As a new business owner, it’s important to understand why operating cash flow matters more than profit. In this guide, we’ll explore the reasons behind this and how financial projections can help you identify potential liquidity issues ahead of time. Plus, we’ll explain why it is important to work with an expert financial modeler to ensure your business stays financially healthy.
Understanding the Difference Between Profit and Operating Cash Flow
What is Profit?
Profit, also known as net income, is the amount of money a company has left over after deducting all expenses from its revenue. It is calculated by subtracting the cost of goods sold, operating expenses, interest, taxes, and other expenses from total revenue.
What is Operating Cash Flow?
Operating cash flow (OCF) is the cash generated by a company’s normal business operations. It is calculated by subtracting operating expenses from revenue and adding back non-cash expenses such as depreciation and amortization. OCF is a measure of a company’s ability to generate cash from its core operations.
Why is Operating Cash Flow More Important Than Profit?
While profit is important for a company’s long-term success, it does not necessarily reflect its ability to pay its bills in the short term. Positive operating cash flow, on the other hand, is essential for a company’s day-to-day operations. It allows a company to pay its bills, invest in capital expenditures (CAPEX), and generate free cash flow after debt service.
The Importance of Operating Cash Flow for New Business Owners
Cash Flow vs. Profit: Which is More Important?
As a new business owner, it’s important to prioritize cash flow over profit. Positive cash flow allows you to pay your bills, invest in your business, and weather any unexpected financial challenges. Profit, on the other hand, is a long-term measure of your business’s success. Especially in the short term, it might be acceptable to generate losses while you are investing in new products or services, capacity expansion, etc.
The Role of Financial Projections in Identifying Liquidity Issues
Financial projections, also called pro forma statements, can help you identify potential liquidity issues before they become a problem. By forecasting your cash flow and comparing it to your expenses, you can identify any potential shortfalls and take action to address them.
How Operating Cash Flow Can Help You Make Better Business Decisions
By focusing on operating cash flow, you can make better business decisions that prioritize short-term financial stability. For example, you may choose to delay a capital expenditure if it would negatively impact your cash flow in the short term.
Best Practices for Managing Operating Cash Flow
Creating a Cash Flow Statement
To manage your operating cash flow effectively, it’s important to create a cash flow statement. This statement tracks the cash generated and used by your business over a specific period of time. By analyzing your cash flow statement, you can identify any areas where you need to improve your cash flow.
Strategies for Improving Operating Cash Flow
There are several strategies you can use to improve your operating cash flow, including:
- Reducing expenses
- Increasing sales
- Improving inventory management
- Negotiating better payment terms with vendors
- Collecting accounts receivable more quickly
Working with an Expert Financial Modeler to Ensure Financial Health
Accurate and actionable financial projections require an in-depth understanding of a company’s business profile, accounting knowledge, financial modeling knowledge and best practices. A common pitfall is that startup founders try to save money by creating their own forecasts. Not only is this a time-consuming endeavor, but it is also dangerous because they might not sufficiently understand the relationship between the different accounts and embed material mistakes in their projections.
That’s why it is extremely important to develop your financial projections in coordination with an expert financial modeler. Only if you can rely on your financial projections, you can make better decisions to steer your company.
Common Mistakes to Avoid When Managing Operating Cash Flow
Failing to Monitor Cash Flow Regularly
One of the biggest mistakes new business owners make is failing to monitor their cash flow regularly. It is recommended that you monitor your cash position and cash flow generation on a monthly basis.
Overestimating Revenue and Underestimating Expenses
Another common mistake is overestimating revenue and underestimating expenses. This can lead to cash flow shortfalls and financial instability.
Not Having a Contingency Plan in Place
Finally, it’s important to have a contingency plan in place in case of unexpected financial challenges. It is not always possible to time the receipt of cash inflows or cash outflows accurately. Moreover, sometimes unexpected costs do occur. That’s why it is wise to check whether you have access to lines of credit or other financing options.
Executive Summary
In conclusion, operating cash flow is more important than profit for new business owners. By prioritizing cash flow, creating accurate financial projections, and working with an expert financial modeler, you can ensure your business stays financially healthy. Remember to monitor your cash flow regularly, avoid common mistakes, and have a contingency plan in place to weather any unexpected financial challenges.
If you need support to develop financial projections and provide you with accurate and actionable insights about the financial position of your business, please feel free to reach out to us. Facfo is a Singapore-based management consulting company specializing in financial analysis, financial modeling, and risk management services to startups, SMEs, VC, and PE firms.