When you set up your business or go freelance, admin and finance can slip to the back of your mind. But understanding cash flow, and managing it are key to the success of any business.
Maybe you’ve heard cash flow cited as a reason for late payment from one of your clients. You might also be aware that cash flow is important to your business but maybe aren’t sure why. So let’s get started with the basics.
What is cash flow?
Cash flow refers to the money flowing in and out of your business. This is made up of:
- inflows, or what you receive for your goods and services, and
- outflows which are your business expenses, from rent to the salary you pay yourself and any taxes owed.
At the end of any given period you end up with either
- positive cash flow, meaning you receive more money than you spend, or
- negative cash flow, when you spend more than you receive.
Why is cash flow important?
Small businesses, start-ups, and new freelancers are most likely to experience cash flow issues. This is because they often have to invest heavily in marketing and product development before they can make money. New businesses also don’t have large reserves of cash that more established companies may have.
For this reason, it’s common to see new businesses trading at a loss initially. But in the longer term, it’s important to get on top of it to ensure that your business is sustainable. Let’s look at a couple of simple ways that you can monitor your cash flow.
Cash flow reporting
You can assess your recent cash flow by producing a statement. This statement shows your inflows and outflows over a period of time, and whether your cash flow is positive or negative. You can produce a cash flow statement in a few simple steps, using the direct method.
- First, define the period you want to assess. For example, you could look at the last three months of the previous tax year (January, February and March 2021).
- Going right back to the start of this period (1 January 2021), write down how much money was available in your bank account(s).
- Then, record everything you’ve received and everything you’ve paid each month. This is usually broken down into:
- operating activities;
- financing activities;
- and investment activities.
You can also anticipate your future cash flow by producing a projection. This lets you see gaps in your cash flow, and allows you to prepare for problems further down the line. Cash flow forecasting is a key tool in evaluating how sustainable your situation is and can offer reassurance to investors.
To do so, you can follow the same process as above, only this time you’re making predictions about your future inflows and outflows. For this reason, it’s important to be realistic. In addition, you might want to make adjustments for the following factors.
- Based on previous trading periods, are there any cyclical or seasonal patterns in your business? For example, you might have noticed that summer is a quiet period because a lot of your clients tend to go on holiday.
- Are there any events that might affect your cash flow in the near future (e.g. risk of late or non-payments)?
Common pitfalls – and how to avoid them
Don’t confuse cash flow and profit
A cash flow statement provides a view of inflows and outflows over a defined period. In this scenario, it doesn’t matter if you’re owed a substantial payment. If the money hasn’t been paid to you, you can’t record it in your statement. This means that a profitable company can still have negative cash flow. Let’s take a look at the example below.
- You are a freelance IT consultant and do some work in March worth £2,000, which is due 60 days from the invoice date (and you send the invoice at the end of March).
- You then do some work in April for £2,500, which is due 30 days from the invoice date (and you send the invoice at the end of April)
- At the start of May, you are offered a large contract, but the client wants you to invest in a software license to be able to produce work in the format they require. This will set you back £1,000 immediately.
Until this point, you’re probably pleased that you’ve had some lucrative work and feel as if business is going really well – which is true. But in this scenario, all this lucrative work will only be paid at or before the end of May. It may be paid earlier, but there’s no guarantee of this.
Until then, you’ll have to cover the £1,000 cost of the software, along with any other non-negotiable expenses, such as rent for your hotdesking space, the tax return bill from your accountant, and the renewal fee for your professional liability insurance. All this means that you might not be able to afford to accept the new contract due to cash flow issues – even though the business is thriving. Alternatively, you could use a credit card in order to be able to cover the upfront costs. This expense is something you should also record and account for, and think very carefully about how you are going to make the repayments or the cost of its interest.
The bottom line: poor cash flow management can harm otherwise thriving and profitable businesses, so make sure to produce regular cash flow statements and forecasts and review your payment terms to give you the best chance to succeed.
Don’t be too optimistic about your future sales
It can be easy to conduct a cash flow analysis based on your last few months of trading and make assumptions about how your business will perform in the future. But if you’ve only been trading a couple of months, you can’t forecast your sales with certainty – hence the need for realistic, as well as worst-case scenario, forecasts.
If the 2020 pandemic has taught us anything, it’s that you have to plan for the unpredictable. Is your business resilient and could it cope with an unforeseen slump in sales that even your best forecasts can’t predict?
The bottom line: being too optimistic can increase your propensity for impulsive spending, so try to keep a level head and always factor in the unpredictable
Make sure you have a reserve fund
Having a buffer for when things get rough is a lifeline for freelancers and small businesses. This could just be a simple savings account that you withdraw from when you need the cash. However, you should treat this as a loan – at some point, you’ll need to pay the money back in, or else that buffer fund will start to shrink pretty quickly.
The bottom line: having a buffer fund is a quick (albeit temporary) fix for cash flow problems, and as a freelancer or small business, it will help you stay afloat when times are tough.
That sounds like a lot of work…
We hear you! Cash flow management can take a lot of precious time when running your own business.
Because of this, we have created an intuitive dashboard that provides you with detailed payments, cash flow updates, and real-time insight into your business’ finances.