Cash flow vital for business success
“Cash is king!” Many times over, this statement has proven to be true, particularly in tough trading environments such as ours. The cash, we are referring to in this article is “cash” in the business sense and not just notes and coins. Therefore we are discussing cash-flow in the accounting sense. Without positive cash-flow, your business cannot and will not survive for very long. Why is cash-flow so vital to all businesses, large and small?
The answer lies in that you need cash to operate and grow your business. How else will you ensure you are able to purchase supplies, pay your rentals, advertise your goods and services, hire employees or take care of the myriad other business activities that require money?
In short, “cash-flow” is the lifeblood of any business, and it is imperative that, as a business minder, you get to understand the ins and out of cash flow management.
In this week’s article we will take a close look at just how cash flow works and why it is an important aspect of sound business management.
The first step in understanding what “cash-flow” really means in your business is first to understand the main sources of cash for any business as well as the many uses of cash in the day to day running of a business and how they relate to the eventual health of the business.
How does your business generate cash inflows?
Generally cash is generated into a business through;
Sales of your company’s products or services
Loans or proceeds from any forms of credit or borrowings made by the business
Sales of assets
Contributions by the owners in the form of capital or shareholder loans
Cash flows out of a business mainly through;
Day to day business expenditures, such as rent, purchase of inputs(raw materials), payments for services such as telephones etc
Repayments of loans (principal and interest payments)
Purchases of business assets
Withdrawals by the owners through dividends
In the accounting framework, these cash inflows and outflows can be categorised into three main business activities.
Operating cash-flows — which are essentially cash flows related to business operations i.e. sales and income and business expenditures
Investing cash-flows — which cover cash-flows related to acquisition and disposal of fixed asset (sales and purchases)
Financing cash-flows – which relate to loan payments and proceeds from new loans, and owner contributions (shareholders funds) and withdrawals by owners.
Operating cash-flows are the most important
Ideally, a sound business should be generating the majority of its cash flow from operating activities, that is, the sale of real products or services. This is critical for the long-term success of any business as the other two aspects–investing and financing cash-flows — are not always viable ways to manage and grow your business in the long term. A business that continuously resorts to borrowing from lenders or getting funds from shareholders to stay afloat is not fundamentally a sound business. It is just a cash sink, literally!!
Operating activities generate cash inflows and outflows through the sale of your company’s products and services and the purchase of raw material supplies and other general day to day business expenditures. The operating cash flow reflects a summary of the daily activities of your business and ultimately its health.
There will be times that additional cash inflows and outflows are generated by the business through investing or financing activities, but these are supplementary aspects and should not be the core source of cash for your business.
Cash-flows from investing and financing activities
The generation of cash flow from investing activities relates to the purchase and sales of fixed assets (for instance, property, plant or equipment). Financing activities generate cash inflows through the investment of money into the business by the owners or lenders. Proceeds of bank loans and credit givers as well as principal repayment of such loans are classified as financing cash-flows. However, the payment of the interest on these loans and credits is classified as an operating activity.
When the business owners invests or withdrawals money from the business, it creates changes in the equity of the business and these movements are also associated with financing activities.
Why does cash-flow represent the health or otherwise of a business?
It is important to understand how the inflows and outflows of cash in your business reflect the health of your company.
A business must generate positive net cash flow that is the difference between cash coming in and cash being paid out during any time period should as a general rule be positive. Cash inflows must be greater than cash outgo. There are times when your business may require to cover gaps created by the operating cash-flows by selling assets or borrowing (cash flow from investing and financing activities.)
However, the long-term success of your business, requires that it must be generating high sales and therefore creating positive cash flow from operating activities.
How can you create a basic cash-flow statement?
It is not rocket science. You can easily create a cash flow statement by simply taking into account all your business’ inflows during a defined time period and subtracting the cash outflows to obtain the net change in your cash position for any given time period, usually on a monthly basis. This can be done manually, and if you do not want to do it manually, one of the simplest ways to generate financial statements is to use an accounting software package or a spreadsheet tool, which are all very easy to use.
Why are financial records important?
From historical cash flow records one can easily do cash-flow projections, which should become part of your budgeting process to ensure and demonstrate that you are being proactive in managing your business. Bankers particularly become concerned if a business owner does not understand the basics of cash flow for their business. You do not have to be an accounting expert, but understanding how your business generates and uses cash means that you will not find yourself in a cash flow crunch or cash bind, where you are waiting for payments from clients but your business is still expected to pay its operating bills.
What is the importance of a bank account in cash-flow management?
Opening and maintaining a bank account and developing a discipline of banking all cash proceeds and making all your payments from the bank account helps you create a credible record.
The bank statement is essentially a basic cash-flow statement and when your business is doing well your bank balance will increase over time. If your bank balance is falling rapidly it means your cash management skills or your business model needs a re-look. Going through your bank statement will tell you how, when and how much you spent on what. It also reveals where your money is coming from. It makes things really very simple. Understanding where your cash is coming from and going to is a critical part of smart business management.–herald
