What Is Cash Flow? A Plain-English Guide with a Worked Example

What is cash flow in simple terms?

Think of your business bank account as a bath. Paid invoices, loans and asset sales pour in through the tap. Wages, supplier bills, rent, loan repayments and tax drain out through the plug.

If the tap runs faster than the plug, the water level rises and you’ve got positive cash flow. If the plug wins, the level drops. It doesn’t matter how much water you’ve been promised next month: if the bath empties this month, you can’t pay your staff.

The word “actually” matters. A sale only counts when the money lands in your account, not when you send the invoice.

Cash flow vs profit: why profitable businesses still run out of money

Profit is what’s left after you match income against costs for a period. Cash flow is what physically moved through the bank. They can tell two very different stories.

A few everyday things drive them apart. Customers pay 30, 60 or 90 days after you invoice them, so the revenue shows up in your profit long before the cash arrives. Buying a van is a big cash outflow on day one, while the cost only trickles into your profit over several years through depreciation (spreading an asset’s cost over its working life). Loan money boosts your cash balance but isn’t profit at all, and repaying it drains cash without touching profit.

What are the three types of cash flow?

A cash flow statement sorts your cash inflows and outflows into one of three types.

Operating cash flow comes from the day-to-day running of the business. Customer receipts, supplier payments, wages, tax bills and other operating expenses sit here. It’s the one to watch, because a business that can’t generate cash from its own trading is living on borrowed time.

Investing cash flow covers investing activities such as buying and selling long-term assets like vehicles, equipment or property. Buying a new van is an outflow here, and selling the old one is an inflow.

Financing cash flow is money to and from lenders and owners. A business loan, a new investment or a share issue brings cash in. Loan repayments, leasing payments and dividends take it out.

Add all three together and you get your net cash flow for the period. That’s the change in your cash and cash equivalents, meaning your bank balances plus anything you could turn into cash almost immediately. Knowing which type of cash flow a problem sits in tells you where to look first.

A worked example: one quarter’s cash flow

One quarter’s cash flow: from £9,000 to £5,400

Operating +£2,300, investing (£12,000), financing +£6,100 nets to a fall of £3,600, taking the £9,000 opening balance to £5,400 at close. Source: Together Accounting worked example, Norwich-based kitchen fitting company.

A £20,500 profit, and the bank balance still fell by £3,600. Profitability on paper is no guarantee of cash in the bank. The £13,000 of unpaid invoices is the big culprit, with the van close behind. A director who only looked at the profit figure might happily take a bigger dividend next quarter, then find the account overdrawn on payday. Getting the director salary and dividend split right helps avoid exactly that trap.

One profitable quarter, a shrinking bank balance

£55,000 Work invoiced this quarter. £20,500 Profit before depreciation and tax. £13,000 Invoices still unpaid at quarter end. (£3,600) net cash flow for the quarter.

Why is cash flow important?

Because cash pays the bills and profit doesn’t. You can’t pay wages, HMRC or your landlord with an unpaid invoice, however solid the customer looks.

There’s a second reason we don’t hear enough about. Cash is the one number that’s very hard to dress up. Profit depends on judgement calls about stock and depreciation. Cash in the bank is just cash in the bank, and that liquidity is what keeps the business running day to day. That’s why lenders, investors and buyers go straight to your cash flow history as the clearest sign of financial health. If you ever want to sell or raise finance, years of clean cash flow records will do more for your valuation than a polished profit figure.

And it’s an early warning system. Your cash position usually signals trouble months before falling profit does, which gives you time to act rather than react.

How UK rules shape your cash flow

Cash basis is now the default for sole traders and partnerships. Under HMRC’s cash basis, you’re taxed on money actually received and paid out in the year, rather than on invoices raised. It’s currently the default for sole traders and partnerships without corporate partners, with no turnover limit, though you can still elect for traditional accruals accounting. That’s a real plus, because your tax figures and your cash flow line up. Once you hold stock, give customers credit or need to show a lender what you’re owed, accruals often gives a clearer view, and our guide to cash basis vs traditional accounting walks through the difference in more detail.

