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.
- 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!