Cash flow - Importance and implications of cash flow in business management

Publication date: 20 July 2023

Determining the health of a business can be done by considering various financial indicators. One of the most important in this regard is the cash flow indicator, also known as cash flow, a phrase that comes from the English language. Cash, in its various forms, is seen as the blood of a body, and its flow to and from the business can indicate the correctness of management decisions.

In the article below you will discover what cash flow means, how many types it is and how it can be calculated easily and correctly. In addition, you will see a list of the main factors that influence cash flow positively or negatively, as well as how to analyse this indicator in order to make decisions to improve it.

Contents:

1. Cash flow - definition and how many kinds can it be?

1.1. What is cash flow? How many types or forms of cash flow are there?

1.2. How is cash flow calculated?

2. Factors influencing cash flow

2.1. Sales and receipts as part of cash flow

2.2. Cash flow expenses and payments

3. Enterprise cash flow analysis

1. Cash flow - definition and how many kinds can it be?

The term cash flow originated in Anglo-Saxon business language, developed in the UK and the USA, and is defined as the movement of money in a business or financial entity (flow = flow). The indicator reflects the simultaneous inflows and outflows of cash over a given period of time.

The importance of this concept comes from its value in indicating and making it possible to assess the financial health of a business. Based on the results obtained and detailed analysis, cash flow can indicate in which direction the company needs to move in order to be managed properly.

1.1. What is cash flow? How many types or forms of cash flow are there?

Cash flow includes several operations and can be viewed from a holistic perspective when all cash inflows and outflows are taken into account. While this model can be useful, providing a limited set of answers, it is more valuable to consider certain parts of the business, each of which is analysed independently. In this way, extremely useful details can be obtained, making it easier for management to decide.

The literature mentions the existence of three forms of cash flow:

• The operating cash flow is obtained by calculating the cash movements (inflows and outflows) that are generated as a result of carrying out the core activities of the business. The indicator includes receipts from sales and receivables collected from customers and payments to suppliers, employee salaries and other operating expenses arising from day-to-day operations. The operational cash flow is of particular importance because it indicates by its value the existence of sufficient funds to carry out the normal activity;
• Investment cash flow reflects the cash movements involved in long-term investment activities. The amounts thus arise from the proceeds from the sale of assets, shares or other financial investments. Outflows result from the acquisition of assets and investments needed to expand the business. This form of cash flow differs from operating cash flow in that the investments are amortised over a longer period;
• Financial cash flow is that which is based on the movement of cash in relation to the financing of the business. This category includes borrowing and issuing shares as cash inflows and repayment of loans, payment of dividends and repurchase of shares as cash outflows.

1.2. How is cash flow calculated?

Research shows those interested how to calculate cash flow. The general formula is relatively simple. From a mathematical point of view, the difference between net cash inflows and outflows over a given period is calculated, which can vary according to the wishes of the manager of the company in question (monthly, half-yearly, annually).

The formula can be used in general for all inflows and outflows or in particular for each category. Thus, for the calculation of operating cash flow, net operating cash receipts will be subtracted from net operating cash payments. The same method of calculation applies to investment cash flow and financial cash flow.

The results, regardless of the side analysed, can be positive, when inflows are greater than outflows, neutral, when the result is zero, and negative, when outflows are greater than inflows. The first variant is the desired one, the second indicates a break-even situation, but one that needs to be brought into profit, and the third shows a problem that needs to be properly addressed.

2. Factors influencing cash flow

The value of cash flow can be influenced in a positive or negative direction by several factors that need to be taken into account. The element is mandatory because a company must always have enough cash to carry out its normal activities, plus funds for investment and business development.

Factors that influence cash flow include:

• sales and receipts;
• expenditure and payments;
• inventory management;
• investment in assets and equipment;
• loans and repayments;
• payment of taxes and duties.

2.1. Sales and receipts as part of cash flow

The volume and type of sales directly influences the cash flow of a business. Depending on the number of goods or services that are purchased by customers, cash flow can vary by significant percentages. The level of sales depends on three main elements:

• Pricing policies can influence demand and sales volume. There are ways to stimulate sales in the short term, such as discounts or promotional offers, but cash flow does not always reflect the current situation, as payments are not always received on time;
• Business cyclicality is observable in some industries where sales volume is in line with the time of year. For example, seaside hotels have higher receipts during the summer season, and firms selling jewellery make most sales during the holidays;
• The length of the sales cycle is the period between issuing an invoice and receiving payment for it. The period may vary from firm to firm for various reasons.

