Once a year I teach an entrepreneurship course at the University of Victoria. Single biggest comment from the students? “You say the word ‘cash’ too much.“
Yes I do. Because 82% of businesses that fail, fail because of cash flow problems. So I’m going to keep saying it until that number drops significantly!
Here’s the first of a three part article on 7 basic cash flow elements.
The 7 Basic Elements of Cash Flow
The 7 basic elements of cash flow introduce key terms that the business owner will use throughout her career. They inform her about her cash flow and allow her to make appropriate, timely decisions. And the 7 elements naturally lead to more sophisticated financial literacy topics when the time is right.
1. Revenue or Sales
Revenue is the source of sustainable cash flow. If you create invoices for your customers, then revenue is the total of those invoices.
If you’re in a cash business, then revenue is the total cash that you receive from your customers.
Rule of thumb: Increasing revenue should increase cash flow.
2. Sales and Marketing Expenses
Sales and marketing activities create revenue. They bring appropriate customers to us and convince them to purchase.
There’s always tension in the minds of business owners about these expenses: we must spend money to find new customers and convince them to buy. But spending money reduces cash flow. So we’re always balancing the money we spend on sales and marketing with the revenue that they generate.
To reduce the tension, it’s very important to track the effectiveness of sales and marketing activities: they MUST generate significantly more revenue than they cost. How to do this is a topic for another day, but the rule of thumb is this:
Healthy cash flow needs sales and marketing activities to generate significantly more revenue than they cost.
3. Cost of Goods Sold (COGS)
When a customer buys a product from us, we incur costs related to acquiring, producing, packaging and shipping that product.
This is also true when we deliver a service to a customer: we have labor or technology costs to deliver the service.
The rule of thumb is simple: The smaller our costs of goods sold, the better our cash flow.
4. Other Expenses
In addition to sales, marketing and COGS, there are many other potential expenses that reduce cash flow: staff, rent, communications, travel, accountants and lawyers, etc.
The rule of thumb: Spend as little as you can without affecting your ability to operate effectively.
Everything in these 4 sections appears on the Income Statement (or Statement of Profit & Loss). Revenue is shown at the top and everything else is subtracted from it to create the “bottom line”. When our revenue is greater than all the expenses, the bottom line is a positive number called profit. When revenue is less than expenses, the bottom line is negative and is called a loss. Which leads us to The Biggest and Most Misleading Cash flow Myth…
…which we’ll discuss in Part 2.
BTW, want to get some great, free online training on cash flow? Learn more about my session on November 10 here.