Cash availability in a business at any point in time contributes significantly to its day-to-day liquidity condition. It is thus essential for any business to be aware of its cash flow periodically. To do so, one must, therefore, have a basic understanding of the flow of cash along with its forecasting methods.

So, here’s everything you need to know about what is cash flow along with its components and calculation.

What is Cash Flow?

Cash flow refers to the inflow and outflow of the amount of cash or its equivalents in business. It determines the amount of cash consumed or generated for a specified period.

Its analysis also identifies the existing sources of the flow of cash along with a possible scope of inflows.

The current flow of cash for a given period is identified by reducing the opening balance of a given period from its closing balance.

Once calculated, cash flows can result in a negative or positive balance. A positive balance implies that the company has sufficient cash to fulfil its immediate liquidity requirements, while a negative balance indicates a constricted liquidity.

The cash flow of a company must, however, be analysed along with the company’s income statement as well as a balance sheet to determine its actual liquidity position.

Also, an increasing flow of cash may not always be a positive indicator and must be analysed thoroughly to arrive at a definitive conclusion.

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Types of Cash Flow

Cash flows can be divided into three main categories depending on their source or utilisation. They include the following –

  • Flow of cash from operations

It specifies the cash generated out of an entity’s core business activities. When preparing a cash flow statement, cash inflows and outflows from operations are recorded in the first section. Cash inflow here mainly includes the money received after the sale of goods or services. Outflows of cash from operations comprise operations expenditures such as rent payments, cost of goods sold, etc.

  • Flow of cash from investments

It represents any changes, i.e., increase or decrease in long term assets of a business. It can be represented by the purchase of fixed assets, any loans extended by the entity, any gains assumed on an investment fund and the likes.

  • Flow of cash from financing activities

Cash inflow or outflow from financing activities is recorded if an increment or reduction in the long term, debts, liabilities, business capital or dividend is observed. A cash flow example from financing activities would encompass principal or interest payments, stock repurchase, dividends issued, liabilities incurred, etc.

During cash flow analysis, the periodic balance calculated for these types of liquidity flows is subjected to various measurement parameters to identify the company’s liquidity position and other financial aspects.

Cash Flow and Its Use

Cash flows of an entity can serve as an essential metric in the entirety of accounting and finance while also proving useful for day-to-day business operations. Not to mention, it has a key role to play in providing accuracy to financial analysis.

The following table illustrates the few uses a business’s computed cash flow can be put to.

Cash flow utilisation Description
Business liquidity It helps identify how efficient a business is in meeting its short-term financial obligations.
Yield per share Represented in percentage, it is the measurement of cash generated by a business for each share it holds as against the existing share price.
Flow of cash per share It measures the cash generated only from operating activities based on per share outstanding.
Gap in funding Existing flow of cash identified also helps a company assess the difference between the cash available and the cash required.
Cash conversion ratio It determines the time taken for a business to convert the initial investment made via inventory into cash through customer payment. Such a ratio can be tactfully utilised to formulate necessary cash flow strategies to bring business to its optimum operational efficiency.

While these were some of the common usages of computation of cash flow, the list is inclusive. Some of its other critical uses of cash flow analysis include calculation of the business’s Net Present Value, funding available for reinvestment, business growth, dividend payment, etc.

Impact of Weak Cash Flow Management

Given that cash flow is a critical metric that determines a business’s liquidity, financial position and flexibility in operation, weak management in the flow of cash can take it through severe risk, along with creating other long and short-term impacts.

  • Increase in inventory: Businesses often stock up the inventory to fulfil high demand from the market. Nevertheless, a sudden change in such demand can leave the inventories indisposed, thus strapping sizable cash, further creating operational challenges.
  • Long payment cycle: Allowing your creditors a long cycle for payment can mean cash invested in raw material for an extended duration, creating a strain on other financial aspects. It is thus critical to decide on the payment cycle that keeps cash flow from operations at optimum.
  • Overspending: Acquiring a new client or getting a high-volume order can push one towards spending more than they can afford. Nevertheless, in the absence of actual cash, it would only mean an added burden on the short-term liquidity sustenance for the business.

Difference between Cash Flow and Income

The primary point of difference between a business’s cash flow and its income is defined by the cash accounting and accrual accounting measures undertaken.

The adoption of these two separate methods primarily results in the difference between an income statement and a cash flow statement.

In the preparation of an income statement, the method of accrual accounting is followed, wherein an income or expenditure is recorded as and when it occurs, irrespective of the involvement of cash.

In the latter, however, transactions are recorded only when they have been dealt in cash and not merely based on accrual.

Difference between Cash Flow and Revenue

In the case of revenue, it is only a measure of the amount of money a business is receiving, whereas cash flow involves a two-way flow.

Thus, in it, both inflow and outflow of cash are considered for the purpose of calculation. Also, revenue is strictly based on the conversion of investment made to business operations while cash flows also take into consideration financing activities.

Steps for Cash Flow Management

To ensure that a business has an optimum flow of cash, undertaking the following measures are advised –

  • Maintain proper bookkeeping records with the in-time entry of all cash transactions made.
  • Companies can keep the tracking and analysis of cash inflow and outflow from different sources through cash flow statement preparations on a quarterly basis.
  • Analyse the statement to decide on whether to free up cash or introduce additional cash to the business.
  • Identify areas that involve overspending and cut down on such spends to increase the flow of cash in a business.

Apart from these, various other measures can be undertaken to bring an entity’s cash flow to an optimum level.

Cash flows serve as a quintessential measure of a business’s profitability, strength, and its overall outlook in the long term. A business must, therefore, take necessary steps to maintain the flow of cash for various periods based on structured analysis and results so obtained.