What is cash flow in business?

by Muhammad Ali

What is cash flow in business?

Cash flow is a measurement of the amount of cash that comes into and out of your business in a particular period of time. The cash flow statement is a financial statement that reports a company’s sources and use of cash over time.

When you have positive cash flow, you have more cash coming into your business than you are leaving it. When you have negative cash flow, the opposite is true.

A sustained period of negative cash flow can make it increasingly hard to pay your bills and cover other expenses.  This is because your cash flow affects the amount of money available to fund your business’ day-to-day operations, otherwise known as working capital.

Why is cash flow management important?

All business owners will want to avoid cash flow problems.  Understanding and managing your business cash flow can help you stay resilient in uncertain times and adapt quickly to changes such as rising prices and supply chain issues. From mitigating financial risks such as late and missed payments, to helping you spot investment opportunities. 

It can also help you set clear financial goals underpinned by a real time forecast of your cash flow, enabling you to stay on track and flex when you need to and avoid any cash flow issues.

A healthy cash flow is also important for a good business credit rating, helping you to secure finance, attract investors, negotiate with suppliers, and win new business.

How to calculate cash flow?

There are two methods of calculating cash flow: the direct method and the indirect method.

Direct-vs.-Indirect-Cash-Flow-Statement-

1. Direct Cash Flow Method

The direct cash flow method uses real cash inflows and outflows taken directly from company operations. This means it measures cash as it is received or paid, rather than using the accrual accounting method. Accrual accounting recognises revenue as it’s earned, rather than when you receive payment.

To prepare a cash flow statement using the direct method, you’ll need to rely on cash receipts and other documentation to find out when payments were exchanged. It creates a straightforward, reader-friendly document with a list of cash receipts and payments. Total cash payments are subtracted from total cash receipts to arrive at net cash flow. 

Example: 

  • Employee salaries
  • Cash paid to suppliers and vendors
  • Cash received from customers
  • Tax and interest payments

indirect-cash-flow-statement

2. Indirect Cash Flow Method

The indirect method of measuring cash flow looks at all the transactions on a statement rather than the cash on hand to determine the financial health of a company. With this method, you can determine precisely how much money you’ve spent and brought in, how much you should have on hand, and get a solid grasp of your business’s financial stability over a given period. 

The indirect cash flow method calculates cash flow by adjusting net income with differences from noncash transactions. It starts with a business’s net income and then lists cash flows, both received and paid, for various activities (i.e., the three cash flow categories: operating, investing, and financing). These activities are then added or subtracted from the business’s net income to determine its final net cash increase or decrease over the specified period.

In Conclusion

A cash flow statement is a valuable measure of strength, profitability, and the long-term future outlook of a company. The cash flow statement (CFS) can help determine whether a company has enough liquidity or cash to pay its expenses. A company can use a cash flow statement to predict future cash flow, which helps with budgeting matters.

For investors, the cash flow statement reflects a company’s financial health, since typically, the more cash that’s available for business operations, the better. However, this is not a rigid rule. Sometimes, negative cash flow results from a company’s growth strategy in the form of expanding its operations.

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