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Here’s a quick quiz to test your knowledge of cash flow:

Which of the following is an ongoing source of repayment for your small business credit line?

a. Your equity
b. Your accounts receivable

Which of the following is a source of cash?

a. Rising inventory
b. Rising debt

If you had to think too long to answer those questions, you might need a little refresher course on cash flow. You see, your small business will live or die on cash flow. You can manage through periods of negative profitability, but you can’t manage through extended periods of negative cash flow. When the cash dries up, you can’t pay your rent, you can’t pay your employees and you can’t buy inventory. You also can’t get a small business loan or an increase to an existing small business line of credit. Your banker will take a quick look at your negative cash flow performance and say “no thanks,” without even blinking. Think of cash as the oil that greases the gears of your business. Without cash, your small business comes to a grinding halt.

So let’s start at the beginning. Cash flow is the change in your cash balances over time. If you have $1000 in your small business bank account on January 1 and $1500 on January 31, you had positive cash flow of $500 for the month. Cash flow is always measured relative to a period of time. This is different from cash on hand, which is measured as of one specific point in time.

Cash flow is typically discussed in terms of sources and uses. An increase in liabilities, for example, is a source of cash. But an increase in working capital accounts is a use of cash. If those relationships don’t immediately make sense to you, think back to the basic accounting equation, assets = liabilities + equity. When you make a change to one part of the equation, you have to make a corresponding change to keep the entire equation in balance. If your liabilities increase, you must have a corresponding increase in assets or a corresponding decrease in equity. Since we are talking about the cash impacts here, increased borrowing is a source of cash. And this makes sense: when you borrow money, you have more debt and more cash.

So what happens to cash when your working capital accounts, like accounts receivable and inventory, go up? Cash, accounts receivable and inventory are all assets. If some assets go up, others must go down. Increases in accounts receivable and inventory, therefore, are uses of cash. This is a crucial point to understand when you are running a small business — because you can improve your cash flow performance by more efficiently managing your working capital. Improved cash flow performance means you have more money to pay your bills and invest in growth.

Back to the quiz above, the answers are both b. You repay your small business line of credit with cash produced from your accounts receivable. And rising debt is a source of cash.

Our next discussion will address cash flow management in more detail and talk to the importance of having a cash flow model for your business. Once you have one, you’ll wonder how you ever managed without it. Have small business questions? Send them to us at questions@businessmorgue.com.