The Role of Cash Flow in a Business
“Cash is king” is a widely accepted maxim in the business world and beyond, but what is the importance of cash flow in a business and how can those running a business better understand it? In this blog, we will get into exactly what cash flow is, why it is important and how businesses can better understand their own cash flow.
Cash Flow Defined
As the name implies, cash flow is the how cash and equivalent assets enter and exit the business. Cash can enter the business through a variety of channels including revenues from operations, revenues from investments and capital infusions through financing activities. Similarly, cash expenditures fall into largely the same categories: costs and expenses from operations, capital expenditures on investments and financial obligations.
Cash and equivalent assets are the most liquid assets possessed by a business, but let us clearly define what these are. Cash, including cash on hand and cash in bank accounts are the basic assets included in this definition. Other assets include foreign currency and assets that are current and are a stable store of value. Some assets that are notably excluded are accounts receivable, marketable securities (due to the fluctuation in their value) or assets that are being used for collateral and inventory.
Now that we understand what cash flow is, let us delve into why it is important to a business.
Importance of Cash Flow
Cash is the most liquid asset possessed by a business, which is necessary to perform a variety of basic business functions. As such there is a need to separate a business’ revenues from its cash flow. Unlike the income statement, the cash flow statement is only concerned with transactions that affect the cash account. This is to measure an organization’s ability to fulfil its obligations and its potential to enter new business opportunities.
Some activities businesses need cash for include: paying taxes, paying suppliers, and purchasing new long-term assets. While a business may extend generous credit terms to its customers, it may not have the same benefits extended to it by its creditors. To be nimble and able to pursue new opportunities, while maintaining current obligations, a company needs healthy recurring cash flows.
Understanding Cash Flow
A company reports its cash flows through the cash flow statement, which gives a diagnosis of a business’ health. The cash flow statement is one of the three major financial statements along with the income statement and balance sheet. The basic definition of the cash flow statement is that it shows the cash and equivalent assets coming in and out of a business in a given period.
The cash flow statement is broken into three sections corresponding to the transactions cash is used for. These are cash flow from operating activities, cash flow from investing activities and cash flow from financing. These breakdowns can help managers identify what areas are generating cash and which are the biggest sources of outflows.
The cash flow from each of these sections is tabulated to determine the total inflows and outflows of cash fora company. A company with a positive cash flow is one whose cash inflows are greater than its cash outflows. A company with cash outflows which are greater than its cash inflows has a negative cash flow. A positive cash flow is symptomatic of a company that is highly liquid, that is, capable of paying its expenses and settling its debts.
Cash flow management is incredibly important in a businesses of all sizes and complexities. It is necessary for managers and owners to be vigilant in analyzing their cash-flows and working to increase inflows and decrease outflows. Recently, advanced cloud-based solutions make it easier to access corporate cash flow data without expending valuable company resources in generating a cash flow statement using manual or legacy systems.