2.2. Cash flow expenses and payments

Cash flow expenses and payments are all costs that arise during the course of the firm's activities. There may be operating expenses, which include purchases of raw materials, rental of production premises, payment of utilities, payment of wages and marketing costs. This category of costs is the most likely to achieve a programme of cost control and a positive cash flow can be achieved.

Beyond these are capital expenditures, which need to be carefully planned in alignment with business objectives to avoid inappropriate or excessive investment that could lead to negative cash flow. Payment policies to suppliers can also affect cash flow, requiring proper and efficient management of supplier relationships.

3.Enterprise cash flow analysis

Cash flow analysis is a good opportunity to identify effective ways to increase profit and understand the financial health of the business. With the data obtained, market trends can be identified and the right strategic decisions can be made.

Such an approach can be quite difficult to achieve, especially by business people without an economic background. In this case, the ideal solution is to turn to consulting firms that can accurately determine, by applying correct calculation methods, what the cash flow situation is at any given time.

Such analysis is carried out through the following steps:

• Data collection is done by capturing relevant information on all cash inflows and outflows from operational investment and financing activities;
• The data collected is used to calculate the cash flow, either for the whole activity or for a specific component (operational, financial, investment);
• The results obtained, either positive or negative, are used to identify trends and determine their evolution. In this way it is possible to identify how cash flow has evolved. If it is increasing compared to previous stages, it can be concluded that management has acted correctly, especially if the increase has been significant. Stability and especially decreases should be warning signals and encourage management to look for effective solutions;

• The results also help to identify surplus or deficit. The two indicators show the profitability of the company and indicate the direction to be taken next. If a negative cash flow is identified, then the business is losing money because it is spending more than it is earning. The situation can be resolved either by obtaining additional sources of finance or by managing expenditure;
• Proper cash flow analysis helps identify problems and opportunities. The analysis is also useful for identifying internal and external factors affecting cash flow (credit policies, payments to suppliers, stock situation, sales volume, etc.).

The main function of cash flow analysis is the possibility to develop strategies to improve cash flow. Financial advisory is appropriate because the employees of such firms are experienced and have at their disposal the latest tools and methods they can apply, both if a positive cash flow is identified and if it is negative. In the first case, one can observe the factors that led to a higher volume of receipts than expenses, and in the second case, one can determine those elements that affect the chances of profit.

Among the strategies that can be applied in most cases to improve cash flow and hence profit are:

• Apply effective credit and collection policies. This means that agreements between companies and customers must be put in place to guarantee timely payments and eliminate the risk of late or even refused payments. This requires close monitoring of customer balances and the application of techniques to speed up collections (discounts for prompt payments, faster and more secure online payment systems, gradual payment arrangements based on advance and successive payments, follow-up and monitoring of claims, negotiation with customers and cooperation with financial institutions);
• Correct inventory management is essential to achieve a positive cash flow. Ideally, goods in stock should be kept as short as possible so as not to generate additional costs. Logistics has developed many techniques and technologies to reduce the time spent in storage to a minimum. In this way, the tied-up capital can be released and put back into the economic cycle to produce profit;

• Negotiating favourable payment terms with suppliers allows for payment extensions and positive cash flow;
• Management of operational expenses provides the opportunity to identify unnecessary or excessive expenses. Examples include replacing morally and physically obsolete technologies with new, more efficient ones, using renewable energy resources such as photovoltaic panels and outsourcing services such as accounting, HR and payroll;
• Investment planning should be done only after analysing the cost-effectiveness of each approach. This will identify the profit potential and prioritise the most worthwhile investment;

• Diversification of revenue allows for increased revenue by offering customers new services or products;
• Additional funding can be a solution when extra money is needed to carry out profitable activities;
• Constant cash flow monitoring and analysis by experienced people who know how to identify risks and opportunities.

In conclusion, cash flow analysis done correctly and by experienced people is an ideal way to identify the health of the business and at the same time establish strategies that maximise the chances of success and profit.

*This material has been prepared for information purposes only and is not intended to provide tax, legal or accounting advice. We recommend that you consult with your team of tax, legal and accounting advisors before making any decisions on the topics mentioned in this article.