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The importance of cash flow in a business

All businesses need to have cash in them in order to operate. Without cash it is impossible to buy materials and cover the basic costs of running a business – making it impossible to survive. Cash is counted as an asset to a company as it can be used for a number of reasons. As well as this, cash is known as a ‘liquid’ asset as it can be spent on anything at all without having to be sold in order to raise funds. This movement is known as cash flow.

Approximately 20% of business failures are related to the fact that the organisation has poor cash flow. Without enough cash in the business it will be hard to pay invoices from suppliers, purchase new goods and materials needed in order to operate the business or pay wages. It is always a good idea to have a good amount of cash in a business in case of the following:

  • To pay suppliers, overheads and employees – invoices will accumulate for a business over time and these will need to be paid. Without the money to pay suppliers money that is owed, a business will be unable to form good relationships and this will be of detriment to future deals. Overheads such as rent, electricity and gas will need to be covered by the business as well in order to continue trading. As well as this, employees will need to be paid wages and salaries. Without cash in the business to pay these amounts it will be very hard to continue to work as suppliers will not be able to continue to give goods away without being paid, energy companies could turn off the power to the company premises and employees may threaten to leave the business due to not being paid
  • To prevent insolvency – a business that does not have enough money to pay its debts will run the risk of becoming ‘insolvent’. This basically means that the business will be at risk of becoming bankrupt as it cannot afford to pay money that is owed to other people or organisations

Cash flow

Being able to control cash is very important for a business. This cash control is known as ‘cash flow’. To be able to pay bills and wages when they are due, a business will need to understand exactly where cash will come from and how much is coming in. Businesses must keep financial records and plan ahead in order to control their pay systems efficiently.

Cash inflows

Money that comes into a business through sales is known as cash inflow. This will be money that comes in from sales, the selling of assets, money that is invested from shareholders and interest on any savings. The money that comes into a business will be used to pay overheads and other outgoings that keeps the business running and making money. Cash inflow will come from:

  • Sales
  • Fresh investment from new or existing owners
  • Interest on savings and loans
  • Sale of assets

Cash outflows

As we have already discussed, cash will leave a business in order to keep running and offering its goods and services. All money that leaves a business is called cash outflow. In order to pay cash leaving a business, money must first be made so that the company can have the finances in order to pay bills. Cash outflow will include:

  • Wages
  • Materials and goods needed to operate
  • Everyday running costs and utilities
  • Machinery
  • Rent
  • Taxes
  • Any other bills and fines incurred

Net cash flow

The difference between the cash inflow and cash outflow in a business is known as the net cash flow. Obviously, a business will want the net cash flow to be positive so that more money is coming in than going out. With a higher inflow than outflow, a business will be making money which will hopefully end in a profit. However, net cash flow cannot always be positive. When the net cash flow is negative, the business may have a good reason for this such as additional investment in certain areas that will result in success at a later stage. If the net cash flow does end up being negative at times then the business must act quickly to stop this in order to avoid losing money in the long term.

Balancing cash inflow and outflows

Cash flow forecasts

Most businesses produce cash flow forecasts in order to keep tabs on what money is coming in and going out of the company. Being able to forecast the money coming in and out will allow you to always pay bills on time and have some money left over for anything that is unexpected.

The cash flow forecast will show the estimated cash coming in and out of the business over a period of time. Look at the cash flow forecast below that shows the cash in and out of a business from January to May. Here you will be able to see the money coming into the business (under income) and the money going out of the business (outgoings). In the bottom row you can see the net cash flow which shows the amount that comes into the business overall. Figures in red indicate negative amounts of cash.

Figures in cash flow

Looking at the example shown above, you can easily see the months where cash flow is negative (these are in red) for February, March and April. While a business is new it will generally lose some money since sales are not at their highest levels. Start-up costs such as materials and machinery can be very expensive for a new company so it is vital that any negative cash flow is only limited.

Sticking with the example shown in this section, the business plan on the net cash flow is £3,375 for January. But over the next three months the net cash flow is negative and totals £4,225 (£2,575 in February, £1,475 in March and £175 in April). From this information we can see that the forecast is not possible as, despite bringing in £3,375 in January, the business will not have enough cash to get through the next 3 months where £4,225 is expected to be lost.

If a business forecasts cash flow and sees that cash is in short supply it can do a number of things. Typically, the business will need to increase the amount of money put in at the start. So, sticking with our example, the business’s net cash flow is £3,375 in January but then negative £4,225 over the next 3 months combined. This means an additional £850 (the difference between the two) is needed. This money could come in the form of further investment in the start-up or by spending less on materials in the early stages as a way to save cash.

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