Significance of Cash Flows

If a company has a high demand for its product, the product has high margins, makes purchases and pays on time, shows an increasing trend in profits, the business is a hit, right? Well, not always.

In most businesses cash is used to buy raw materials, produce value added goods, buy assets and turn it back into more cash than when they started. A newly set up company is more likely to use its cash in setting-up: renting its facilities, and installing utilities, all of which are made in cash. Parallel to this they acquire assets to begin operations. Activities such as hiring staff are not always done by using cash on hand, but through bank finance. This means cash is going out.

Production, where raw materials are purchased, labor comes at a cost, and taxes are all a further drain on the business. Other costs include marketing, sales and distribution costs. Even before the first product rolls out, the company incurs all these expenses and purchases. Cash is yet to come in. Once the product comes out, most businesses offer them on credit and not ‘cash and carry’. Till this money is collected it is cash in the customer’s hand. Till this happens it is not cash back in the hands of the company.

Every company must keenly note its cyclic process of cash to increased cash. That is, it must track its working capital needs carefully. This involves a process of clearly understanding the company’s cash needs, forecasting any delays and finally contingency plans for additional cash.

Some of the factors companies can control to keep their cash flow smooth include:

Pricing: Accounting for all costs direct and indirect related to the product. Filing taxes may not be a direct cost, but hiring a CPA who does the same needs to be factored in.

Accounts receivable cycle: Bill discounting, factoring and other accounts receivable techniques help better cash flow.

Contingency plan: A reserve fund raised from angel investors would help in a situation of tight cash flow. Further costly loans could be paid off with loans from friends and family, freeing cash.

Forecasting: Proper forecasting of orders would reduce inventory build-up and thus cash. A forecast of cash needs in the investment heavy period leads to better flow of cash and therefore profits.

How transactions affect profit and net cash flow?

Transactions can:

  • Increase profits but not give cash until later
  • Decrease profits but not reduce cash until later
  • Put cash in the bank but affect profits
  • Take away cash but may or may not affect profits

Transactions that increase but not give cash until later: When a sale is made on credit, while you record the sale, the cash flows in later. This sale shows a profit currently, but does not immediately translate into cash. So between the sale and till you receive cash you must arrange for cash to take care of operating expenses.

Transactions that decrease profits but not reduce cash until later: When raw materials are purchased on credit, no cash outflow occurs. These materials are used typically before they are paid for. The resulting sale may have recorded a profit, but leads to a reduction of cash when the credit period is over.

Transactions that put cash in the bank but affect profits: A loan taken from a bank shows increase in cash balance. Put to productive revenue generating options this will lead to profits, else reduction .If the borrowing is used to purchase equipment it will lead to increased profits later. Further, this borrowing needs to be paid back at some later point of time.

Transactions that take cash but may or may not affect profits: Items such as pre-paid expenses and repayments of borrowings on assets do not directly affect profits. In these cases there is a time difference between expense and cash flow. This can lead to a shortfall in cash if not carefully planned.

It is important that managers do not overlook the importance of timing in cash flow management. This is especially important in the short term when most of the financial planning is done.

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