One of the most commonly cited terms in any discussion of the health of a business is cash flow. It has been aptly dubbed the “lifeblood of any business” by Sir Richard Branson. But what exactly is cash flow and how does it affect a business in terms of its day-to-day operations and credibility?
Explore the definition of cash flow and what it means for business owners in this in-depth guide.
What is cash flow?
The business definition isn't a million miles from the common sense meaning we all use from time to time. Investopedia's cashflow definition, is simply, “the net amount of cash and cash equivalents being transferred in and out of a company.” The “flow” part of the definition refers to the two-way movement of cash. Revenue comes in, and expenditure flows out.
Free cash flow definition
Whether a company can generate shareholder value is related to its ability to demonstrate its cash balances in the bank, or more specifically to optimise free cash flow (FCF) over time. Free cash flow is calculated as:
FCF = Revenue minus Capital Expenditure.
What types of cash flow are there?
Cash flow can be subdivided into three main streams:
Cash flow from operations
Operations are the standard revenue-generating activities of the business – the amount of cash a car company makes by selling cars, for instance.
Cash flow from investment
Investment is money set aside in interest-generating and speculative accounts or projects. Investing cash flow is an essential strategy for many business owners to help secure growth.
Cash flow from financing
Financing cash flow is cash generated from lines of credit or bank loans.
While there is a difference between cash flow streams, in any given period of time, a business may be pulling in cash from all three sources. It will also always be spending money (on inventory, utilities, taxes, bank interest, capital expenditures, or salaries, for instance). Inbound cash flow isn't limited to actual banked currency. Non-cash or cash equivalents can also include royalties, bank interest, investments, and licences, as well as sales made on credit, which will be converted to cash at a future point.
Let's look at some different types of cash flow in more detail:
Core Business Cashflow (CBC) – found at the top of a company's Statement of Cashflows, this describes the common-sense notion of where a company's revenue comes from, including the driver behind its business operations - the products or services it creates or distributes. For example, McDonalds' CBC is its income from the sale of burgers, fries and drinks.
Free Cash Flow to Equity (FCFE) – how much cash is left over once a portion is reinvested into the business via capital investment.
Free Cash Flow to the Firm (FCFF) – the amount of cash available to debt and equity holders, after a company covers its core business expenditure and capital investment.
Unlevered Free Cash Flow (UFCF) – The gross revenue available to a company before interest payments on debts are considered.
Why maintain a steady operating cash flow?
Given the old adage that “you have to spend money to make money,” why is it important to maintain a positive cash flow? There are several benefits:
- A company's operating cash flow can demonstrate that it is fully liquid and able to cover obligations, building trust.
- Positive cash flows present a buffer in case of future emergency (such as a global recession, pandemic, or supply chain crisis).
- It increases shareholder confidence and allows for the payment of dividends.
- Cash flow allows a company to be more agile, taking advantage of opportunities as soon as they arise (think of the businesses that stockpiled PPE at the start of the pandemic).
- Negative cash flow can lead to operational problems, causing delays to payments to suppliers and employees, an inability to purchase stock and supplies, and can negatively impact a business' reputation.
What are cash flow statements?
Cash flows can be described using a cash flow statement. This is a common financial document that describes a company's sources and expenditure of cash over a finite time period. Alongside the balance sheet and income statement, the statement of cash flows is one of the primary documents by which a company can demonstrate financial health.
Here is an example of a cash flow statement:
You can see that the true cash flow figure at the bottom of the financial statement now includes deductions for:
- Unpaid Debt
- Money owed to suppliers
- Inventory purchases
- Capital investments
- Finance payments and interest
You can also see the three main types of cash flow – cash flow from operations, investment, and financing – are clearly delineated and kept separate.
The cash flow statement reconciles the balance and income statements – it shows, at a glance, the bottom line of all monies coming in and going out - the cash inflows and outflows. Maintaining a positive total at the bottom of the sheet is vital, to ensure that your business has a contingency for dealing with threats and seizing opportunities.
What isn't included in a cash flow statement is money that may be owed in the future. In other words, if a subscription payment is being paid monthly, the total value of the subscription will not be listed in a monthly or quarterly cash flow statement, but the cash flow refers to only that period's individual payment. If you have a SaaS business, for instance, this is an especially important consideration.
The figure at the bottom of the cash flow statement is the Cash and Cash Equivalents (CCE - items that could be converted into cash upon demand) total, and you should also find this listed under current assets in your balance sheet.
Cash flow does not equal profit
Profit is a measure of a company's revenues minus ALL expenses. Revenue can include sales made but not paid for yet (i.e., accounts receivable). Unpaid invoices are not included in cash flow statements, but they would be included in an income statement.
One way to think of it is that cash flow is a measure of cash that is available at any given point in time. Money owed to you, but not yet paid, isn't available to spend, therefore doesn't form part of a cash flow statement.
Cash flow measures actual CCE coming in, and money paid out, and is assessed over a specified time period or at a moment in time. Profit is generally assessed at set intervals in quarterly or annual profit or loss statements.
The importance of monitoring your cash flow and profit
Nobody can see what's coming around the corner, whether it's a dip in the market for a period of time, the sudden success of a competitor or a global pandemic. Therefore, it is sensible to maintain a positive cash flow at all times. Cash flow and financial statements can be used together with income statements and balance sheets to get a complete picture of the financial health of a company. By monitoring cash flow, companies can prepare for the eventualities which can be predicted (end of financial year, taxes, salary increases, stock depreciation, changes in legislation), as well as those that cannot. In difficult or emergency situations, healthy net cash flow can help a company resume normal business operations and ensure operating expenses can be covered.
