Understanding Cash Flow

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Cash flow is one of the primary considerations for business, with software suites like SystemLink dedicated to clarifying and predicting it. However, what does cash flow mean for companies, and why does it matter? Here’s everything you should know about it.

What Is Cash Flow?

Cash flow is the term businesses use to define the amount of cash (or cash-equivalent value) going in and out of a company over a set period. These periods are usually every two weeks, every month, every quarter, or every year. If the company gains more cash in that period than it spends, it has a positive cash flow. The reverse is a negative cash flow.

It’s important to remember that cash flow refers to money entering and leaving a business. For example, any day the business is open, it’s incurring wage costs for employees. However, most companies don’t pay that money until a predetermined payday.

If a company pays out monthly and you only look at a two-week snapshot, it may not include any of the company’s regular expenses, and the cash flow can look much better than it is. Similarly, if you focus on a single week of payouts and ignore revenue-generating days, its cash flow could look worse.

This is why you should look at the broader picture for cash flow.

Cash Flow and Pay Periods

There are three common types of cash flow charts most companies prepare: pay period, quarterly, and yearly.

Of these, pay period statements are among the most important. Businesses need to have cash on hand to pay employees and bills as they come due. If the company is late or struggling to make payroll, that indicates significant financial distress.

However, most businesses don’t make a steady amount of money every day of the week or even every quarter. Many companies aren’t profitable in a fiscal year until the holiday season rolls around. Cash flow from the rest of the year can help cover payments, but owners must set aside extra cash to make up for the difference.

Longer cash flow sheets are a better measure of a company’s overall health, though not a perfect measure. For example, selling off some valuable intellectual property could provide a one-time gain and improve cash flow then, but at the cost of less cash later.

Annual cash flow reports are a better measure of a company’s overall health, and preferably, you’ll have several years of them available to look at. This provides the most holistic look at how a company is performing.

Cash Flow Categories

Beyond the periods for reporting cash flows, there are three main categories on most statements. The categories can vary somewhat depending on the way a company operates, but most companies will be similar to this.

Operating Cash Flow

The first category, operating cash flow, covers the day-to-day business transactions. This includes minor equipment purchases, basic stock, employee salaries, and other typical expenses for the company.

Operating cash flow accounts for the bulk of cash use at most smaller businesses, where costs like rent, payroll, and stock tend to take up most of the money. It’s usually a smaller ratio at large companies, where income significantly exceeds daily costs.

Investing Cash Flow

Investing cash flow covers cash a company is directing towards growth and expansion. Some businesses focus more on this than others. Smaller companies may not want to expand, so there’s no money here, while others focus aggressively on growing and reaching new areas.

Investing cash flow tends to generate little or no money by itself, so this is usually a negative value that mainly states how much the business is putting into growth.

Financing Cash Flow

Financing cash flow covers cash moving between the company and its owners, creditors, and investors. Most companies have some transactions here, even if it’s just paying off a lease or letting the owner take a salary. Cash directed to paying dividends also falls into this category.

What Is The Ideal Cash Flow For Companies?

Aside from being positive year-over-year, there’s no ideal cash flow ratio.

While being profitable is good, being too profitable implies the business isn’t investing in growth strategies that could further increase its value. If you have $10 million in excess cash a year, rather than just saving it, it’s better to put that cash to use somehow.

For example, it’s not fundamentally bad to have a rainy-day fund if the business is profitable, but that should be proportionate to the size and risk involved.

Cash Flow Ratios

Most companies have several major cash flow ratios that may appear on a report. These provide information about its typical performance. These ratios are one or more values divided by another value.

Operating Cash Flow Ratio: Cash Flow From Operations / Current Liabilities

Operating cash flow divides the income from core business activities by its current liabilities, which are debts payable within a single year.

These definitions are an important distinction. Cash flow from operations means income from the company’s core business activities, excluding additional sources of income like investments. Ideally, a company will be profitable with no external costs.

If a company earns $1 million and has $400,000 in costs each year, it’s 1000000 / 400000 = 2.5. In other words, the company can pay its expenses two and a half times over using its income each year, a comfortably large ratio.

Asset Ratios: Net Sales / Average Assets

An asset ratio shows how good a company is at converting its total assets into profit. A higher ratio means a company is more effective, while a lower ratio shows the opposite.

It’s important to remember that in many industries, getting a high asset ratio can be difficult. Companies with historically small profit margins, like grocery stores, can only do so much without facing a lot of backlash from their communities.

As an example, if our company is earning $1,000,000 and has $600,000 in assets, its ratio is 1.66. If we accomplished the same with only $200,000 in assets, the ratio would be 5.0, saying that we earn five dollars for every one dollar in assets we acquire.

External Financing Ratio: Cash From Financing / Cash From Operations

This ratio indicates how much a company depends on external financing compared to what it earns from business activities. Lower is better here, with the strongest companies being in the negative.

If our million-dollar business example has $250,000 in external financing and $750,000 in core cash flow, it has a ratio of 0.33. If we had $0 in external financing and paid $250,000 out instead, we could get a ratio of -0.25.

Accounts Receivable Ratio: Net Credit Sales / Average Balance of Accounts Receivable

This ratio focuses on the overall effectiveness of collecting sales from customers.

Credit sales are times when a business makes a deal with the expectation of the money getting collected later. The balance of accounts receivable is how much customers owe you on average.

If you have $500,000 in credit sales and average accounts receivable of $25,000, you have a ratio of 20, indicating that you’re very good at collecting money. If you have the same amount of credit sales but average accounts receivable of $450,000, your ratio is just 1.11, which means much poorer efficiency.

In the broader view, this ratio shows how many times per year you’ll collect your accounts receivable. Our earlier ratio of 20 means we’re collecting the balance twenty times per year, while 1.11 means getting the ratio just a little more than once a year. Stay in business long enough, and you’ll get to collect it twice now and then.

Both ratios involve a lot of money, but higher is better because it indicates you’re collecting money sooner. The earlier you can get that money, the sooner you can allocate it to expenses, growth, or dividends.

Systems that support accounts receivable automation can help improve this ratio by automating many parts of the billing and collection process.

Improving Cash Flow

There are many ways to improve cash flow, from implementing better marketing strategies to finding inefficiencies through software like SystemLink. Some companies even seek outside investment to grow core business operations and improve cash flow that way.

However, it’s easy to get lost in the details. There are so many numbers and ratios that you may wind up focusing too much on trying to improve a single one of those while ignoring other aspects of your business. The best way to improve cash flow is usually working to make the business stronger overall.

Final Thoughts

Cash flow is a valuable tool for businesses because it provides a snapshot of overall performance and a way to compare the company to other businesses. While it’s not the only thing that matters, software suites like SystemLink exist because finding ways to improve cash flow always helps a company.

Beyond all of that, the most important thing is to set realistic expectations for the business. Not every startup is going to make dozens of times its assets in profit. If possible, study the cash flow for other businesses in your industry and find out what’s normal. Once you have that context, you’ll be in a better place to decide if your cash flow is good or bad.

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