The VAT threshold is currently £90,000. You must register once your taxable turnover passes that over a rolling 12 months, or if you expect to pass it in the next 30 days alone. Registering usually means adding the current 20% to invoices and paying it over quarterly, so plan the timing. Our VAT advice and preparation service can help you get the registration date right.

Making Tax Digital for Income Tax means quarterly updates. Sole traders and landlords with qualifying income currently over £50,000 now keep digital records and send HMRC updates every quarter. The threshold drops to £30,000 from April 2027 and £20,000 from April 2028 (HMRC guidance). It’s extra admin, but up-to-date books are the foundation of decent cash flow management, and our guide to Making Tax Digital for Income Tax covers exactly what you need to do before it applies to you.

Making Tax Digital for Income Tax: the qualifying threshold is falling

Payment terms are tightening in your favour. Under the Procurement Act 2023, public sector contracts now carry 30-day payment terms, and that requirement passes down the supply chain to subcontractors. The voluntary Fair Payment Code encourages businesses of any size to pay suppliers within 30 days, though only its top Gold tier asks for that across the board. If a customer pays late anyway, you have a legal right to charge interest and compensation on business invoices, and the Small Business Commissioner can help with larger customers.

A simple cash flow forecast template

A cash flow statement looks backwards. Cash flow forecasting looks forwards, and in our view it’s the most useful financial tool most small businesses don’t use. Here’s the layout we’d suggest, running 13 weeks ahead and rolled forward every week.

Fill in receipts based on when customers actually pay, not when they should. Put every big bill in the right week, especially VAT quarters and tax dates. Any week that goes negative is a problem spotted early, while you still have options.

If you’d rather not build this from scratch, download our free 13-week cash flow forecast template and start filling it in today. No sign-up needed.

How to manage cash flow better

The different types of cash flow point to different fixes, but most cash flow problems are timing problems, and timing is fixable.

One client drifting from 30 to 75 days ties up £12,000

Agreed / 30-day terms: £0 tied up. Client pays on the agreed 30-day terms.
Actual / 75-day drift: £12,000 tied up. Client drifts to paying at 75 days.

IT contractor billing £8,000 a month, £96,000 a year, on 30-day terms. An extra month and a half of income, £12,000, ends up sitting in the client’s account instead of the contractor’s. Source: Together Accounting worked example.

Late-paying customers are usually the biggest culprit. These are the changes that make the biggest difference for the businesses we see:

• Invoice the day the work is done and state clear payment terms on every invoice.
• Chase accounts receivable (money customers owe you) on a set day each week, before invoices go overdue rather than after.
• Take deposits or bill in stages on longer jobs, so you’re not funding the whole project yourself.
• Negotiate payment terms with suppliers that match how quickly your own customers pay.
• Keep cash reserves for known pinch points, and arrange an overdraft, line of credit or other borrowing before you need it. Lenders are far more helpful when you’re not desperate.

Then review the forecast every week. Ten minutes on a Monday morning beats a nasty surprise on payday, and it’s the kind of discipline our management accounts service is built around. Doing this consistently also shows up cash flow patterns you’d otherwise miss.

FAQ

What is cash flow, explained simply?

Cash flow is money in minus money out over a period, counted only when it actually moves through your bank. If more comes in than goes out, your cash grows. If more goes out, your cash shrinks, even if you’re making a profit on paper.

What is negative cash flow, and is it always bad?

Negative cash flow means more cash left the business than came in during the period. One negative month isn’t always bad, say if you bought equipment that will earn money for years. Several months of negative operating cash flow is a warning sign.

How often should I do a cash flow forecast?

Weekly, on a rolling 13-week forecast, if cash is tight or you’re growing fast. Monthly works for steadier businesses. Either way, update it with what actually happened so it gets sharper over time.

Does cash basis accounting show my cash flow?

Close to it. Under HMRC’s cash basis your taxable profit is based on money received and paid out in the year, so it tracks your cash flow far more closely than accruals accounting. It won’t split your cash into the three types, though, so you’ll still want a proper forecast.

Can I borrow money from my limited company to cover a gap?

Yes, as a director you can, and it goes through your director’s loan account. It’s a short-term fix rather than a cash flow plan, though, because loans that aren’t repaid in time bring extra tax, as we cover in our guide to the director’s loan account and S455 tax.