Cash Flow vs. Working Capital: What You Need to Know

cash flow vs. working capital

Operating a small business requires time, dedication, patience, and critical thinking skills. However, few small business owners understand the differences between working capital and cash flow. Since both of these terms involve the financial responsibility of a given business, many business owners use them interchangeably. Unfortunately, lenders, business partners, and stakeholders may make negative decisions for a business if either of these terms are used incorrectly in the preparation of financial statements. So let’s break down the concept of cash flow vs. working capital and how you can get a handle on them in your business.

Cash Flow vs. Working Capital: What’s The Difference?

Cash Flow

Consider a typical month or week in your business. How much money are you able to generate and use for expenses in this set time frame? This is a cash flow summary, and it reflects how money moves in and out of your business. In some cases, you may want to generate a cash flow summary for a quarter or even a year. However, a cash flow summary does not take into account how your current assets impact the financial responsibility of your business.

Since the net profits for your business reflect your expenditures or liabilities against your income, the cash flow summary will never accurately reflect your net profits. Essentially, the cash flow summary is a means of measuring and tracking how much money can be gathered from your business in any given time frame.

Working Capital and Your Assets

The key consideration in understanding the difference between working capital and cash flow involves assets and liabilities. Unlike your expenses in a cash flow report, working capital takes into account how your outstanding debt compares to your current assets. For example, if you have a current loan of $10,000, you would expect to make payments on this loan as time goes on. However, an unforeseen decline in your customer base results in your inability to make payments, and the lender demands full repayment of the loan at the end of the month. The working capital allows you to see what debts can be resolved by liquidating your existing assets.

Obviously, this is an extreme scenario. In most cases, the working capital report is generated on a 12-month scale, and it takes into account all debts due within the next 12 months. The working capital report identifies what can be liquidated or sold to generate cash to pay down existing debts if your business experiences a sudden or gradual decline. This is a vital aspect of scalability. Unlike the cash flow report, working capital does not routinely include your planned monthly expenses that have not been paid for on loan or credit.

Why Is Maintaining a Working Capital and Cash Flow Summary Important to Scalability?

Growing your business can be difficult. You must determine how much product your customers will need, how many staff members will be needed to ensure your customers are happy and satisfied, and what business processes will change to adapt to the new demand. Unfortunately, even well-planned businesses will sometimes experience a periodic decline in sales. This may be the result of economic instability, new competition, or unidentifiable factors.

When a decline occurs, how will you pay your bills in the meantime? You may be able to generate enough cash flow to scrape by if business picks up. However, if business does not pick up, can you liquidate your existing assets to cover your liabilities and debts? Now, consider how the expenses of growing your business play into asset and liability generation.

If you purchase new equipment, lease a new office space, or take out a loan to cover your expenses in the process of growth, you will incur a new liability. Regardless of how successful growing your business turned out to be, you owe this debt. Physical items, such as desks, computers, inventory, and proprietary information, can be liquidated to generate cash flow. As we’ve explained previously, you can minimize the risk of developing a negative working capital by growing in stages.

What Do Cash Flow and Working Capital Have to Do With Resiliency?

Scalability is often used to refer to business growth. In reality, the term can be applied to either the growth or contraction of your existing business. Resiliency, on the other hand, refers to how quickly your business can respond to a problem and return to its original state. In the event of a decline, your business can be more resilient if your working capital exceeds the debts you can expect to pay in the next 12 months.

If you were to apply this idea to the cash flow summary, you would be incapable of determining how your business would stay afloat. The only information you would have would be how much money was generated and how much was spent. Ideally, in the event of a decline, your cash flow will increase and your debts will be paid. Unfortunately, this type of thinking will lead to problems and an even greater chance of failure.

To help safeguard against uncertainty in the success of your business, you need to understand the differences between working capital and a cash flow summary. The cash flow summary simply shows how much money came and went, but the working capital report shows how stable your business will be in the coming year, an absolute necessity in meeting your business’s goals.

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