Cash flow in simple terms is the income and outgoings that are liquid in nature. A positive cash flow means that more liquid money is received than is spent during operations and the purchase of inventory. Liquid is the term used for assets that are cash equivalents or those assets that can be quickly converted to cash. For example, some products e.g. postage stamps in some countries (historically in the UK) can be exchanged for their face vale in cash. Also, a product that is supplied to a company on a sale or return basis where money is instantly received upon return could be described as being a liquid asset that (subject to the associated terms and conditions) can have a realisable cash value within a short time frame or defined accounting period.
Cash flow is essential. A company can be in profit by selling $100,000 of products that only cost $20,000 to purchase (i.e. $80,000 profit). However, if the $20,000 is spent when the product is purchased and the $100,000 is received 30 days’ following the sale, the company will have a period between the purchase and the receipt of funds where they are down by $20,000. You may think that in this instance, the company could ask for their money sooner (or even at the point of sale). However, in markets where larger amounts are invoiced it is usual to have invoice terms where the money owed is due within a defined time frame. If your company does not offer a period of credit where competitors do, it may mean that your company loses the sale unless it has other unique selling points that make its proposition more attractive.
Imagine if this series of events happened ten times within the same 30 day period. The company on paper would show a healthy profit of $800,000 (10 x (100,000 – 20,000)), however the cash flow would be minus $200,000 (10 x $20,000). If the company only had $150,000 in the bank at the beginning of the 30 day period, it would need to find another $50,000 in order to fulfil the orders and remain operational whilst fulfilling all the orders. The company may choose to get a loan to bridge the shortfall period or may even decline orders. Declining orders means lost profit and potentially a negative impact on the company’s reputation.
The above scenario and many other similar ones have lead to the use of the phrase ‘profit is vanity, cash is sanity’.
Cash Flow Analysis
Business owners and management must conduct a cash flow analysis to ensure that the business continues to be a going concern for the foreseeable future. A going concern is a company that is expected to remain operational in the future (at least for the next accounting year) based on its current financial health, financing structure and future projections. The accounts must be used in order to gain insights into what has happened previously and what is likely to happen in the future. Many companies have failed because they have grown too quickly for their liquid funds to be maintained. This is shown in the example at the top of this page but is often seen in firms that have to purchase products in quantities to service the sale of just one item. For example, many toiletries such as moisturisers and shower gels are sold from wholesalers in outers of 12 units. When one sale is made, 12 units may need to be purchased. This leads to a positive inventory value and a profit in respect of the sale of the individual unit. However, the cash used to purchase the outer of 12 units has now gone and until the cash from the sale of the number of units to cover the cost of the initial purchase is made, there remains a negative cash flow in relation to the initial sale. If this happens repeatedly, it is quite easy to see how a company that is making profitable individual sales can soon get into financial difficulty with regard to its cash flow. Even if within the accounting year it is likely that all the units purchased to facilitate the first sale will be sold, it leaves months where the company may not have sufficient cash to continue the operations that lead to future sales. Often it is advantageous for a company not to market as heavily (or as well) as it possibly could do, just to ensure that cash flow remains controlled. This is a concept many people fail to grasp.
There is a positive side to this though. When a company can clearly demonstrate a profit on sales and the likelihood of continued sales, it is more likely to either attract investment or show a financing company (for example a bank or loan company) that it is able to service additional debt. Companies that are profitable, in stable markets with some barriers to entry, are very attractive to investors. Investors are aware that their cash is needed but can also see a clear strategy for how their cash can be repaid (with interest). In business, the negatives can often be turned into positives once you know how.
This article is a basic introduction and is by no means an exhaustive reference to answer the question of what is cash flow? There are more articles on Bizzle Dizzle relating to cash flows and how to finance a company. We urge you to read several articles so that you get a holistic understanding. In business, one process, tool, system or strategy is unlikely to lead to success by itself. Remember, business does not always need to be complex, but for a level of success does need to be logical and well planned.