Understanding Cash flow


Get Results: cash cycle
Get Results: Cash Cycle

When I first started off in business, I found cash flow one of the harder things to get my head around. I figured as long as I had my prices right and was making a profit, I would be fine.

However cash flow is one of the most important aspects to a business, the lifeblood of it, in fact. Without good cash flow, your business is dead in the water, unless you have access to enough cash reserves or funding.

Cash Flow doesn’t mean “Cash”, as in paper money

Just something to bare in mind here, when we are using the term ‘cash’ we are not literally talking about cash-in-hand, as in paper money, but referring to money actually entering or leaving your bank account in whatever form either through electronic payments, cheques, or cash.

How cash flow impacts business

Below is a simple example of how cash flow impacts a business, and why careful consideration needs to be given to it, particularly when you are starting off and in periods of growth.

Cash flow projections

Example 1 Month 1 Month 2 Month 3 Month 4
revenue £10,000 £10,000 £10,000 £10,000
costs £7,000 £7,000 £7,000 £7,000
profit £3,000 £3,000 £3,000 £3,000
Accum reserves £3,000 £6,000 £6,000 £6,000
Example 2 Month 1 Month 2 Month 3 Month 4
revenue £0 £10,000 £10,000 £10,000
cost £7,000 £7,000 £7,000 £7,000
profit -£7,000 £3,000 £3,000 £3,000
Accum profit -£7,000 -£4,000 -£1,000 £2,000

I have tried to keep the numbers very simple and constant for illustration purposes only, of course revenue and costs will vary from month to month in the real world especially for a business start up, usually building up over time. As we see in example 1, revenue of £10,000 is coming into the business each month, with costs for that period of £7000, this leaves the business trading at a profit of £3000 during each month. The business is profitable. If you want to imagine how this would work for a larger business, just add more zeros to the end of each of the figures in the table.

Now lets assume that the business is trading in exactly the same way in example 2 as it is in example 1 with just one big difference, revenue is not coming into the business during that particular month, but is being delayed a month. This wouldn’t be uncommon if you were a business dealing with other businesses where standard payment terms tend to be 30 days from date of invoice, and can even be as much as 90 days when dealing with some larger organisations.

The business is still trading at a profit technically from a profit and loss point of view. But from a cash flow basis, it doesn’t look as healthy as example 1. The revenue earned in month one is not actually coming into the business until sometime in month 2 which means that due to costs of £7000 in month one which had to be paid in month 1, there was a shortfall of £7000 in month 1. This would have to be paid otherwise you would have problems with your landlord, utility companies, suppliers etc.  So you have to find £7000 in financing to cover the shortfall, maybe from the bank, maybe an overdraft facility or your savings or from friends and family.

Now when it comes to month 2 you are trading with revenue from month 1 coming in, the trading pattern of revenue, costs and profit is the same for month 2 in example 2 as it was for example 1, but because you had a shortfall in month 1 of £7000 you are able to put £3000 of your profit into paying off some of this, but it still leaves you £4000 down overall (see the accumulated profit row above).  In fact it takes to month 4 to pay all of the initial £7000 deficit in full.

Now this doesn’t necessarily cause your business a problem as long as you have prepared for it, which is why as part of doing a business plan you should do a cash flow statement which tries to predict how money comes in and out of the business during each month. It is a great way of predicting where you will need to finance shortfalls in cashflow.

Understanding the Cash Cycle

There are various things we can do to reduce the ‘cash cycle’. The cash cycle is a great way of measuring the way relationship between incoming and outgoing payments.

  • Cash cycle is:

Time that elapses between the delivery of inventory and its conversion into sales (1 week)

PLUS time that elapses between the sale of goods and services to customers and receipt of monies due from these accounts receivable (nil – payment terms are cash on delivery)

LESS time that elapses between the receipt of goods and services from suppliers and subsequent payment to these accounts payable (4 weeks)

= 1 week + 0 weeks – 4 weeks = -3 weeks

The -3 weeks above refers to the fact that in this example you would have delivered your goods or services to your customer and received payment for them 3 weeks before you would actually have had to pay your suppliers for them. This is good cash flow. It effectively means your customers are financing your business. They are paying you to pay your suppliers.

To improve the cash cycle look to get better terms from your suppliers (increase creditor days). There are a number of payment terms such as pre-paying for supplies, or paying cash on delivery, beyond that you may have 30/60/90 day terms. Try to get the best possible deal for you business. The rule of thumb is try to arrange to pay you bills as late as you possibly can. Don’t do this in a unethical way. Such as telling a supplier the cheque is in the post,  but negotiate with them a deal that satisfies you both. If you mislead supplies they may refuse to deal with you again, which can cause you damage to your business and reputation.

On the other side of the equation are “customer payment terms”, it is good practice to look at reducing debtor days wherever possible. Getting money up-front, or cash on delivery is the best you can aim for. Try to avoid giving your customers credit for 30/60/90 days unless you know you can deal with the lack of cash coming in. Generally it is difficult to dictate terms outside your industries norms, unless  you are particularly valuable to your supplier or customers, but try to get the best deal for your business that you can.

There are other things you can do within your business to help improve your cash flow position. I have myself used interest free credit periods on credit cards to get me over difficult periods. If your business holds stock you can look to reduce stock levels by improving inventory control and using warehousing to store inventory from suppliers to improve bulk buying margins

Increase stockturn (less stock levels moved quicker) on the basis of forward cover (reduced volume of stock order, order more frequently), or Improve IT ordering system to help control stock levels and avoid holding too much stock and running out of inventory.

Rationalize outlets by scaling down outlets by closing not profit making outlets or by move away from cyclical sectors into more non-cyclical sectors.


Cash flow isn’t an easy subject to master, mainly because when you start to talk about the subject most peoples eyes start to glaze over. But lets be clear, it is one of the most important aspect of running a business you should understand, other wise your business life could be short lived.