What is the difference between cash flow and liquidity?
Liquidity is a measure of how positive your cash flow is over time. If you regularly dip into negative cash flow, your business may be said to have poor liquidity. This creates a risk and could result in your business being less investible or less valued by potential shareholders.
Potential liabilities which can negatively impact cash flow include:
- Excessive capital expenditure (expanding premises)
- Overstocking – holding too much inventory.
- Outstanding accounts receivable (AR)
- Excessive debt burden
To name but a few.
Debt Service Coverage Ratio (DSCR)
Debt Service Coverage Ratio (DSCR) is another measure that investors pay attention to – it is a marker of whether your current cashflow can cover your short-term liabilities.
Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations
Investors pay close attention to how much debt a company is managing alongside its operating cash flow because even a high positive cash flow figure may conceal significant medium to long-term expenditure. One relevant business operations example is a company that has to invest in a new manufacturing plant or repay an outstanding loan that has reached its maximum term.
Net Present Value (NPV)
Potential Investors also look at the Net Present Value (NPV) of a company they hope to profit from. To determine NPV, the investors first calculate something called the Discounted Cash Flow (DCF), which, without going into intricate detail, takes projections of future cash flow and uses a formula to discount them into a more realistic picture of how liquid a company really is. You can read more about this in Investopedia's helpful and thorough article on DCF.
Part of any investment process will be an analysis of the company's current credit rating. A high credit rating will indicate that the company has a good record of debt repayment, and that it has been responsible in terms of its access to credit and its schedule of repayments.
Other measures that cash flow informs
As well as NPV, cash flow can be used to calculate other significant metrics, such as:
- Internal Rate of Return – IRR is the expected ROI an investor receives.
- Cash Flow Yield – a percentage measurement of the cash a business generates per share, relative to share price.
- Cash Flow Per Share (CFPS) – cash from operating activities divided by the total number of outstanding shares.
- P/CF Ratio – the price of a stock divided by CFPS
- Cash Conversion Ratio – the time elapsed between a business investing in inventory and receiving payment from customers constitutes the cash conversion ratio
- Funding Gap – in the case of a negative or insufficient cash flow, this would be the difference between the cash in hand at any given time and the money it needs to achieve its stated aims.
Common uses of cash flow
As well as demonstrating liquidity and providing a cushion against the vicissitude of fate, cash flow can be used for a number of additional business purposes, including:
Director or Shareholder Dividends
This includes payments to investors, made when the company achieves substantial profits.
This includes the money spent on the purchase of buildings, equipment, and other items which will promote growth and attract additional investment.
Payment of Employee Bonuses
Employee bonuses maybe paid as a reward for hitting targets or achieving key milestones.
Having an up-to-date statement and balance sheet can aid company decisions, particularly those that need to be made quickly.
Are cash flow statements mandatory?
FRS 102 is the Financial Reporting Standard that applies within the UK and the Republic of Ireland, and was instituted in 2015. It requires a cash flow statement, which includes cash received and spent within the following categories:
- Operating activities
- Dividends from joint ventures and associates
- Returns on investments and servicing of finance
- Capital expenditure and financial investments
- Acquisitions and disposals
- Equity dividends paid
- Management of liquid resources
However, Section 7 of the same Standard, requires that these be listed only under the following three headings:
Operating activities – day-to-day revenue generation,
Investing activities – interest on investments,
Financing activities – loans and borrowings,
Operating cash must include the amount of money in from the sale of goods and rendering of services, royalties, and other fees, as well as how much money out to suppliers, salaries, the inland revenue, and other recipients.
Under Section 7, corporation tax is included within operating activities, so long as it's not attributable to any investing or financing activities.
Investing activities are those activities that involve the acquisition and disposal of long-term assets – for example, monies used for the purchase of fixed assets and cash receipts from the disposal of such assets.
Strategies for maximising cash flow and profit
Given the importance of maintaining a positive operating cash flow, many companies work hard to optimise this aspect of their finances. There are a host of potential strategies to adopt to maximise cash flow and profit, including:
In Revenue Expansion
- Reducing customer churn.
- Upselling existing customers.
- Developing new products.
- Rethinking pricing strategies.
- Seeking new markets.
In Operations Optimization
- Striking better supplier deals
- Automation and AI
- Offshoring of departments
- Reducing overheads
- Improving Accounts Receivable
In Capital Efficiency
- Protecting assets like patents and trademarks
- Better inventory management
- Reducing manufacturing costs
- Better return on assets
- Selling unprofitable divisions
These are just a few of the ways in which a company can seek to improve its cash flow, although some of them may require short-term financial outlay to ensure improved flow of cash in the medium to long term.
How accounts receivable relate to cash flow
As we've seen, unpaid invoices issued by your company are not included in a statement of cash flows. This means that sums of money that could contribute to a positive cash flow remain in a kind of financial limbo. While invoices are overdue, they are effectively liabilities. Many businesses, especially smaller business owners, suffer as a result of unpaid invoices, which can affect cash inflows and outflows in both the short term and long term. This is more likely to affect a small business owner versus a company that has a significant net income.
Chaser have created a platform to help your Accounts Receivable (AR) department secure prompt payment and therefore maximise cash flow and profit. Our solution includes invoicing, credit checking, automated reminder issuing, and simple facilities for your clients to pay you, allowing you to focus on normal business operations. Check it out today or schedule a demo.