Updated: Apr 27
Companies are in business to make profits, plain and simple. Most business owners therefore focus on generating a profit and forget about something more important to the survival of the business than profits: cash in the bank. While the ultimate goal is to make a profit, without cash to pay workers and bills and expand the business, profits will be meaningless as the business will eventually fold.
Profitable businesses have gone under because of a lack of cash. Successful companies like Amazon and Tesla went for years without profits but were able to stay in business and thrive because they had the cash to invest. If we switch it around and these companies were making profits but no cash, they would have struggled to survive.
What Is Cash Flow?
Cash flow is the net of cash the company collects and what it pays out. Cash flows into and out of a business in various ways and is classified into three categories.
1: Operating Cash Flow: Operating cash flow is the cash that comes into a company from selling goods and services minus what is spent to produce and market the goods or services, such as paying salaries, utilities and buying raw materials. In other words, it is cash generated from operations involved in getting the products or services to customers. This is the most important type of cash flow. Operating cash flow sustains the business in the long run. No business can continue indefinitely without positive operating cash flow.
2: Investing Cash Flow: Investing cash flow is cash not generated from the company’s operations, that is, selling goods or services. Investing cash flow comes from activities like selling buildings and equipment or putting cash into investments such as stocks or bonds. Investing cash outflow includes cash used to pay for capital equipment and buildings or to buy another company.
A company should not rely on investing cash flow to provide the cash it needs, as this is not a sustainable source of cash flow. A company is more likely to have negative investing cash flow than positive investing cash flow, as asset sales tend to be infrequent, and a company is more likely to be adding to its fixed assets than subtracting.
3: Financing Cash Flow: Financing cash flow are funds received from borrowing or from selling company stock. Financing cash outflow includes paying off debt or repurchasing company stock. Companies that are not generating sufficient operating cash flow sometimes need to raise capital and have no choice but to borrow or sell stocks. This is not a sustainable way of running a business and eventually a company must generate operating cash flow to stay afloat. Proper cash flow management is important to ensure a company has adequate cash to pay its bills and remain solvent.
Cash Flow Management
Having adequate cash on hand to run day-to-day operations and grow the business is at the heart of cash flow management. Good cash flow management requires an understanding of the current cash situation: cash in the bank and current expenses. Just as important is the ability to forecast the future cash situation. How soon will you be collecting your receivables? What is the cash balance likely to be in six months or a year? For this a budget incorporating anticipated expenses and cash collection is key. Budgets and forecasts should be dynamic by updating them as new information becomes available.
Knowing how long your customers take to pay is critical to understanding your cash inflow. Ratio analysis can be used to estimate the number of days customers take to pay.
Strategic planning should be incorporated into the budgeting/forecasting process. For example, if the company is planning an expansion which will require a large cash outlay, this will affect its future cash needs. Forecasting and budgeting can help the company decide whether it might need to borrow or sell stock to fund the expansion. Good cash flow management practices will ensure the company is not caught flat-footed when it needs extra cash, and possibly missing out on opportunities, or worse, unable to fund its operations and going out of business.