Understand What Cash Flow Is and How You Can Manage It Properly
For small businesses, Cash Flow plays a vital role in its growth and progress. Many companies declare that cash flow can become an obstacle to success if not managed properly.
In this article, you’ll learn what Cash Flow is and how you can manage it properly to ensure business growth and success.
What Is Cash Flow?
Cash Flow (CF) refers to the movement and amount of a business’s incoming and outgoing money.
It is one of the main determinants of a company’s financial health. It reflects how much money the business takes in as income compared to the amount it takes out for expenditures.
A positive CF reflects a business’s capacity to pay off creditors and debts. A negative CF, on the other hand, indicates that a company is incapable of paying off debts using cash from their operations, and will need to find another source of income to compensate for these debts.
CF is crucial in the analysis and evaluation of a business’ financial performance. A CF statement is used for different applications of financial analysis, including Cash Conversion Ratio and IRR (Internal Rate of Return).
What Are the Types of Cash Flow?
CF has several types, each pertaining to different financial aspects of a business’ operations.
1. Cash from Operational Activities / Cash Flow from Operations
This pertains to cash generated by the business’ operational activities such as sales and service transactions. This type of CF doesn’t include cash from investments and other financial sources not related to the business’ core operations and activities.
2. Free Cash Flow to the Firm (FCFF) / Unlevered Free Cash Flow
This pertains to the measure of a business’ financial leverage. This type of CF is commonly used in financial valuation to measure enterprise value and determine whether the company is deep in debt or not.
3. Free Cash Flow to Equity (FCFE)
This pertains to the amount of cash that is left available from the reinvestment of capital expenditures. This type of CF is used to determine the available amount of cash that can be potentially distributed among the business’ shareholders.
4. Net Change in Cash
This pertains to the difference in a business’ CF from one accounting period to another. This is the type of CF used in calculating changes (net increase or decrease) in the amount of cash that the business has generated over a period.
What Are the Different Uses of Cash Flow?
Cash Flow can be used for different financial applications like the following:
- Calculating the business’ Net Present Value
- Determining the business’ Liquidity or capability to meet short-term costs
- Determining the Internal Rate of Return (IRR) of the business’ investments
- Calculating Capital Expenditures as the basis for reinvestment
- Calculating Cash Conversion Ratio to determine the average amount of time between payments for inventory and payments from customers
All these applications are performed using the business’ Cash Flow Statement.
What Is a Cash Flow Statement?
A CF statement is a type of financial statement that shows the movement of cash into and out of the business. It looks like a balance sheet that also includes a statement of profit and loss.
The CF statement is comprised of three main parts or sections:
1. Cash from Operations
This section represents the amount of cash spent and received through the business’ core operational activities. This includes the business’ Net Earnings or Income, Depreciation and Amortization, and Changes in Working Capital.
2. Cash from Investing
This section represents the amount of cash used by the business for property and equipment investments. This includes a breakdown of Capital Expenditures and Acquisitions.
3. Cash from Financing
This section represents the amount and changes in cash flow relative to the business’ borrowings, debt repayments, debt issuance, and share issuance or buying.
How Do You Calculate Cash Flow?
Cash Flow can be computed in different ways depending on the type.
Cash from Operational Activities or Cash Flow from Operations commonly uses the following formula:
Cash Flow from Operations = (Net Income) + (Non-Cash Items) + (Increase in Working Capital)
FCFF or Unlevered Free Cash Flow can be calculated as:
Unlevered Free Cash Flow/FCFF = (Earnings Before Interest and Taxes/EBIT) – (Taxes) + (Depreciation and Amortization) – (Capital Expenditures) – (Increase in Non-Cash Working Capital)
FCFE is calculated using the following formula:
FCFE = (Cash from Operations) – (Capital Expenditures) + (Net Debt Issued)
Finally, the Net Change (increase or decrease) in Cash can be calculated based on the results of the three main parts of the Cash Flow Statement: Cash from Operations, Cash from Investing, and Cash from Financing.
The Net Change is simply the sum of these three sections:
Net Change in Cash = (Cash from Operations) + (Cash from Investing) + (Cash from Financing)
Depending on the resulting amount, the Net Change can either be an increase or decrease.
What Can Lead to Negative Cash Flow?
Negative cash flow is the result of inadequate CF monitoring and management. Usually, negative CF occurs due to the following:
Over-stocking means the business has too much stock—more than it is capable of funding. This commonly happens when you order large stocks of certain items due to high demands. And when the demand suddenly drops, the large stock becomes hard to sell, and your business is left with more stock and debt than cash.
Over-spending refers to the purchase of non-essential materials or items for the business before investors have actually given money. This is a common problem among companies that like to splurge on luxury items that are worth more than the business’ cash flow.
Over-trading involves the execution of impractical trading moves that might leave the whole business in debt. This usually occurs when a company scores a big order or demand and thus moves to expand to more locations, invests more cash, or employs more people. In contrast, the cash flow isn’t adequate to support these activities.
· Over-extending payments
Extending payment terms to lengthy periods can put a business at risk of negative Cash Flow. This is because it takes longer for the company to receive cash payments from customers and debtors.
This exposes the business to long periods of cashless operation, where unexpected events can happen, such as office accidents and machinery breakdown. And because the company does not have enough cash when these events occur, it’ll be unable to pay for damage or repair costs, and thus leave the business deeper in debt.
How do You Manage Cash Flow?
To manage cash flow efficiently, you should keep track of the business’ incoming and outgoing cash, no matter how small the amount. It’s also best practice to perform the following:
1. Regular bookkeeping of the business’ transactions
Bookkeeping is the best way of keeping track of all your business’ income and expenses. If your small business can’t afford to hire a professional bookkeeper, you can choose to use accounting software that will help you keep a record of everything.
2. Timely invoicing
Issuing and sending invoices promptly is crucial for a business’ success. Make sure that you complete and send out invoices after every product delivery or service completion. It’s always best to do it early rather than late.
3. Cutting unnecessary costs
It’s always a good idea to check for things that your business might not need anymore. This includes subscriptions and services that your business no longer uses. Even your utility expenses can be reduced by exploring alternative options that may help the company save some cash and resources.
4. Leasing business equipment
Leasing work and office equipment instead of buying them proves to be best for small businesses. This allows you to choose, replace, and access up-to-date equipment for your business. You won’t have to buy and get tied-up to any equipment that will only become obsolete in a few years.
5. Using and offering different payment solutions
By using various payment methods, your customers can pay you more quickly, and you can receive payments on time. This will help stabilize your cash flow and prevent payment delays that can negatively affect your CF.
6. Charging partial payments or deposits
If you offer long-term payment contracts to customers, the best way to do this is to charge partial payments. The amount of cash received from partial payments or deposits helps secure your business’ cash flow. That way, your business won’t go without cash for long periods, and you can maintain a healthy business relationship with your customers.
7. Getting a business line of credit
Getting a business line of credit will help ensure your business when CF problems occur. This is a type of insurance policy that small businesses should invest in.
8. Getting business credit cards that reward you with every use
If you use a credit card for your business, it’s better to choose a card that rewards you points with every use. You can use these points to shoulder or cushion miscellaneous expenses such as business travel and lunch meetings.
9. Cashing in unused assets
Convert unused business assets such as work equipment and machinery into cash by selling or leasing them to other businesses that might need them.
10. Maximizing payment terms
Another good way to keep cash in your business’ account is to delay payment to your suppliers or vendors. If the due date is not up yet, you don’t need to pay earlier. Also, you can negotiate your payment terms to prolong due dates so you can avoid incurring late fees.