Cash flow: what is it and how can you manage it?

What is cash flow?

Cash flow refers to the amount of money that comes in and out of a company over a set period of time.

Cash flow does not only refer to “cash” in the usual sense of the term, but also to what are known in finance as “cash equivalents”. Cash equivalents basically include anything referred to as having “high liquidity”. In other words, items which could quickly be turned into cash, including cheques which have been received but not yet cashed, marketable securities, short-term government bonds, commercial papers and so on. 

Cash flow, therefore, refers to the amount of cash and cash equivalents that move in and out of a company. Inflows to the company take the form of cash received, while outflows are in the form of expenditure.

The cash flow of a company determines how much cash the company has available to fund its day-to-day operations, or what is known as its “working capital”.

A cash flow can be either positive or negative. A positive cash flow situation means that there is more cash coming into the business than there is leaving it and therefore that it has a lot of working capital. A negative cash flow situation means there is more money leaving the business than it is generating, creating a situation of low working capital.

Although short-term negative cash flow can precede a period of growth, lengthy periods of low working capital obviously spell difficulties for a company and cannot be sustained.

The risks of poor cash flow management

The advantages of understanding your cash flow situation are obvious – owners and investors can rest assured that bills can be covered and can plan for the future with confidence. Conversely, the risks of not understanding cash flow situation can lead to a number of consequences, none of which bode well for the future of a business.

Cash flow problems often arise due to lengthy payment schedules. This is a particular issue for small and medium companies. Long before a debt is written off as a bad debt, if invoices are not settled within a reasonable amount of time, small companies can find that they have insufficient funds available to be able to settle their own liabilities.

This leads to several knock-on consequences, which can spell disaster for a small business.

Overstocking

Without a good handle on cash inflows and outflows, it is all too easy to fall into the trap of overstocking. Overstocking leads to higher financial costs, as the extra stock takes up space and does not generate profit. Valuable space is taken up and stock isn’t shifting fast enough to generate cash.

Delays in settling bills

When your own cash flow is suffering, for whatever reason, one of the biggest knock-on consequences is that you may be unable to settle your own liabilities in time. It may mean suppliers invoices can’t be settled which can lead, in turn, to late interest payments and penalties being generated, triggering higher costs. In the worst case scenario, it may mean employees’ wages can’t be paid.

None of this is good news for your business. By monitoring cash flow accurately, and introducing good invoice management, such situations can usually be avoided.

Overspending

Without a clear overview of what cash is coming into and going out of the business, it is easy to overcommit resources through overspending. All too often, businesses can rush into spending without fully investigating all the options and the consequences of the expenditure. This can, in turn, put even greater strain on cash flows and reduce the working capital available. 

The solution to avoiding overspend is to keep an even closer eye on every financial transaction. Integrated accounting solutions can help monitor spend and identify potential unnecessary commitments.

Types of cash flow

A company’s cash flow can be divided into three categories.

Cash flow from operations

Cash flow from operations, also known as “operating cash flow” (OCF) refers to cash and cash equivalents which arise directly from the production and sale of goods or services as part of the company’s normal operations. In basic terms, OCF is calculated by deducting operating expenses from net income over any given period. It is the simplest way of judging a company’s financial health and viability.

Cash flow from investment

Cash flow from investments refers to cash which is generated through investments over the specified period. Although not significant for many small businesses, depending on the sector of activity, cash flow from investments can include income from speculative assets and securities. More commonly, it covers income from the sale of assets.

Cash flow from financing

Cash flow from financing refers to inflows and outflows of cash used to fund the company. This includes issuing debts and paying dividends. It reflects increases and decreases in longer-term liabilities and debts, as opposed to operational cash flow. 

Cash flow statements

Alongside its balance sheet and income statement, a company’s cash flow statement forms a key element of a company’s financial statements. Financial statement analysis gives a snapshot of the financial health of the business.

A cash flow statement is usually divided into three categories of cash flow, namely operating, investing and financing. Taken together, this information reveals a great deal about whether the company is growing, where its revenue is coming from, and how much debt it owes.

A company’s cash flow statement demonstrates whether the company is able to cover all its bills and can help owners identify when they may need to request additional investment to get through a rough period, such as initial start-up, expanding into a new market, or to an unexpected event such as COVID-19. Businesses with more seasonal activities, in sectors such as tourism and hospitality, may use their cash flow statements to make sure they are generating enough revenue during busy times to get them through the leaner periods of the year.

Optimising cash flow management

Regardless of the size of your business, there are some key lessons that can be learned about building good cash flow management procedures, which can help avoid some of the more common difficulties and be vital in the event of an audit. These include: 

Good invoice management

Issue invoices in a timely manner, indicating a clear deadline for payment. If payment has not been made by the time the deadline arrives, send a reminder. Good accounting software can be configured so that payment reminders are sent automatically and it’s worth investigating this option, particularly if you are a small business or sole trader often with little time to dedicate to tracking and following up on invoice payments.

Flexible payment options

Offering flexible payment options can encourage your clients to settle their bills in a more timely way. Asking for partial payments up front, introducing the possibility to pay in instalments, and offering reductions for early payment can all entice clients to pay their bills earlier, ensuring you have great inflows of cash and freeing up more working capital.

Penalties for late payment

Equally, introducing penalties for late payment can deter clients from taking their time with settling invoices and can encourage prompt payment. In the UK, the Late Payment Law sets out the right for all business to charge interest on invoices that are not settled within a defined payment period. This law states that all invoices must be settled within 30 days of the invoice date or within 30 days of delivery of the goods (whichever is later). By law, the interest rate to be charged on unpaid invoices is 8% above the base lending rate of the Bank of England.

On top of interest payments, since 2013, UK businesses are also entitled to claim any other reasonable costs associated with collecting their debt. This amount is set at between £40 and £100 for each invoice.

Conclusion

Keeping track of cash flow is essential for any company to not only survive the rough patches, but to thrive and grow as much as possible. Monitoring cash flow can be built into your company’s financial management systems through good accounting software. Mooncard can adapt your accounting procedures to ensure you have the right information at the right time to enable you to optimise your cash flows, anticipate any difficulties and forecast the future with confidence.

Book a demo today to see how Mooncard can help you help your business.