Accounting & Finance

Understanding How Cash Flow Works

someone holding a bundle of their cash flow while leaning against a car

If you run a business, you need a healthy cash flow to maintain your operations. But what is cash flow? Cash flow is vital to fueling a business, as many companies dissolve without this money stream. It’s estimated that 82% of businesses can attribute their failure to cash flow problems. Just like the blood in your body, cash flow is the life force that keeps a business operational. Learning more about cash flow will help you see the importance of keeping track of payments to meet your business goals. Read on to learn what operating cash flow is and how to create and use a cash flow statement to understand the way money moves through your business.

someone holding a bundle of their cash flow while leaning against a car

What is Cash Flow?

Cash flow represents the money that moves into and out of a business. For instance, when a vendor adds stock to their inventory, they direct money toward their suppliers. When they sell some of the merchandise, money comes into their business from their customers.

If a business operator pays their employees or their utilities, cash flows out of the company, or toward the business’s debtors. If a retailer collects a monthly payment on an item a customer financed, cash flows back into the business.

Therefore, the cash flow of a business references the net balance of the money moving into and out of a company at specific times. The cash flow for a business can be positive or negative. When the cash flow is positive, the business receives more money than it spends. When the cash flow is negative, more money is moving out of the business than coming in. The way you manage your cash flow is critical to your success as a business because it helps you understand and improve your business’s financial health.

Types of Cash Flow

Fortunately, we can break down cash flow even further into types. This will allow you to see how it moves in different segments of your business. In turn, you can assess your cash flow from operations, or review what type of cash flow you realize from investing, or the financing used for securities, equity, or assets.

(CFO) Cash Flow from Operations

A cash flow from operations or an operating cash flow refers to the net cash flow that results from business operations. Examples can include sales, utilities, payroll, etc. Furthermore, for a business to expand and grow, it needs to have a positive operating cash flow.

(CFI) Cash Flow from Investing

A cash flow from investing or an investing cash flow represents the net cash that comes from a business’s investments. Investments may include securities, such as shares of stock, investments in real estate or equipment, or the sale of assets. If a company is frequently investing in its business, this number will usually be represented in the negative on a cash flow statement.

Investments have to support a company’s Cash Flow Returns on Investment (CFROI). This metric for valuation considers cash flow in relation to the cost of capital. The return on investment metric assumes that the financial marketplace establishes stock pricing based on a business’s cash flow as opposed to its earnings.

Investors regard a CFROI to check how a company operates, including how it generates cash, finances projects, and spends what it makes. Similarly, entities use the CFROI to compare companies with similar businesses or review a company’s performance.

(CFF) Cash Flow from Financing

The cash flow from financing or financing cash flow refers to the way money moves between a business and investors, creditors, and owners. Therefore, the net balance generated from financing cash flow may involve payments for dividends, equity, or debt.

How to Use a Cash Flow Statement

One of the best ways to gauge your cash flow is to prepare and review your cash flow statement. This financial document provides a detailed review of what has happened to a company’s cash during a specific time frame. The statement shows where the company spent and received cash. The cash flow statement helps reconcile an account’s starting and ending cash balances. Before you can create this statement, you can perform a cash flow analysis to obtain the figures you’ll need to put in the document.

The structure of the cash flow statement

Also known as the statement of cash flow, a cash flow statement has three major sections. These sections include an operating section, investing section, and a financing section. Under the operating section, the document provides the following:

  • Net Income
  • Adjustments to Reconcile Net income
  • Depreciation/Amortization
  • Deferred Income Tax
  • Changes in Operating Assets and Liabilities
  • Net Accounts Receivable
  • Inventories
  • Vendor Non-Trade Receivables
  • Other Current and Noncurrent Assets
  • Cash Resulting from Operating Activities

Cash Flow vs. Income

Two people going over their cash flow statement on a desk with cash and coins and a calculator

Based on the information featured on the statement of cash flow, the cash flow shows how a company uses its capital during a specific period of time. The document shows how the company used or received cash for operations, financing, and investing, and reconciles the beginning and ending balances.

By comparison, a company’s income is linked to cash flow by the net profit or loss indicated on the cash flow statement. This reflects the cash flow from operations. While the cash flow statement shows the exact amount of money a business made or spent over a certain period, the income statement displays a business’s revenue and total expenditures, including depreciation, over time.

In accounting, the cash flow statement is linked to the income statement and balance sheet with the statement of cash flow and income statement supporting a company’s balance sheet.

You will find, when you work with accounting documentation, that the paperwork syncs together seamlessly. Therefore, it pays to know how the stream of cash is coming into and out of your business. Without a healthy cash flow, you cannot maintain your operations and grow your business over time.

Cash flow vs. profit or net income

While cash flow represents the money moving in and out of a business at a specific time, profit represents the balance remaining when all of a company’s operating expenses are subtracted from its revenues. In other words, profit shows what is left when you balance the books and you subtract the costs from the proceeds. While revenue and net profit (or earnings) show a company’s financial strength, they are not interchangeable terms.

How to Maintain a Healthy Cash Flow

To maintain a healthy cash flow, you need to follow certain practices, primarily the following:

  • Take the maximum time provided to pay suppliers
  • Offer customer discounts to clients who pay upfront or pay ahead of schedule
  • Closely monitor and collect accounts that are overdue
  • Never extend credit without making sure the customer can repay the financing
  • Keep your inventory lean versus overbuying
  • Frequently perform cash flow projections to monitor your financial health
  • Free up your cash by choosing to lease over buying

Understanding the importance of cash flow will help you expand your business and ensure better accounting practices. Use it as your gauge for making financial decisions that will give you an advantage as you develop and grow your company.

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