increase your startup's chances of success.
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