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What is Cash Flow in Business
What is Cash Flow?
Cash flow margin shows how good a company is at producing cash from sales. The margin indicates in a percentage how much cash is generated for every sales dollar. The operating cash flow is found on a business’s cash flow statement. This is important information for investors as it shows a business’s ability to produce profits through cash the business has generated rather than through funds (debt) such as loans. It also shows the business’s ability to expand – if cash flow margin is low or negative then it cannot expand without the injection of capital from outside of the business.
Cash fuels a business – the health of a business’s cash flow business is the difference between success and failure. Cash flow is the way cash moves through a business i.e. in and out.
• Cash flow is the way cash cycles through a business.
• Liquidity is the availability of a liquid asset (cash) to a business
A business needs cash flow in order to conduct day to day business activities. The cash cycle is the amount of time it takes a business to generate income from the resource materials it inputs at the start of the cycle. It is essential that a business always has the ability to pay for the cost of operating that business. This may be achieved by holding adequate cash in reserve, or alternatively, by developing and maintaining a facility by which adequate cash can quickly and easily be raised, for example through overdraft banking facilities; by being able to return unsold goods to suppliers or by having assets which are very easily converted into cash. This ability to access funds is referred to as "liquidity". A business with good liquidity is able to survive unexpected occurrences; but a business with poor liquidity may fail if something unexpected happens.
Note: Although some businesses help cash flow by using credit or loans. Loans come at a cost of course, interest on loans create extra expense and results in lower profits. If the business is not financially stable then it also adds risk.
In a business we need to shorten the cash flow cycle as much as possible i.e. the time it takes to generate income from a cash investment. This is so that the business has enough cash to continually buy the raw materials it need to produce the product or service it is offering. If the cash cycle is interrupted at any stage it may reflect badly on the businesses ability to continue trading.
For example if cash is short then the business can’t buy materials this in turn means it can’t make sales and as a consequence it won’t receive cash required for more materials. The same applies at any point in the cycle if customers do not pay their accounts then there is no cash to generate further business. If sales drop the same applies.
Cash flow does not reflect profitability a business may be profitable but still be short on cash this could be because it offered too much credit to customers. A business may make huge sales and if no one pays on time then they can still run into trouble. So a business depends on its debtors to settle their debts as quickly as possible in order to generate cash flow to fund further business operations. Offering credit terms to customers may be balanced with using credit to purchase the materials etc. required to run the business. And this needs stringent controls and reporting systems in order for the business to understand exactly where they stand financially, at any point of time in the cash cycle.
Is there a way of analysing a business’s cash flow?
Cash flow analysis is a tool that can be used to check the financial standing of a business. Cash budgets are one way of determining cash flow patterns and predicting future cash flow patterns. Budgeting is covered in the following lesson.
There are several other tools businesses use to determine the efficiency of cash flow through a business. We discussed ratios in an earlier lesson – cash flow efficiency can also be shown by using ratio analysis.
Account Receivable Turnover Ratio
A high accounts receivable ratio means that a company’s debtors’ assets are liquid. Conversely it can also mean that a business has a very tight and restrictive creditors’ policy – this could mean that they are missing out on sales. It also shows a business how successful they are turning over creditors debts to their business.
The account receivable ration is very simple to calculate – only the credit sales are included to give an accurate result of the turnover ratio:
Account receivable turnover = total credit sales ÷ the average accounts receivable balance (average = balance at the beginning of the period added onto the balance at the end of the period divided by 2)
As an example: Total credit sales for the business for the year was $80,000, the opening credit sales on the first day of the July was $20,000 the closing balance on the last day of the accounting period (30th June) was $5,000.
20,000 + 5,000 ÷ 2 = 12,500
80,000 ÷ 12,500 = 6.4 times per annum
365 (days a year) ÷ 6.4 = 57
This means that on average debtors are turned over every 57 days.
Operating Cash Flows Ratio:
This ratio uses the information of cash flows from a Statement of Cash Flow and the current liabilities figure off the balance sheet so:
Operating Cash Flows Ratio = Cash Flows From Operations ÷ Current Liabilities
So if a company took $50,000 in revenue from its operations and its current liabilities are $40,000 50,000 ÷ 40,000 = 1.25.
Generally it is assumed if the ratio is below one (1) then the business is not viable and may find it is unable to meet its commitments or continue to operate.Learn More
Study our online bookkeeping or financial management courses. See www.acseduonline.com