All You Need to Know About Cash Flow

Image of a hand pulling dollars from a brown wallet.

What is Cash Flow?

The term “cash flow” refers to the net amount of cash or cash-equivalents (such as checks, coins, or liquid investments) that are moving in and out of a business. If a company has positive cash flow this means that the company’s liquid (meaning easily converted into cash) assets are increasing; providing it with enough money to cover operating expenses and business activities such as reinvesting in the company, settling any additional debt, providing returns for shareholders, preparing for future financial crises, etc. Comparatively, negative cash flow means a company’s liquid assets are decreasing.

Net Cash Flow vs Net Income

There are sometimes some confusion surrounding these two key terms, but there are some distinguishing traits. Cash flow includes only the actual cash/ cash equivalents or liquid assets that a company owns, while net income also includes accounts receivable (referring to outstanding invoices of a company or money owed by clients) or other items for which payment has not been received.

For this reason, cash flow is often used to assess the quality of a company’s income, and not necessarily only quantity. While a company may appear to have quite a bit of income, if this money is not in the form of liquid assets, the company may not have the capital it needs in order to function. Cash flow may also be contrasted with working capital as working capital includes all current assets (such as inventory and accounts receivable) in addition to cash alone.

Accounting Concepts

With the accrual accounting method, businesses consider credit as part of the company’s total income. Money still due from customers as well as accounts receivable will appear as line items on the company’s balance sheet. Since these are not completed transactions, they do not count as cash. It is worth noting that completed transactions from credit cards are not considered “credit” but cash.

There are three main types of financial statements used in a business: balance statements, cash flow statements, and income statements.

Balance statements provide a snapshot of a company’s financial standing (usually of the last day of the fiscal year) in regards to their assets and liabilities. The amount remaining in accounts at the end of the year is referred to as a closing balance. 

The income statement does the same, however, instead of only showing one day of the year the statement provides information on a range of time whether a full accounting period (the 12 month period for which an account prepares financial statements) for a yearly report or a quarter for a quarterly report. In addition, an income statement will usually provide two or three previous years for comparison.

The cash flow statement demonstrates how differences in balance sheets and income statements affect cash and cash equivalents. A cash flow analysis breaks down operating, investing, and financing activities.

Financial Models

In order to construct a financial representation of a firm or investment companies use financial modeling. Financial modeling is the process by which a company can predict how well future investments will perform and forecast future earnings of the company.

One of the most common calculations for financial modeling is using the Internal Rate of Return (IRR). This calculation provides business owners with the means to calculate how profitable any capital expenditures or investments will be. The calculation sets the Net Present Value (present value refers to the value of money in today’s dollars) of any future investments equal to zero. Among projects that require the same initial capital to undertake, projects with a higher IRR should be undertaken first and are likely to be a more profitable investment.

Financing Cash Flow

In order to generate cash flow, many companies turn to external activities. These activities would fall under the category of “financing activities” in a company’s cash flow statements and include repaying investors, issuing more stock and adding or changing loans.

Income from financing activities can be contrasted with operating cash flow (also known as free cash flow) as operating cash flow refers to revenues generated from a company’s normal operating activities.

Short-Term vs Long-Term Assets

When calculating cash flow a company must consider the liquidity of its assets. Short-term assets are those which will be sold (liquidated) for cash within one year in order to pay for liabilities. They include marketable securities, trade and employee accounts receivable, prepaid expenses (such as rent or insurance) as well as inventory. 

Long-term assets are those which will not be sold for at least a year (or perhaps not at all in the case of items such as copyrights or patents). They may also include securities, bonds or even real estate which the company intends to hold.

Improving Your Company’s Cash Flow Situation

When a company requires more money to pay expenses or develop itself than it is bringing in (or if future expenses will overshadow expected sales), it will lead to cash flow problems, or a burn rate problem. This is particularly prevalent in venture-backed businesses and startups.

Unfortunately, many businesses resort to quick fixes in order to provide their business with capital, however, this will lead to a low-quality financial standing as the company will quickly run into more and more debt and be unable to remain solvent.

Despite making a good deal of profit, if a company has little to no cash balance it may have to resort to taking out undesirable loans with high debt services (the amount of money required to pay the principal and interest on any outstanding debts) in order to fund the company.

In order to improve your situation, deposit checks as soon as possible and consider offering discounts to customers who pay before the standard 30 days. Request payments to be made in cash or at least credit cards. Buying equipment upfront will also provide your company with significant advantages as you will not pay for the depreciation of the product (as you would with a lease agreement).

But most importantly, developing a good Spend Culture within your business is crucial to keep your cash flow positive and your burn rates low. Income may be unpredictable, but company spending is predictable, and by managing how people within your company spends and being more aware of what is being spent and why will help keep your company in the green.