Cash flow management is an imperative part of any organization, and structured cash flow can help a business reach unparalleled heights. That being said, let us get a better understanding of what exactly is cash flow and how it impacts businesses.
Cash flow is exactly what it says on the tin – the incoming and outgoing of cash. This structured and continuous flow of cash basically represents the operating activities of any organization and determines its success rate. In terms of financial accounting, cash flow is the difference in the cash amount available at the beginning of a period, which is opening balance, and the amount at the end of that period, which is the closing balance.
When it comes to cash flow, there are multiple versions of it, which have their part to play in performing different financial analysis and achieving a smooth business run. Let us discuss them in detail.
Cash Flow Types
There are several types of cash flow, so when the term is being used, it is important to get an understanding of the specific type of cash flow which is being mentioned. The following are the various types of cash flow.
1. Free Cash Flow to Equity (FCFE) – This is the cash amount generated by a business that can be distributed among the shareholders. FCFE can be obtained by deducting Capital Expenditures from the cash from operations.
2. Free Cash Flow to the Firm (FCFF) – It is used in financial modeling, calculating a company's enterprise value. Assuming the company is completely debt-free and has no interest expense, it is a cash flow figure for a business, theoretically.
3. Cash from Core Operating Activities – This comprises of the cash which is produced as a result of key operations of a company, excluding the investments’ cash flow. This can be looked out on the company's Cash Flow Statement, which is the statement that reports the cash generated, and spent during a particular time period and acts as a connection between the income statement and balance sheet.
4. Net Cash Flow Change – In simple terms, it is the change in the ‘cash flow amount’ between two consecutive accounting periods and one can gain access to it at the end of the Cash Flow Statement.
Cash Flow Uses
Smart cash flow management is imperative for the sustainability of any business. Every company tries to ensure that through every cycle of cash flow, money gets saved in the form of incoming cash as compared to the money that flows out. Hence, there are many uses of cash flow.
1. Determining the NPV (Net Present Value) – NPV analysis is used extensively across the financial accounting industry for determining the net value of a business, its new ventures, cost reduction programs, and anything that includes cash flow. It is calculated when the immediate value of cash outflows is subtracted from the immediate value of cash inflows. It is used to gauge the extent of profit of any project or investment.
2. Analyzing the Liquidity – Financial liquidity is an extent of the ease with which assets can be converted into cash. Hence, cash flow helps in gauging the capability of a company to surpass the financial hurdles in the short run.
3. Funding Dividend Payments – A company's earnings can be either reinvested in the business or can be paid out to the shareholders as a dividend. Cash flow can be used to fund these dividend payments to the shareholders and investors.
4. Reducing Funding Gap – Funding gap is the amount of money which a company needs to fund for future developments or ongoing operations that are not currently funded. Cash flow analysis helps reduce this gap and get an overview of the same.
Why Does Managing Cash Flow Matter?
The creation of a dependable cash flow structure and maintaining enough cash on hand is vital for the growth of any business. Few business professionals even believe that maintaining cash flow is more important than the business's ability to deliver its services.
One may think that cash flow is being highlighted but think with a different angle– If you lose out on a customer's business because of any given reasons, you can always develop strategies to acquire the new customer. However, if you face a lack of cash to pay your suppliers and employees, you will be out of the business.
Hence, managing cash flow is an imperative step for business growth. A thorough understanding of what cash flow analysis brings to the table is very important in this regard. We understand that the funding gap is a major offset for the companies, but, with the efficient cash flow management, the same can be tackled with utmost perfection. Let us discuss how.
Components Which Help to Analyze Cash Flow Gaps
To correctly manage the cash flow of a business, components affecting the cash inflow and outflow should be examined. With a thorough analysis of the same, you can get a better understanding of the cash flow gaps in your business. Cash flow management involves the narrowing or completely closing these cash flow gaps. Some important components to examine are stated below-
- Accounts Payable- It is the amount that is owed to the suppliers and is due in the near future (30 to 90 days). Proper management of the accounts payable is required so that the cash flow is maintained adequately.
- Accounts Receivable - It refers to the sales for which the cash is yet to be obtained. For efficient cash flow, it is important for you to know the effects a negative cash flow is causing to your business.
- Inventory- Inventory refers to the racked up raw materials and goods that the company has kept in advance in order to meet the requirements of the customers. Keeping a decent inventory is important, but it is also important to keep a check that you do not have an excess of these raw materials so that the cash is not misused in the first place.
- Terms of Credit- This affects the time of cash inflows, hence, affecting the overall cash flow. It is the time limit that you decide for your customers to pay you for the supplies purchased or services undertaken.
Closing Your Business's Cash Flow Gap
If left unchecked, the cash flow gap can be a serious issue for businesses. For example, you buy a stock and pay the supplier on the same day, but when you sell out the same stock, your customer takes 30 days to make the payment. Hence, 30 days will be your cash flow gap, which means your business will face a cash flow gap if your cash inflows and outflows do not line up.
You can find out the cash flow gap for your business using the following equation -
Period of Receivables + Inventory days – Period of Payables = Cash Gap (in days)
Where, the period of receivables is the number of days your customer takes to pay you, days in inventory is the average number of days’ worth of sale you have in your stock, and payables period is the number of days it takes you to pay your suppliers for the stock.
To avoid the cash flow gaps:
- Do not rack up large amounts of stock and raw materials.
- Avoid accepting short payment terms from the vendors.
- Invoice your customers as soon as possible.
- Make sure that you provide a convenient payment method to your customers.
In layman terms, cash flow can be described as the money which goes in and out of your company. But, if analyzed through its depths, well-structured cash flow can make a business grow by leaps and bounds. It allows the business to be cost-effective and streamlined with its core activities.
About the Author: Kellie Connor is a Sr. Business Analyst and certified accounting professional at Cogneesol, a global business accounting services provider. With extensive experience in delivering financial accounting services, she has evolved herself from a professional accountant to a writer and now turned into a highly-focused business strategist who always pens down effective accounting solutions through her writings to the business verticals’ audience.