Cash flow reveals a lot about a company’s ability or lack thereof to meet its financial obligation, and thus it tells a more accurate story about a company’s situation than net income. In a nutshell, it is the money that moves in and out of the business in a month.
Companies with positive cash flows can easily expand their business, pay dividends, pay off their debt, and buy back shares, which all have auspicious effects on their long-term profitability.
What Is Cash Flow?
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While it seems that cash flow only goes in one direction, i.e., out of the business, the truth is that it flows both ways, since it also takes into account the cash and cash-equivalents coming in from customers who are paying for products and services. Take note that a portion of the cash flow may also come from collections of accounts receivable.
Non-Recurring Revenue
Meanwhile, cash flow does not include non-recurring revenue that is unlikely to occur again. Common examples of non-recurring revenue include the sale of assets, insurance settlements, donations, one-time gifts, and anything that is not part of normal business operation.
Cash Out
Cash flow also takes into account the money that goes out of the business in the form of loan payments, taxes, expenses such as rent, mortgage, employees’ salary, and other accounts payable. In the ideal scenario, there should be enough money to cover your financial obligations, which suggests that you have a positive cash flow.
Conversely, if more cash is going out than coming in, your business would face a deficit or overdraft, which could force you to get a new line of credit in an attempt to fix the shortages in cash flow. Of course this situation is not always a cause for concern ,as start-ups and seasonal businesses typically need a boost in their working capital, usually in the form of loans.
What It Means
Most investors, accountants, and money managers believe a free cash flow reveals the true profitability of a business, suggesting that it is even a more accurate representation of a company’s financial strength than other measures of financial performance, such as revenue and net income.
But knowing the core definition of cash flow is not enough. It is equally important to develop the right strategies to maintain a healthy cash flow, i.e., a positive cash flow, which can be achieved by adopting these measures:
- Work with a reputable accountant to analyze your cash flow
- Encourage use of payment cards
- Speed up the receipt of cash by shortening payment terms and giving a small discount to clients who pay early (and a penalty to late payers)
- Use a business credit card when paying suppliers and making purchases and take advantage of grace periods
- Put cash to work in a high-interest savings account
- Get a line of credit to cover short-term needs and emergencies.
- Consider long term financing when you make large purchases such as car, equipment, computer system, etc., instead of using cash or savings
- Consider “continuity” sales that offer deals to customers who buy for a fixed period of time
Why Is Cash Flow Important?
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Companies with a healthy cash flow fare better during downturns and other financially challenging periods. They have the resilience to overcome short blips in their revenue cycle or downturns in the market. In fact, having a positive cash flow is significantly more important than simply increasing profits. Therefore, even a profitable business may still fail if most of their profits are tied up in inventory and accounts receivable, or they spend too much on capital expenditure. The important thing is to have a good, reliable cash flow.
Here are the reasons why a positive cash flow is important:
Increasing Liquid Assets
A positive cash flow indicates that you have sufficient liquid assets that allow you to settle debts and meet other financial obligations.
Buffer
It protects you against future financial challenges.
Better Customer Reputation
If you are paid on time, you can also pay for your suppliers and enjoy a smooth operation. After all, any interruption in your business operation can be a huge turnoff for many clients who need the job done quickly.
Better Deals with Your Suppliers
If pay on time and have a good reputation, you might be able to haggle down the price with your suppliers.
Tax Liabilities Are Met on Time
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Reinvest in your business. A positive cash flow allows you to expand your business and buy back shares. In addition, you can take advantage of new profitable investments.
Provide Dividends
One of the reasons why investors seek companies known for giving regular dividends is that it typically indicates a healthy cash flow—i.e., they have a surplus of cash that can be returned to shareholders.
Better Deals with Creditors
While it may sound like a paradox, creditors want to see if you can meet your current and short-term liabilities with the money you generate from normal business operations before they approve your loan. Furthermore, paying on time helps you build trust with them, putting you in a better position for future credits.
Cost Reduction
If you can pay on time, it you can minimize interest charges. Also, lenders often give low interest rate if you are able todemonstrate that your business has enough cash and cash-equivalents to settle your financial obligations.
Good Reputation for the Business
In the long run, maintaining a positive cash flow demonstrates that you are able to stay on top of your finances.
Prevents You from Making Rushed Decisions
A healthy cash flow gives you a sense of control, which in turn precludes you from making rushed or poor decisions often committed by businesses that are struggling to keep their finances afloat.
It Promotes a Healthy Economy
Arguably, small businesses and start-ups are more susceptible to poor cash flow than their larger counterparts. But should they fail, bigger companies would still bear the brunt.
Benefits of Cash Flow
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Almost every part of your business operation is affected by cash flow: investment and business expansion, customer service reputation, the ability to secure loans and other lines of credit, share buyback rates, hiring and maintaining talent, and debt and other financial obligations.
Several studies have shown that a good number of small businesses and start-ups fail because of poor cash flow or mismanagement of their cash. Consequently, the long-term success of any company boils down to keeping a healthy cash flow.
To reiterate, a healthy cash flow allows a company to survive economic downturns, increase its assets, expand its operation, settles its debts, meet its financial obligations, and return money to shareholders. Furthermore, the financial flexibility allows any business to take advantage of new investments.
While it is true that cash flow reveals a lot about a company’s liquidity, it doesn’t always indicate good news. For instance, a business might have a surplus of cash after selling its critical assets, and then proceed to take on unsustainable levels of debts and other activities that could put its future growth in jeopardy. The amount of cash in hand is almost never the critical issue: it is the cash flow.
Conclusion
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Having enough cash and a positive cash flow is the key to running a business smoothly, and thus financial experts often refer to it as the lifeblood of the company. The cash flow pays for salaries, debts, and other financial obligations, and for expenses such as mortgage and rent.
However, some novice entrepreneurs focus more on growing their profits, which is the difference between the gross sales and expenses, with little or no regard for their cash flow. This could spell trouble especially when there is not enough cash on hand to run the business smoothly.
Your business’ long-term survival boils down to maintaining a healthy cash flow, which entails adopting different tactics, such as speeding up your cash receipts, which you can do by sending out invoices immediately after the delivery of goods and services. You may also change your payment terms, say, from 60 days to 30 days. Some businesses even give a small discount to clients who pay their bills early, while those who settle their obligations late are slapped with penalties.
Working with a reputable accountant could further help you maintain a healthy cash flow. This is particularly true if your business goes through cyclical highs and lows. Oftentimes, seasonal businesses experience higher profits during holiday seasons, long weekends, summer vacation, the beginning of school year, etc.
Your accountant can also point out the “challenging periods” so you can time your borrowing and marketing efforts, and adjust your labor force. He or she can also help you plan for possible cash flow-related problems and curb them before they turn into bigger financial trouble.
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