Cash is king, they say. As a bootstrapped entrepreneur, managing your cash flow effectively is key to staying afloat while you scale your product. However, many entrepreneurs don’t dedicate time to good accounting practices, sometimes even letting their startup’s money share real estate with personal cash. There’s no surer recipe for disaster.
“A big problem with small businesses that we have that come to us, that have never had a professional accountant, or bookkeeper, or advisor help them with, is that they manage their business out of their bank account,” says CPA Brad Ebenhoeh.
Ebenhoeh, managing partner at startup-focused South Carolina firm Accountfully, explains that the biggest misconceptions behind cash flow is looking at the money coming in as “ready to spend.” For example, if you brought in $20K in sales, it does not mean that you have $20K of immediate, spendable profit.
“The biggest thing that we do is that we transition them from managing their books out of their bank account, in the business side of the bank account, to actually managing their business from an accrual-based profitability standpoint,” says Ebenhoeh.
This means switching companies to accrual-based accounting, the process used by most startups. Accrual-based accounting is essentially jotting down revenue when it’s earned versus when the payment is made. “This means that you look at profits and expenses on a period over period basis, which is like month over month basis. And it doesn’t necessarily have to reflect when the money comes in or money goes out,” explains Ebenhoeh.
That means that if you hired a subcontractor in July for $5K and you don’t pay them until September, the expense goes on the books in July versus when it happen versus in September, says Ebenhoeh. “Migrating a client over to that perspective of reviewing their books on an accrual basis and profitability standpoint is step one in having that business become mature.”
Ebenhoeh dives into three cash flow metrics you need to keep in mind as you grow your startup.
Operating Cash Flow
This is money that comes in from day-to-day operations. Basically it’s taking your profit losses on a normal recurring basis and including cash that you may have received from accounts receivable, or past invoices, or paid out in bills or accounts payable. Then you can say, during the month you made X amount of money in operating cash flow. That’s key because those core operations are actually going to sustain your business.
Free Cash Flow
Free cash flow is the operating cash flow minus any investment you made in fixed assets or capital expenditures. That includes investing in equipment, computers, furniture, leasehold improvements on a building, building out a space, rent, or buying a vehicle for the business, if that makes sense for your business model.
Capital expenditures are not recurring or not part of your operations; they’re just assets that you buy for your business to help you support the operations of your business. They are typically one-time in nature or very periodic, so that’s why it’s not included in the operating cash flow.
Net Cash Flow
Your Net Cash Flow is the free cash flow minus or in addition of any money flowing out to investors, money flowing in from investors, as well as money flowing in or out from a long-term liability.
You want to subtract any distribution payments you make to the owners of your business, or dividends, outflows of payments to owners of the business, or inflows of money that you’ve received when you’ve raised capital.
So for example, when a tech startup is operating with $500K in seed capital, that $500K is an increase in net cash flow. It is anything that you receive or pay to owners or stockholders of the company, as well as any long-term liability, or long-term debts that you’ve paid out on receipt.
When tech startups are in the early stages when they’re raising money, often instead of getting common stock or preferred stock, money comes in. A convertible note is long-term liability. That inflow of money that they receive would be within the net cash flow section.
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