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Why is Cash Flow Management Important to a Business?

A modern proverb states that money makes the world go around, and while this is open for philosophical debate, money absolutely makes a business go around. Business to business or bank to bank transfers are known as cash flow, and while the concepts of cash flow and all that it entails can become somewhat complicated, in a nutshell, it relates to payment coming in against money going out.

The whole point of any business is to be paid for a product or service that has been provided as agreed upon by contract and law. When a service has been provided then payment for that service is transferred from someone else’s bank account to yours. This type of transaction allows you to continue to provide services to others by paying for materials, staff, and leases.

What is Cash Flow?

The principles of cash flow are a little more than simple bank to bank transfers, however, and can be expressed in formulaic terms as time (t), nominal amount (N), currency (CCY), and account (A):

CF = CF(t, N, CCY, A)[1]

However, cash flow is also used to represent such things as project income and expenditure, return on investment (RoI), and net present value.

In simple terms, cash flow is used to determine if a company has sufficient monetary income in order to continue its daily and regular operations by covering expenses such as payroll, utilities and land rental or other costs involved with a particular sector. Of course, the concept of cash flow gets more complicated than this when other fiduciary responsibilities are taken into accounts such as taxes, equity, dividends and debt.

How Cash Flow Affects Business

Without sufficient cash flow, you cannot hope to achieve continued business, even with the best creditor arrangements who need to be paid back at some point and continued credit is measured against cash flow analysis anyway, therefore without positive cash flow your business will be unable to grow.

Positive Cash Flow

Sustaining a positive cash flow should be the primary focus of your business from a financial perspective as it allows your business to continue to operate and avoid unsavory actions. While in positive cash flow, your business can pay all of its bills, guarantee employee wages, return dividends to investors and accrue a liquid bank balance for insuring against future issues where extra monies might need to be depended upon.

Negative Cash Flow

With the absence of positive cash flow, i.e. income lower than total expenditure, your business will become stagnant and begin to suffer. New equipment cannot be purchased, license fees could expire, rental arrangements could be defaulted on and staff may have to be let go. But even in times of hardship there are tried and tested cash flow techniques that can achieve positive cash flow such as increasing prices, coming to arrangements with suppliers, and canceling inefficient projects.

The Reasons for Negative Cash Flow

Negative cash flow is generally unexpected and can become a gradual problem that occurs over time or instantly as a result of external processes and events. Some of the most common reasons for negative cash flow are the result of client problems rather than a poorly managed business and can include revenue loss related to such things as late client payments, lower than expected profits, overexpansion or overstocking of product and creditor issues.

An uncommon yet concerning issue that can severely affect cash flow is that of too much stock; not product stock but stock in other companies. Using liquid assets to invest in stock or other capital assets is a risky venture more akin to gambling than doing business, yet many companies do this on a regular basis. While the rewards can be substantial, there remains the potential for huge losses of real money if and/or when any invested stock loses value or even crashes, essentially meaning money down the drain.

How to Stimulate Positive Cash Flow

Maintaining a positive cash flow isn’t easy as even the best-managed business can suffer depending on external factors such as the state of the market, advancements in the sector and global pandemics that require everyone to stay indoors and isolated. Having said that, managing cash flow is like managing anything else: it has to be done properly and there are methods of managing cash flow in order to maximise potential and decrease the chance of a negative impact or cushion the effects of temporary inversion.

As a business owner, you should know exactly what your business has coming in and going out. To achieve this you should consider a full audit of all financial items concerning your company, from the cost of pens to the salary of your most senior manager and everything in between. Once you have identified all expenditure then this can be compared to income, making cuts where necessary. Internal audits are recommended to be assessed annually

Final Thoughts

All businesses require adequate cash flow management in order to survive since a negative cash flow means that expenses are in the position of outweighing income. This results in less money being available for use in expanding your business, ordering new supplies, paying any creditors or even covering staff wages. Essentially, cash flow needs to be positive for sustained operations or your business will eventually have to cease trading.

While there are many reasons for a mismanaged cash flow such as unforeseen circumstances, shifting markets and late or non-existent client payments, other factors like investing liquid assets into volatile capital assets can result in massive losses for a company, but all is not lost and recovery can begin if you are willing.

While you can make cuts here and there and lay off some staff in order to resolve debt and shift from negative to positive cash flow, one of the best methods of recovery or prevention is that of internal audits. An internal audit should be performed at least once per year as they allow you to identify items of expenditure that can be removed such as too much ordering of office supplies or an overpaid employee who underperforms.

As to why cash flow is important to a business, the answer is simple: a business cannot survive without readily available cash to cover expenses. Creditors will only go so far as to lend you money and the more money you owe, the less will become available to you.

References

  1. Wikipedia. Cash Flow. https://en.wikipedia.org/wiki/Cash_flow
  2. RG&Co. What is Cash Flow and How Does it Affect Your Business. https://www.rgcocpa.com/news/what-is-cash-flow-and-how-does-it-affect-your-business/#:~:text=Cash%20flow%20also%20affects%20your,freedom%20you%20have%20to%20reinvest.
  3. Investopedia. Trading or Gambling. https://www.investopedia.com/articles/basics/10/investing-or-gambling.asp
  4. Synergos Consultancy LTD. How Often Should I Do Internal Audits? https://synergosconsultancy.co.uk/how-often-should-i-do-internal-audits/#:~:text=At%20the%20least%2C%20internal%20audits,over%20a%20number%20of%20months.

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