Are You In Control of Your Business’s Cash Flow?

Estimated reading time: 20 minutes

Cash flow is the lifeblood of any business, and yet it is so often overlooked in favor of profits.

There’s often a misconception that if the income statement is showing a profit, then the business is doing OK. However this isn’t necessarily the case, because there is a difference between profit on paper and cash in the bank.

I recently did a Facebook Live where I discussed the importance of managing your cash flow in order to have a more accurate outlook on the success of your business, and how to foresee and prepare for future challenges that might come your way.

You can watch the video below, or keep reading for a summary of the main points I discussed.

The Difference Between Cash Flow and Profit

Cash flow is more than just revenue and expenses—it’s the tangible, real-world movement of cash in and out of your business. It’s the actual dollars and cents that you have at your disposal to meet immediate needs, pay bills, and invest in growth opportunities. While profitability is a crucial metric, it doesn’t always translate directly to cash in the bank.

Profit is simply the difference between your income and expenses. However your cash on hand will often be different because some of that profit is reflected in your Accounts Receivable — invoices that have been sent out but not yet paid.

There are also often expenses that are shown on the income statement and yet not immediately paid out, such as Accounts Payable, or even tax expenses incurred but which are paid on a monthly, quarterly, or even annual basis.

Because of all of these reasons, your profits rarely match your actual cash on hand. And so if you want to know if you can afford some expense today, your profit and loss is not the place to look to answer that question.

Cash flow, on the other hand, provides a dynamic view of your financial situation. It shows you the rhythm of your business’s daily operations—the cash coming in from sales and the cash going out to cover expenses.

Understanding your business’s cash flow is not only vital for making informed financial decisions but also for maintaining a stable business. It impacts your ability to pay vendors, meet payroll, invest in marketing, and seize growth opportunities. Without a healthy cash flow, even profitable businesses can find themselves in a difficult position.

In fact, according to a recent survey, most business owners don’t know where their cash is going, and one in two reported that this has negatively impacted their growth.

How to Gain Insight into Your Cash Flow

To get a clearer picture of your cash flow, there is a common financial statement called the “statement of cash flows”. This statement provides a historical overview of how cash has been generated and used by your business over a given period. It outlines cash inflows and outflows from operating, investing, and financing activities, giving you insights into the sources and uses of cash in the past. This information can be immensely valuable for understanding your business’s liquidity, cash flow trends, and its ability to meet financial obligations.

However, it has a few limitations:

1. It doesn’t show you where your cash is needed in the future. It is purely a historical report. The statement is useful for understanding the sources and uses of cash in the past. It helps to assess the overall cash position of a business at a given point in time. However, it does not provide information about future cash flows or how the cash should be allocated for future needs.
2. The statement does not provide granular information on specific expenses or goals that a business may have. It does not provide insights into the day-to-day operational cash flow needs or the specific allocation of cash for future expenses. It is more focused on providing a high-level overview of cash movement rather than detailed guidance on cash allocation.

And so while this is helpful, it’s not what we’re looking for. A useful method for tracking your cash flow needs to (1) plan for the future, and (2) be granular enough to give insight into the specific expenses cash needs to be allocated toward.

Your Cash Needs a Job

Your employees need to be assigned jobs so they know what you expect of them to best support your business. In the same way, your cash needs a job so it can faithfully carry out whatever you need it to do.

For many business owners, when they want to know how much they can spend, they simply look at their bank balance. If there seems to be a healthy balance, then they feel free to spend. If not, then they try to cut back a bit.

This is called “bank balance budgeting” and it often leads to unpleasant surprises. Often there is an upcoming expense that you weren’t anticipating, and so you jeopardize your financial stability by spending more than you can comfortably support.

When every dollar is given a job, you know where your money is needed and so you don’t “double book” it, so to speak. Every dollar has a clear purpose, and so reallocating that money to another purpose becomes a conscious, deliberate decision instead of an impulsive one.

Now you can clearly see your goals in real-time and whether they align with your priorities. If they don’t, you shuffle around your funds — give them different jobs — until they more accurately reflect your desired goals.

Introducing Zero-Based Budgeting

This principle of giving every dollar a job is the foundation of zero-based budgeting (and indeed is the first rule of the YNAB methodology).

A zero-based budget is derived from the old envelope method of budgeting. When cash was more common, people would often label several envelopes with different tasks — like rent, groceries, utilities, etc — and place into each envelope the cash they needed for that expense. They did this until every dollar was placed into an envelope, and thus every dollar had a job.

Zero-based budgeting simply brings this method into the digital world. Whether you use budgeting software like YNAB, or simply use a spreadsheet, it uses a list of virtual envelopes (generally called “categories”) to allocate your cash.

The idea is that you assign your cash to each category, until there is nothing left over — i.e., there is zero left to budget.

