Cash Flow

Imagine you wanted to know how well your business is doing. How would you find out? How would you determine how much money was coming into the business and how much you needed to cover expenses?

The first thing you could do to answer these questions is to look at cash flow. Cash flow is directly related to all the money coming in and out of business. It's one of the most important metrics investors use when assessing a company's value. This explanation will teach you everything you need to know about the topic of cash flow. In the end, you'll be able to make sense of any company's cash flow.

Cash flow definition

Cash flow refers to the money that comes into the business, as well as the money that leaves the business. That is to say, it records and calculates all the money circulating within the company. There are many reasons why cash goes into or leaves a business.

Inflow of cash examples

Money coming into the business is referred to as cash inflow. Cash inflow results from the business activities that a company engages in. Some inflow of cash examples include:

• Incomes from sales,

• Bank loans,

• Investments.

On the other hand, examples of outflows of cash include:

• Wages,
• Rent,
• Interest payments, etc.

Cash inflow and outflow

There are different types of cash inflow. The most common ones are:

• Income from sales: This represents all the money a business makes from selling its products or services. All the income from this source creates cash for the business.

• Bank loans: Often businesses use bank loans to finance their business activities, such as buying raw materials, renting offices, etc. This is considered to be a cash inflow.

• Investments: This type of cash inflow includes the business owners' money into their business and the money that a business has managed to secure through other investors.

On the other hand, businesses also experience money leaving the firm. This money may be used for different purposes, such as paying for salaries or raw materials to keep the production going.

Types of cash outflows include:

• Raw materials: All the money that a business spends on raw materials to manufacture final products is a cash outflow.

• Wages: All the wages that a business has to pay to its employees are cash outflows. That is due to the money leaving the business and counted as an expense.

• Rent/ Mortgage: Many businesses need a building from where they can operate, and to get that building, they would have to either rent it or buy it. In both cases, it causes a cash outflow for the business.

• Interest payments: The payments that a business makes towards interest on the loans that they took out is a cash outflow.

Fig. 1 - Cash Inflows and Outflows

Cash flow v profit

Often people confuse cash flow and profit. Although they might have many similarities, they are not quite the same.

Profit usually belongs to the owners of a company.

In contrast, cash flow refers to the money that moves in and out of business. In contrast to profit, cash flow is more about the business than business owners. Cash flow enables businesses to cover all the expenses while providing final goods or services.

Profit is concerned with the money left after all the expenses are covered, whereas cash flow is concerned with the net flow of funds.

Both cash flow and profit are essential factors for business owners and investors. These metrics are used when assessing how successful a business is. Many companies show a positive cash flow, but are making a negative profit. This doesn’t mean that the firm failed - they were simply able to keep going for some time without a profit, as the inflows were enough to cover cash outflows.

Cash flow statement

Another important part of the cash flow is the cash flow statement.

This financial statement is very important for investors. Investors are significantly concerned and always look for whether a company will have a positive cash flow in the future, meaning that there's more money coming in than leaving the business.

Table 1. Cash Flow Statement ENRE Ltd

The table above shows an example of what a business's cash flow statement looks like. Note that March is the actual month, and April is the month forecast. A typical cash flow statement has three sections that you need to keep in mind.

It starts by having the cash inflows at the top of the statement. All of the cash inflows added together equal the total cash inflow. We can see that ENRE Ltd's cash inflows for March add up to £32,000.

Then you have the cash outflows. After accounting for all the cash outflows, you add them up to develop the total cash outflow. In our example, cash outflows in March are equal to £29,500.

The third section is the net cash flow, which is calculated by subtracting the total cash inflows from the total cash outflows. From our example above, you can see the net cash flow:

£32,000 - £29,500 = £2,500

Opening balance refers to the amount that the business started the month with, whereas closing balance refers to the amount of money the business has been left with at the end of the month. Opening balance, in this case, was £2,000, whereas by the end of the month the company had:

£2,000 + £2,500 (the net cash flow) = £4,500

as their closing balance.

Cash flow forecast analysis

The cash flow forecast estimates the planned cash inflows and outflows of ENRE Ltd during April. Figure 1 shows that the company is expected to have a negative net cash flow by the end of April. That is because the cash inflow has not increased by as much, only £3,000, which is calculated by taking the difference between cash inflows in April and March:

£15,000 - £12,000 = £3,000.

At the same time, the business expects to increase total outflows by £1,500 (£31,000 - £29,500 = £1,500).

This analysis is very useful to business managers, as it helps them properly plan what they will do with the negative net cash flow they are expecting. Business owners can use this information to decide whether they want to reduce total outflow or seek more financing into the business to bring in cash inflows.

The cash flow also enables business owners to find out where the cash outflow is coming from, which in this case, there are three main sources: raw materials, wages, and new equipment.

Advantages of having positive cash flows

Many advantages come with a positive cash flow. One of the major benefits is getting loans. If you want to grow your firm, you may need to take out a small business loan. To be eligible, you must show that your firm is stable and generates consistent revenue. This need may be met by having a solid cash flow.

Even though you might not get a loan, a positive cash flow will significantly help expand your business. There are two main ways in which this can be done. Firstly, you could have the extra inflows used to invest in new projects to expand. This expansion may take the form of establishing a new business site, expanding into a new market, purchasing new equipment, etc.

Secondly, a positive cash flow is always attractive to investors. You could have other people invest in your business and use that money to develop your operations further and generate more sales.

Lastly, a positive cash flow assists a company in meeting financial obligations. In the early stages of a new firm, it is common to depend on credit to pay for costs, including staff salaries. Nevertheless, after the firm has established itself, it will be able to utilize cash flow to reduce its debt. This reduces the cash flow problems a business might run into and, as a result, reduces the risk of failure.

Cash flow management

Good cash flow management is the most critical part of any company's operations. It increases the chance of a business having a positive cash flow, which allows the company to pay its employees on time and have enough capital to invest in its development and expansion.

Additionally, performing business analyses and staying up to date with recent developments allows the company to achieve a better cash flow forecast and make decisions about the future accordingly.

Inefficient management of the business's cash flow is one of the leading causes of cash flow problems. This is especially true for small businesses that lack the financial expertise to manage cash flow properly. However, big companies can also face problems arising from poor management.

Solutions to cash flow problems

There are two critical factors to consider when finding a solution to business problems. Cash flow managers should consider finding the source of the cash flow problem and analysing the business's circumstances. This helps provide for more efficient and accurate management of cash flow.

Some of the solutions that you can implement to cash flow problems include:

• Rescheduling payments. When you face cash problems and see an imbalance between cash inflows and cash outflows, it is better to ask suppliers whether you can pay them later. That way, you delay cash outflows which then helps cover the expenses of raw materials.

• Using overdrafts. Overdrafts is another alternative solution to cash flow problems. This includes taking out small short term loans to cover the cash outflows. It is a widespread practice amongst cash flow managers.

• Cutting cost. Cutting costs significantly helps reduce the cash outflows when a business is having cash flow problems. It is a solution that usually involves finding alternative and cheaper raw materials, cutting the cost of fuel, etc.

To sum up, cash flow shows the financial situation of a company throughout a period. It focuses on showing and accounting how much money enters and leaves the company. The cash flow is important to businesses for them to better manage their company. Additionally, the cash flow is important for investors as it is one of the most significant tools in valuing a company.