What Does the Term “Cash Flow” Mean in Accounting
What exactly is cash flow?
The movement of money in and out of your business in terms of income and expenditure is referred to as cash flow. You want to have a positive cash flow, which means that more money comes in than goes out of the business. Your company will be able to pay its expenses and invest in expansion if it has a good cash flow. If you have a negative cash flow, you’ll need to find another source of income to pay off your debts.
To calculate net cash flow, simply total up all of your cash payments over a given time period (usually a month) and subtract them from your cash receipts. However, it’s crucial not to get too hung up on a single month. Because most firms have peaks and troughs, your cash flow can be more correctly measured over a period of three months or more.
While your turnover may be a great huge number that gives you confidence that your firm is doing well, cash flow provides a more accurate picture of how well your organisation is performing. Turnover is vanity, profit is sanity, and cash flow is reality, as the old adage goes.
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What Is the Importance of Cash Flow?
Cash flow is critical in the following areas:
Maintaining the viability of your company. You’ll need cash flow to pay bills and cover day-to-day expenses, or you’ll have to close your doors. The idea is to keep your cash flow positive and ensure that you’re constantly making more than you’re spending.
Expanding your company. A growing company will want enough cash to reinvest—to buy new equipment, advertise, build offices, and so on—while still absorbing costs.
Making more informed business decisions Knowing your cash flow helps you make better decisions. Let’s imagine you’re planning on purchasing a new laptop and discover at the end of the month that your revenue greatly outweighs your costs. Because you have adequate money, you may now confidently make that buy.
Businesses that operate only during certain seasons. Seasonal enterprises are characterised by distinct slow and busy periods, as well as unpredictably fluctuating cash flow. They must carefully manage their cash flow throughout the year to ensure that they have enough cash to get them through the slow times.
Improved financial management. Understanding your cash flow will help you better understand how you manage your money and which business activities cause increases or declines in cash flow.
What happens if you don’t manage your cash flow properly?
Failure to effectively monitor and manage your cash flow puts your organisation at risk and can lead to a variety of issues. Here are some of the most pressing concerns you may have:
There’s a lot of stock in this. It’s tempting to order a large quantity of material in order to meet an unexpected surge in demand for a product. However, if demand shifts, you could end up with far too much inventory and, potentially, debt from the items you ordered. If you order too much inventory, you may end up having resources that are outmoded and difficult to sell.
Payment periods are lengthy. Long payment terms can leave you with long periods of time where no money is received. Any unanticipated problems, such as a fire at the office or the need to replace a laptop, can become troublesome due to a financial shortfall while you wait for the money to arrive. There’s also the risk of bad debt, which occurs when consumers fail to pay.
Overspending. When you have a new customer, it’s easy to go on a shopping binge, buying everything from sophisticated orthopaedic chairs to an office ping pong table. You must keep in mind, though, that you do not have the money until they have paid you. It’s never a good idea to spend money you don’t have.
Overtrading. It’s easy to get carried away with your business vision after securing a large order, just as it is with stock. Expanding your business by hiring more people or opening additional locations may appear to be a fantastic plan, but you must have the cash flow to back it up. While revenues fluctuate, rent and salaries do not, so if you want to expand your employees and facilities, you must be prepared to bear short-term financial strain.
Cash flow statement
Given the necessity of good cash flow management, creating a statement that proves this may be beneficial. A cash flow statement resembles a profit and loss statement and a balance sheet in appearance. It should examine how money flows in and out of the company. As a result, you’ll be able to:
- Consider how money flows in and out of the company.
- What effect does cash flow have on a company’s operations?
- How do payments match up to cash balances and values?
A cash statement is essentially a reduced version of the balance sheet that you prepare once a year. The final figure in your statement should be a ‘Net Cash’ figure, which is the sum of all the other figures in your report.
What should your cash flow statement include?
There should be three categories on a cash flow statement: operating, investing, and financing.
Operating: This is your net income, adjusted for changes in your present assets, liabilities, and expenses.
Investing: Any additions or declines in long or fixed term assets are shown in this figure (independent of accumulated depreciation).
Financing reflects any changes in long-term liabilities/debt, shareholders’ capital, or dividends.
Once you have these three numbers, add or subtract them from your starting cash amount to determine your entire net cash balance.
What is the purpose of a cash flow statement?
The cash flow statement not only summarises how much cash is available for operations, but it also describes how the organisation generates revenue. As a result, this indicates a lot about how (or if) growth is occurring, such as whether it is from increased debt, income, or other means. If you want to be able to plan ahead, you’ll need this kind of information. You could even want to construct a projection based on how you expect future cash flow statements will reflect changes you make to the firm.
This statement serves as a guarantee that you will be able to pay all of your payments. Until a startup, it may imply that you need to seek out a different source of funding as you establish your bearings. Seasonal enterprises can use this to keep track of what happens throughout peak season and off-season.
FURTHER READING: What Does the Term “Equity” Mean in Accounting