This is a new way of budgeting to be sure. When many business owners hear the word “budget”, they think of a static, inflexible system that restricts their spending within predetermined limits. Traditional budgets are often set and expected to be followed for a fixed period, often even up to a year.

Zero-based budgeting turns this method on its head. A zero-based budget is dynamic and flexible, designed to grow with and adjust to the needs of the business. Instead of being restricted to a set budget, you can change your allocations on an as-needed basis, as new priorities become apparent.

This approach encourages a more proactive and strategic approach to managing your business’s finances. It ensures that your cash is allocated based on the most current and pressing needs, rather than being tied to a predetermined plan that might become outdated quickly.

By following this method, you will have a clearer understanding of your cash flow and where your money is needed the most. By allocating every dollar to a specific job, you can gain better control over your business’s finances and become more aware of where your money is going. This level of awareness allows for more informed decision-making and the ability to identify areas where adjustments may be necessary.

Demonstrating the Principles

Imagine a successful service-based business. We know these things about the business’s performance in July:

• For illustrative purposes, we’re assuming the business is brand new and thus had a balance of $0 prior to July 1
• The business brought in total revenue of $22,000 in July
• The business has one employee, who is paid $1,500 of net pay every two weeks
• Including that payroll, there were cash outflows of $5,032 toward expenses
• The owner paid herself $6,300
• Thus, at the end of July, the business has a bank balance of $10,668

You can picture it like this:

Prior balance	$0.00
Total revenue	+ $22,000.00
Expenses	– $5,032.00
Owner’s draw	– $6,300.00
	= $10,668

The business owner wants to know, can she afford to hire a new employee?

If she used bank balance budgeting, it would seem obvious she could afford a new employee. The business had $10,668 left over at the end of the month, and if the new employee is paid the same as the current one, then they would cost on average $3,000 per month ($1,500 ✖️ 2 pay periods per month).

But instead of using bank balance budgeting, we’re going to see if the business can truly afford a new employee by creating a zero-based budget for the month of July. I’ll create this budget in YNAB, though it’s the methodology that’s important here, not necessarily the software.

I’ve created some sample expenses for this hypothetical business and will show how the funds are assigned to the needed categories, and how every dollar is given a job. Then we’ll see if one of those jobs can be paying a second employee.

Note as I do this that I like to loosely follow the Profit First system. It’s basically where the business pays itself (and you, the owner) first, before paying expenses. It works the same as in personal finance where the common advice is to pay yourself first — meaning to build your savings or investments before using the rest of your money for your expenses.

As such this hypothetical business will be allocating 10% to profits, 35% to owner’s draws, 15% to taxes, and the rest (40%) to operating expenses. We’ll discuss later why it’s so important to actually take a profit, even when considering taking on a seemingly important expense.

The First Client

Our hypothetical business is paid $5,000 by Client 1 on July 1 as you’ll see in the below screenshot.

The question to always ask yourself when assigning your funds to categories is, “What does this money need to do before I get paid again?”

You’ll see that we have $5,000 ready to assign, and a list of categories all with $0 balances, since we haven’t actually assigned any of our funds yet.

First and foremost, we need to assign the money to our allocations as such:

That leaves us $2,000 to allocate to operating expenses.

The next sale won’t be until July 8, so the rest of our cash needs to cover any expenses that arise before more money comes in.

Each time we get paid, a merchant fee of 3% is charged (it’s not actually this much but I rounded up to make it easier).

We also have some other expenses, like our email, business phone, mailing list service, QuickBooks Online, and QuickBooks Payroll.

You’ll see that those categories are now red, until we assign the needed funds to them.

Once we assign those funds, we are left with $1,708 ready to assign.

But what to do with the rest?

Let’s keep entering our upcoming expenses and see how far it can go. Note that some business names have been made up for illustrative purposes.

We’re able to cover everything up through the first payroll and still have $133 left.

But wait, we have a bit of a problem.

Payroll isn’t just the net amount paid to the employee. We also have payroll taxes to worry about, which might not actually be charged for a month or more.

While the expense won’t come out, we want to make sure that money is spoken for so we don’t accidentally spend it unwittingly.

In this case we have $400 of payroll tax, but for now we can only afford to assign $133 to that category.

You’ll notice it says we still need to assign $667 to this category. That’s because I created a target for that category in YNAB, specifying we’ll need $800 ($400 tax per payroll ✖️ 2 pay periods in July), and so YNAB will make sure we are reminded to add more to this category.

The Second Client

At this point we get paid $4,500 on July 8 from Client 2, including a $135 merchant fee.

Again we need to do our initial allocations so the business pays itself first.

After doing that we’ll have $1,800 left over to assign.

