You’ve likely heard the phrase ‘cash flow’ in a movie about a struggling brick-and-mortar business, but it’s actually relevant to all business owners, including sole traders.
Cash flow is essentially about the amount of money that your business has on hand, available for you to spend and invest right this minute. It’s different from profit, because cash flow is all about timing.
Your business might be extremely profitable – thriving, making more money than you thought possible! – but you could still be cash flow negative, meaning you can’t actually pay your bills. It’s not a fun position to be in – without positive cash flow, you risk your business going under.
What does cash flow look like in action?
Let’s break this down.
Your name is Felix (hi, Felix!) and you own an electrical business. You provide services to domestic home owners, like replacing or adding light switches and powerpoints (your clients are undoubtedly grateful for you literally lighting up their lives).
When you charge these clients you charge them for:
- Your labour, say $50 an hour
- The materials you use, with a 30% markup, because you buy these materials wholesale
On one specific job, you worked a total of three hours and earned $150 for your time. You spent a total of $500 on materials, but with the 30% markup, you’re charging your client $650 for these materials.
You’ve made a profit of $300 (fantastic work), but at this point, you’re out the $500 you paid for materials. The client will pay you back, but their invoice isn’t due for payment for another 30 days.
In this waiting period, you’re essentially a smidge cash poor, even though your business is turning over a profit.
Why is cash flow important?
The importance of cash flow is going to be different for each kind of business, depending on how many outgoing costs they have in order to keep things functioning and running smoothly.
For example, if you’re a sole trader and you work as a graphic designer, you might not have a whole heap of outgoing costs. Sure, you might be paying for the software that you use, and any other membership fees that your business requires, but you’re not charging your clients for the cost of materials like Felix is (hi, Felix!).
So, if you’re turning over a profit and have less outgoings, your cash flow should hopefully remain positive – meaning you have cash on hand when you need it. A big win in our books.
However, when you’re first starting out, it’s likely your cash flow might take some time to get going. You’re doing all these amazing, high paying-jobs for corporate clients – designing logos and images for blogs – but you haven’t been paid for any of them yet. These clients don’t pay until 30 days after the work has been published. So even if your work is profitable, your cash isn’t flowing just yet.
What is the main difference between profit and loss and cash flow?
Felix knows all about profit: he ensures he’s getting charged for his time and services, as well as making money on the materials he uses and supplies.
But, as we mentioned earlier, if Felix is out of pocket for a whole bunch of materials on a range of different jobs, and he’s still yet to be paid, there’s no cash flow. When these invoices do get paid, and Felix has some mula sitting in the bank, he has some cash to work with towards any of his upcoming business expenses.
Then, there’s loss. This is when your business isn’t turning over a profit. You could technically be sitting in either positive or negative cash flow at any given time, but when you reach the end of the financial year and you look at all the money you put out and all the money that came in and you end up with a negative result – as in, you didn’t make any money in the end – well, that’s loss.
Essentially, a successful business is one that turns over a consistent profit. But a successful business that runs smoothly and stress-free? Well, they have positive cash flow.
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