The Importance of Understanding Cash Flow

Written By: admin

Table of Contents

Last updated: November 5, 2020

Running short of cash is a nightmare for every startup. This mostly occurs through runway expenses where the startup’s expenditure is higher than its income. In some cases, it is just an impermanent cash crunch while in others, it is a permanent shortage that ends with the failure of the startup.

A cash crisis can occur at any time and in any economy thus causing unanticipated challenges for your startup. At such a time, you need to establish your current financial status and the likely trajectory going forward.

To do this, you will need an income statement, a cash flow statement, and a balance statement. Understanding these documents will help you to correctly interpret the financial position of your startup and to make informed decisions.

The Income Statement

The accrual accounting method is the most common way used to track the finances of startups. With this method, incomes and expenses are recorded the moment a service is delivered. Though the money for the service may not be immediately paid, it is recorded as an asset for the business.

An income statement is, therefore, a record of the money that the business has transacted over a set duration. It provides an overview of the profit or loss the business is likely to make. It also informs you of where and when the money will come into the account, and also how you have committed to spending it.

The income statement further gives you visibility on how many sales your business is making, their frequency, size, etc. This visibility is more detailed than if you just looked at cash without knowing from which sale it came from.

It is, however, worth noting that an income statement only tells you of the income you are expected to see but does not indicate when the money will reflect in the account. Knowing the actual balance in the account will help avoid making expenses that may lead to a cash crunch.

The Cash Flow Statement

As you have already seen, an income statement will not detail how much money you have in the account. For that, you will need a cash flow statement which is a record of the money you had between the start and end of a certain period. It may be yearly, quarterly, monthly, and so on.

A cash flow statement contains three sections namely; investing activities, financing, and operations activities. These are important in helping you to understand how the money you have in the bank was realized.

Also known as capital expenditures, the investing activities section details income realized from related ventures made by your business such as development expenditures. Worth noting is that the investments here are not external but exclusively made by your business.

Financing activities, on the other hand, refers to money your startup receives from investments made by others. It also includes raised capital such as from a bank loan. This section rarely reflects large influxes of cash into the business as such investments don’t happen often.

The last section is the operating activities which refers to the money made by your business during its normal operations, e.g., from sales. It can also be called operations income. You should be keen on this section as it is a direct pointer of the health of your startup.

Most startups operate on negative cash flow. This means that the amount of money spent on running operations is higher than the amount earned from the operations. An income statement helps you to track your burn rate and avoid exceeding the expected burn rate figures.

The Balance Sheet

While the income statement informs you of the amount of money you have, it does not detail the amount you will have. For that, you will need a balance sheet. This is a statement that details the money you will have after all expenses and your clients have paid their debts.

If a client is expected to pay in say, the next one month, the amount they will pay will be listed in your accounts receivable. If you also make a purchase but haven’t paid for it yet, that amount will not be listed as part of your cash balance but as an expense. With this information, you will be able to make wise decisions including how much money you have at your disposal before spending.

If you utilize the three statements, then you will be able to correctly assess and understand the cash flow of your startup. This means that you can track changes in income or expenditure and anticipate cash crunches. With the information, you will act promptly and correctly thus keeping your startup from failure. It will also make it easy for you when filing for tax returns or in the case of an audit.

Make sure your company is compliant

Your focus should be on your business. Appoint a registered company secretary to handle everything else.