In this piece of article, you will learn all about cash flow. Right from what is cash flow to what is the significance of it, you will get information on everything. Below, you will learn many interesting things associated with cash flow in any business.
The amount of cash or cash equivalents that an organization receives from various sources including customers and lenders and gives out to creditors and vendors is known as cash flow. Cash, being the most real thing in a business, makes cash flow the key indicator of a business\’s financial health and performance. It is all about how much cash is received from where, how much is gone out where, and what remains. While a cash flow statement tells you the current liquidity position of the organization, cash flow forecasting that looks into the future cash flow is critical for managing the survival and growth of the business.
What is Cash Flow?
Before we move on to discussing what is its importance, it is better for you understand what is cash flow. Cash flow refers to the transfer in and out of net cash and cash equivalents in an organization. While cash coming in represents inflows, cash going out represents outflows as shown in a cash flow statement which is an important financial statement – a statutory report in most countries. A cash flow statement measures and analyzes the cash inflows or outflows that have happened during a given period whereas cash flow forecasting looks into the future to help the company to plan for the short-term or long-term cash requirements of the organization. Cash flow is a common challenge among businesses but more so for the majority of small businesses including startups and has a negative impact on their businesses.
Depending on where the cash is coming from and going out, cash flow is classified into three categories, which include:
- Cash flow from operating activities is about the Opex cash flows from the business’s core day-to-day activities like buying, producing, and selling products or services, etc.
- Cash flow from investing activities focuses on the cash activities related to the company’s purchase and sale of the capital asset (Capex)- the assets having a useful life of more than one year instead of being shown in the profit and loss statement in the year of purchase or sale.
- Cash flow from financing activities considers the flow of cash arising from equity, debt, and dividend transactions. This part provides investors with insight into the financial health and capital structure of the company.
Critical Significance of Cash Flow
To understand the significance of cash flow, it is important to understand the basics of doing business. A healthy cash flow allows you to meet your current financial obligations as well as future investment plans. Managing cash flow well helps ensure the smooth day-to-day running of your business and keep aside sufficient cash reserves to weather turbulent times and make investments in the future. Let us examine the significance of cash flow for an organization through the lens of three elements.
Liquidity vs Revenue and Profit
There is a wrong but common notion that revenue growth and profit enhancement are sufficient proof of the health of a company. While both are important measurements, that alone won’t suffice because they don’t ensure positive cash which is indispensable for the existence and growth of the business. You may scale your business or generate book profit, but will still be struggling with a tight cash position because the cash is blocked in your debtors, inventory, and other assets.
This creates a situation where you won’t be able to pay your employees, suppliers, and other creditors in time making it difficult to run the business and kick-starting a spiral that ultimately affects your revenue and profit. Analyzing cash flow position and forecasting it as accurately as possible helps enterprises get better visibility and insight into the company\’s financial position so that proper decisions can be made on managing short-term cash flow to run day-to-day operations and planning long-term investments to expand and diversify and scale. This is the importance of cash flow for any business.
Growth and Scale
A better understanding of cash flow in the present and into the future gives you insights into how much cash is needed for day-to-day operations including working capital management of the business and how much can be earmarked for investments to add capacities, go to new markets, run promotions/discounts, develop and market new products or service lines, bring in top talents on board, etc. It is critical for businesses to know how much money is available now, how much more will be added in future timelines, what portion can be used for long-term reinvestment plans, and how the gap, if any, will be funded.
Strong cash flow is imperative to manage short-term day-to-day operations to generate strong cash reserves, which is critical for future long-term investments. If short-term cash flow is weak, long-term cash will not be existent. Cash flow forecasts help you understand whether your business might encounter a shortfall or have a surplus of cash in the future. This will enable you to consider cost control measures and financing options.
Sources of finance
How the short-term and long-term requirements of finance will be funded is one of the most crucial questions for a business, particularly a startup. Depending on the stage, type of business, and financial needs, the sources of finance can differ. Established or growing companies have more comprehensive options like equity financing through the issuance of stock to the public – through IPO or FPO – and external debt financing from lenders, but the feasible and popular source of funding for small businesses including startups is investments from investors like VCs and debt financing.
While lenders review the cash flow of the borrower to ensure that the company is capable of paying interest on time and returning the principal amount as per the agreement, the investors base their decision on the potential of the businesses and startups to generate future cash flows that will allow investors to multiply their investment.
The Critical Element in Cash Flow
While revenue and expenses are recognized in the profit and loss statements as and when they occur, they appear in cash flow only when the cash is received from customers, lenders, and investors or paid to creditors and lenders. Profit is an important metric for businesses but a profitable business can have poor or even negative cash flow. This can happen, for example, when you sell to customers that pay their invoices late or when there are extended credit periods. It makes the collection of customer payments in time critical to ensure that you pay your employees, vendors, and lenders in time for smooth day-to-day operations and future investments. Delays in servicing vendors and creditors have negative effects on your credit score leading to penalties and higher cost of debt.
PACI’s finance platform provides small and medium enterprises including startups with key insights into the present and future cash positions without needing external finance professionals. As a founder or a CEO, you must make sure that poor cash flow should not be the reason for the undoing of your business. With PACI financial analysis and management tools, there is no need to spend innumerable hours understanding and analyzing your cash flows to run the operations, plan future growth, and negotiate with investors.
Paci.ai, a unified finance management platform for SMBs, looks forward to tackling the backwards-looking nature of accounting with its insights and predictor modules.
The insights module works on the concept of proactive messaging on trends ( Income, expenses, customers, and key notifications providing a small business with actionable insights at the right time.
The predictor module ( Coming soon), leverages historical data to simulate key but the day – to day decision-making on hiring, buying capital equipment and planning promotions among others.