The Significance of Cash Flow

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 business’ 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. Staff hiring etc 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, labour comes at a cost, 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 chartered account 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 angle 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 does each transaction affect profit and net cash flow?

Transactions can: