It is a well-known cliché in business that “cash is king” and that is a fact. Apart from being the source of paying monthly bills, wages, and other expenses, cash is also an indicator of business success. Also, a company can appear to be in profit “on paper” but may not have actual cash to fulfil the inventory requirements and operating expenses. It may soon go out of business. Profit figures in business consider several non-cash line aspects like depreciation expenses and goodwill write-offs etc. Also, profit reports are calculated from sales income, which could be different from actual cash received from sales. Hence, cash flow is a more prevalent factor in representing the financial health of a business over profits.
What is cash flow?
We can understand the meaning of cash flow as the movement of cash inward and outward in the business. Cash is the money in hand and money deposited in banks. Cash equivalent is a highly liquid investment that is readily available for use. Cash is considered the lifeblood of a growing business. The effect of cash flow is immediate and real, if not managed properly, it’s disastrous. Hence, it must be monitored, controlled, protected, and utilised appropriately.
Cash Flow in business is a cycle. It is used to avail of the resources. They are then utilised to offer some products or services to the customer. Cash then flows inward in the form of revenue.
The inflow of cash can be from various sources such as:
- Receiving money from the sale of products/services
- Receiving money from royalties, fee, and commissions
- Getting money from bank loans
- Interest generated from the invested money
- Shareholder’s investment in business
- Selling long term assets like land and property
The outflow of cash can be in several directions such as:
- Buying raw material for manufacturing of goods
- Buying finished products for resale
- Buying fixed assets
- Paying taxes, long term debts, or redemption of debentures
- Various operating costs and salaries/wages of workers
- Paying interests to bank loans
Types of cash flow
Activities that result in cash flow in business can be divided into three categories:
1. Operating activities
These are the primary activities of a business. For instance, in a cosmetics company, it could be manufacturing of cosmetics, procurement of raw material, sale of cosmetics, etc.
These are the main activities that are responsible for profit generation. The amount of operating cash flow indicates the capability of the business in paying its dividends, managing working capital, and other expenses, and investing money without the help of an external source of finance.
Cash inflow from operating activities can be from the selling of goods and royalties, commissions, or other revenues.
Outflow can be for raw material purchasing and other manufacturing expenses, salaries of workers, and tax payments.
2. Investing activities
Investing activities include the purchase of fixed assets like machinery, land, and building and furniture, etc. Transactions concerning long-term assets are also counted under investing activities. These activities are mostly futuristic and can generate some income and cash flow in the future.
The cash outflows from investing activities can be to purchase fixed assets, shares, warrants, and other debt instruments.
Cash inflow from investing activities can be interests and dividends received from loans given, investments done, repayment of a loan from third parties or disposal of fixed or long-term assets etc.
3. Financing activities
Financing activities include the equity issue and repayment, debt issue and repayment, dividend payment, and obligations of a capital lease. Cash flow in business from these activities is the net amount of cash generated by the company in a certain period. As and when a company requires capital, it will issue debt or equity. The accountants, investors, and financial analysts are eager to know how the company is funding its operations.
Cash inflow from financing activities can be from issuing shares, debentures, loans, and other short- and long-term borrowings.
Cash outflows from activities like repayment of amounts taken, interests to be given on debentures and advances, or dividends to be paid on equity.
What is Net cash flow?
Net cash flow is the profitability or loss measured by finding the difference between total inflow and outflow of cash through investing, financing, and operating activities. It can be calculated as
Net Cash Flow= Total Inflow – Total Outflow
where inflow is the revenue generated from sales of goods/services and outflow is the expenses made for utilising resources to avail those goods/services
What is Free Cash Flow?
Free cash flow is the amount of cash that is free and clear of any obligations to be paid to the shareholders in the form of dividends and interests. So, with FCF statements, investors get an idea about the company’s capability to repay expected dividends or interests within a certain period.
If the debt is subtracted from the free cash flow in business, the company will also get an idea about cash available for additional borrowings. Also, investors can find out the insights of future dividends based on current free cash availability after interest is paid.
Free cash flow can be calculated as
Free cash flow = cash flow by operating activities- capital expenditures
Since it considers the working capital, it provides a clear view of the fundamental trends. For example, a decrease in inflow means the company is getting cash from the customers rapidly, or an increase in the inventory could mean the piling of huge stock.
What is cash flow statement?
Cash flow statement is a financial statement showing the inflow and outflow of cash and cash equivalents from different types of cash flow activities. The primary purpose of this statement is to show the total cash inflow and outflow details for a certain period, under headings of financial, investing, and operating activities. It has various significances:
- This statement is a tool for the stakeholders who are interested in the financial information and condition of the company.
- It has huge importance due to its practical utility in financial matters.
- It shows a transparent picture of the financial health of the company.
- It helps the firm in balancing the two aspects: cash inflow and cash outflow.
- It helps in comparing the operating performance of different enterprises.
Although positive cash flow statements are a good sign, negative statements cannot be completely called a bad financial condition. There can be companies that have some expansion plans and, because of that, have negative statements. Hence, regular monitoring and analysis should be done before concluding.
Cash flow projection
Based on the cash flow statement, prediction can be made on the flow of funds in your business. That is called a cash flow projection. After all, you can make decisions on expansion or requirement of funds based on the current scenario only.
What is cash flow management?
Cash flow management is the process by which an organisation monitors, optimises, and analyses the cash flow in its business. As per a study conducted, 82% of businesses fail because of poor cash flow management. If the cash inflow lags the cash outflow, it may cause a financial crisis.
Hence you should be using some cash flow management techniques. You can follow these methods:
First of all, it’s very important for you as a business owner to keep a check on your cash flow.
Many accounting software is available which can help you in analysing the cash flow and generating reports. This would help you to be prepared for the coming situation.
Secondly, you may use different strategies to shorten your cash conversion period, which will help you get cash readily available for use.
Thirdly, if you are planning for an expansion and need funds, you can consider debt financing or equity financing as an option.
- Debt financing is suitable for land or machinery, building or equipment where they are kept as a security for availing loan services. For small funds required, this is a good option.
- Equity financing is another option where an investor is given a share of the business. Here you don’t have to repay the debt if the business goes in loss. However, he/she should be involved in all the business decisions.
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Q. What is cash flow management?
Ans. Cash flow management is the process by which an organisation monitors, optimises, and analyses the cash flow in its business.
Q. What is Free cash flow?
Ans. Free cash flow is the amount of cash that is free and clear of any obligations to be paid to the shareholders in the form of dividends and interests.
Q. What is Net cash flow?
Ans. Net cash flow is the profitability or loss measured by finding the difference between total inflow and outflow of cash through investing, financing, and operating activities.
Q. What is operating cash flow?
Ans. It is the cash flow from operating activities like manufacturing.