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26 Jul 2021

Importance of Cash Flow Management - The key to Business Success

importance-of-cash-flow-management-the-key-to-business-success

Startups

Cash is the lifeline of every business. Every business needs to generate enough cash through its  activities (products or services) to pay the expenses and have enough left over  to achieve its growth.

Through this blog, we shall shed some light on one of the most critical factors for any business - Cash Flow. Here we focus on practical tips that will help business owners  manage cash flow better, carry out correct projections and ultimately grow  their business in the long run.

In simple terms, Cash flow refers to the movement of money coming into and going out of a business.  Hence, Cash flow management is the process of keeping track of this flow and  analyzing the changes. This, in turn, helps predict and spot trends, prepare  better for the future and tackle any problems that may arise as a result.

It is best to practice cash flow management to make sure you can sustain the business and identify the runway available. If there is one thing, we as KGMC India understand, it is  that cash flow tells a story. In most cases, that story includes something to do with a lack of oversight in cash flow. In other words, business owners are  so busy working on their business, they aren't aware of how much cash they're generating versus the burn rate.

Key Takeaways

  • Cash  flow management broadly includes how a business manages its daily operations,  business activities and financial investments.
  • A  business has to generate adequate cash flow from its activities to survive,  cover expenses, repay investors and for business expansion.
  • It is  of prime importance for a business to be aware of its cash situation to meet  its immediate and long-term needs.

Why is  Cash Flow important?

Yes, Cash is King, but  Cash Flow is the Emperor! To be in business, earnings should be more than spending;  you must understand how vital cash flow is. After conducting a cash flow  analysis, you'll be able to analyze whether the company generates enough income  to cover its current expenses and debts. If the business is positive, there is  more cash coming into the business than going out. Alternatively, cash flow  negative means your business is operating with a cash deficit.

"The success of a company is often determined by  one's ability to maintain healthy cash flow. Moreover, businesses fail because  they lack cash reserves."

If  there is negative cash flow and no cash reserves, the risk of default is high  and may require additional loans or capital through other means to avoid losing  your business. Therefore, understanding the cash flow is essential to a company  as it reveals trends and provides insight that can be used to make strategic  business decisions, manpower planning, or execute a merger or acquisition as  the case may be.

Understanding  the Impact of Cash Flow on your Business

Not maintaining a  healthy cash flow is one of the main reasons why businesses fail. Therefore,  it's essential to document your company's cash flow within bookkeeping and  understand how it impacts your business. First of all, there is a difference between profit and cash.  "Profit" relates to the accounting principle for financial gain,  whereas "Cash" is the actual money at hand.

For example, you invoice  a client INR 50,000 for the work completed. Some companies may recognize this  as profit as soon as they send the invoice. However, you will not have INR  50,000 cash until you collect it. Understanding the difference between profit  and cash is crucial as it emphasizes the importance of collecting the  outstanding receivables you may have.

In the long run, cash flow will suffer for  businesses that are unable to collect overdue invoices and reconcile accounts  receivables. When clients pay late or do not pay, it impacts the ability to  operate the business efficiently and pay any outstanding debts. Moreover, if a  company experiences negative cash flow due to client payment issues and does  not pay liabilities on time, it could also affect the ability to get a business  loan in the future.

Cash  Flow Categories

Cash Flows from Operations (CFO)

The operating cash flow  describes the money involved directly with the production and sale of goods or  services from regular operations. CFO is an indicator of whether a business has  enough funds coming in to pay its bills or operating expenses and be  financially viable in the long term.

In simple terms, CFO = Cash received from sales - Operating expenses
Operating cash flow is recorded on a company's  cash flow statement, which is reported generally on a quarterly and annual  basis. Hence, the Operating Cash Flow further signifies the ability of a  business to generate enough cash flow to maintain and expand operations, or the  need for an external financing round.

Note: CFO is  useful in segregating sales from the cash received. For instance, if a company  generates a massive deal from a client, it may boost revenue and income.  However, the additional sale does not necessarily enhance cash flow if there is  difficulty collecting the customer's payment.

Cash Flows from Investing (CFI)

Investing cash flow  reports how much cash has been generated or spent from various  investment-related activities in a specific period. For example, purchases of  real estate, investments in securities, or their sale, respectively.

Sometimes negative cash flow may arise from such  investing activities due to significant amounts of cash being invested in the  company's long-term health, such as research and development (R&D), and is  thus not really a warning sign.

Cash Flows from Financing (CFF)

Financing  cash flow indicates the net cash flows used to fund the company, like  transactions involving issuing debt, equity, or paying dividends. Cash flow  from such financing activities provides investors with insight into a company's  financial strength and how well a company's capital structure is managed.

Statement  of Cash Flows

The three crucial parts  of a company's financial statements are the balance sheet, income statement and  cash flow statement. Whereas the balance sheet gives a one-time snapshot of a  company's assets and liabilities and the income statement indicates the  business's profitability during a specific period, the cash flow statement  differs from both the financial statements and acts as a corporate checkbook  reconciles the other two statements.

The cash flow statement  records the company's cash transactions, namely - the inflows and outflows  during the given period. This implies whether all of the revenues booked on the  income statement have been received.

Moreover, the cash flow  does not necessarily showcase a business's expenses in their entirety as not  all costs accrued are paid right away. Although the company may have incurred  liabilities, any payments toward these liabilities are not recorded as a cash  outflow until the transaction occurs.

The first and foremost item to take note of on  the cash flow statement is the bottom line. The bottom line represents the  overall change in the company's cash and its equivalents (the assets that can  be immediately converted into cash) over the previous period. Cash and cash  equivalents (CCE) are shown under current assets on the balance sheet. The  difference between the current CCE and that of the previous year or quarter  should be equivalent to the number at the bottom of the statement of cash  flows.

What  is free cash flow, and why is it important?

Free cash flow (FCF) is  the cash left over after a business pays for its operating expenses (OpEx ) and  capital expenses (CapEx). It is the money that remains after paying for  expenses such as payroll, rent, taxes etc. Knowing how to calculate FCF and  analyze it will help a business with its cash management and provide investors  with insight into a business's financials, helping them make better investment  decisions. FCF is an essential aspect since it indicates how efficient a firm  is at generating cash.

Assess  Your Cash Flow in Three Easy Steps with KGMC India

Once  you are aware of where your revenue streams are coming from and going to, you  can determine how much money can be invested in your business for long-term  growth. Ask yourself these three questions to get started with the process:

  • At  what pace is your business growing, and what will be the upcoming cash flow?
  • Where do you need to invest in to fund your  business growth?
  • How easily accessible is the money in savings  and investments. Is there enough to cover at least 6 months of usual operating  expenses in case of uncertainty?

Once you've answered  these questions, you'll get a fair idea of your business's overall cash flow  process. Hence, you'll be able to diagnose your business process and determine  what needs improvement. For example, if you continuously accept overdue  payments on invoices, you might want to charge a fee to encourage clients to  pay on time. If your bills are getting paid late regularly, you might want to  rethink the process and set calendar reminders or hire an assistant to help you  manage your time.

Without a cash flow assessment, you might be  shocked when you cannot meet your financial goals. If you're ready to take your  finances to the next level, get in touch with us now!


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