Let’s enter some more of our upcoming expenses:

At this point we can make it up to the second payroll, but can only assign it $760 so it’s going to remain red for now.

But before moving on, the business owner wants to pay herself. She does so on the 10th and 25th of the month. There is $3,325 in Owner’s Draw, so that’s what she’ll pay herself.

And you’ll see that category is now zeroed out.

The Third Client

We get paid again on July 15 by Client 3.

We do our initial allocations again, and have $1,600 left over for operating expenses.

Of course $120 will need to go toward the merchant fee again. But then we also need to finish covering the payroll, not to mention allocate the other $667 for payroll tax.

After all that we have $73 left over.

We can enter our final expense for July, which is a $250 charge from Facebook for an ad campaign.

And we’ll allocate that $73 to that category, leaving the rest for later.

The Fourth Client

Now on July 20 we’re paid $4,500 from Client 4.

The process should be pretty clear by now. We make our initial allocations first, leaving us with $1,800 ready to assign.

There are no expenses left, but we have to assign $135 to the merchant fee, plus another $177 for Advertising for the Facebook ad campaign.

And it might seem like we’re in the clear. But there are a few minor things our business owner wants to assign money for.

• Even though the Facebook ad campaign was $250, she actually wants to assign $300 monthly to that category no matter what is spent. So we’ll need to assign an extra $50 there.
• She wants to assign $100 monthly for office supplies in case anything like that is needed in the near future.
• And, she’s required to pay workers’ compensation, so she needs to assign $50 for that as well.

So now the budget looks like this:

And so we’re left with $1,288 ready to assign.

We’re going to break the cardinal rule of assigning to zero, just so that we can easily see how much is left over after everything is said and done. Please never do this in practice.

Before moving on, the business owner wants to pay herself again on the 25th. We see there is $2,975 in Owner’s Draw, so she makes that payment.

And now there is nothing left in that category.

The Fifth Client

The last payment is received on July 28 from Client 5, for $4,000. We now only have the merchant fee of $120 to worry about.

Once we make our initial allocations, and also assign money for the merchant fee, we’re left with $2,768 ready to assign.

This is our final budget:

Answering the Question

So the question remains, can the business afford to take on an additional employee?

Considering an employee, if paid the same as the existing one, will cost $3,800 per month ($3,000 net pay + $800 in payroll taxes), and we only have $2,768 left over right now, then the answer is a pretty clear no.

But wait. You might ask why we need that 10% profit. If we took out some of that $2,200, then we would have enough for another employee.

But first of all, you should always endeavor to make a profit. That profit will, among other things, allow you to build a solid cash reserve that will protect your business against unforeseen circumstances.

Imagine this: if you took the amount needed out of the profit to cover the employee cost, you’d barely have $1,000 left over. Remember the workers’ comp amount will have to increase, too, since there would be a second employee.

And that means with a barely $1,000 profit each month, there’s not much to buffer the business against unexpected expenses, slow periods, or other financial challenges that may arise. Without a healthy profit margin, the business is more vulnerable to financial stress.

And just as a hint, we haven’t even discussed long-term expenses yet. These are covered by YNAB’s second rule, “embrace your true expenses”.

But we might want to think of having to pay an accountant during the next tax season. We might also have to pay other business taxes depending on the state the business was registered in.

There might also be annual software subscriptions we haven’t considered, or equipment costs to save for, such as new laptops.

We’ve really only scratched the surface. I might discuss these more long-term expenses in a followup to this post.

But with all that in mind, I can pretty confidently say that the business cannot afford to bring on a new employee.

But if the business owner really wanted to, she could think about getting an additional client, which should comfortably fund the expense of a second employee. Whether that is feasible for her depends on the specific circumstances.

These are the decisions that have to be made. But as you can hopefully see, merely looking at your bank balance can’t give you the information you need to comfortably make that type of decision. Only by giving every dollar a job could we accurately determine whether there was enough financial capacity to hire a new employee.

The Takeaway

Understanding your business’s cash flow is fundamental to its success. It’s not just about profits on paper; it’s about managing the actual flow of money in and out of your business. Cash flow management requires more than just monitoring your bank balance. It involves giving every dollar a specific job to ensure that you’re prepared for both your immediate needs and future expenses.

This is, by no means, a substitute for accurate bookkeeping. But when added to your (hopefully) existing bookkeeping system, a zero-based budget can give you a clear picture of where your money is going, so you have the capacity to make informed decisions about the future of your business.

As mentioned, giving every dollar a job is only the first rule of the YNAB methodology. There is more to consider, and I may have some followup posts where I discuss those at greater length.

In the meantime, I hope you enjoyed this rather lengthy post. I’d love to hear your thoughts, so please feel free to leave a comment.

And if you’d like help with creating a zero-based budget for your own business, I’d be happy to help. Click below to get started:

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