In this wiki, we explain why cash flow is extremely important to any business. We also explain the definition, how to calculate cash flow and what are the consequences linked to good or bad cash flow.
What is Cash Flow?
Cash flow is an important measurement metric to determine the financial position of a business. e.g when assessing credit applications, financial institutions will assess the cash flow element. Cash flow can be defined as the difference between income and expenditure over a certain financial period.
Calculating cash flow?
To get the full and accurate picture of your cash flow, you need to pay close attention to all activities which contribute towards the incoming and outgoing transactions.
Cashflow = Revenue – Expenditure
Expenditure should factor operational costs (e.g. purchase of raw materials etc.) associated with the product/service provided.
What are the consequences of positive or negative cash flow?
Calculating the cash flow is the first step in the process, however monitoring cash flow levels is key to the financial performance of a business.
Negative cash flow:
Simply put, it means more money is pumped out of the business than is being generated which is likely to have negative impact on a business. A negative cash flow may most likely involve increasing borrowing with associated costs etc. However, not all negative cash flow instances can be taken on face value as there may be instances where huge sums of investments require companies to report on negative cash flows for a period.
Positive cash flow:
On the flip side, a positive cash flow is an indication that the company can easily meet the business requirements for all expenditure operations. Too much cash in the business is never ideal as there may be lost opportunities for investments. Striking a cash flow optimum is critical.
Causes of a negative cash flow?
With long term negative cash flow, you need to dive deeper to determine the root causes.
Sales strategies have a direct impact on the cash flow component. Volume and pricing are major players in the cash flow cycle. E.g. selling less and at low prices. Furthermore, the lead time from stock to finished and paid invoices is also critical. If this period is long, more resources are required to finance the inventory. Time is money.
A measure of success is the cash conversion cycle (CCC). Compare the payment credit you provide to your customers with the supplier credit received.
Another definition: Profit and Tax and depreciation
Often, there is also another definition which is Earnings Before Interest and Tax (EBIT) which can cause a degree of confusion.
Financial institutions like banks use this to determine the financial ‘cash flow’ position of a business.
Profit is the balance of income and expenditure which doesn’t always coincide with revenue and expenditure. Due to the nature of reporting on revenue, it doesn’t factor unpaid income. So therefore despite revenue contributing greatly to profit, as the money isn’t necessarily within the business, it cannot be claimed to contribute to the cash flow. This provides a more accurate measure of cash flow.
Cash flow is essentially the difference between revenue and expenditure. Companies need to ensure to monitor expenditure to prevent overspending without the ability to finance the expenditure longer term.
Banks and other financial bodies, however use a varied definition of cash flow. Which essentially has nothing to do with the ‘cash flows’ but rather the overall solvency. This definition is particularly common in assessing credit applications.