Cash is king - cash flow is the lifeblood of any business. If you run out of cash for a prolonged period of time, your business will fail – it’s as simple as that!
Positive cash flow allows the business to pay its debts as they become due, while allowing it to take advantage of any opportunities that may arise.
As an entrepreneur, you’ve probably had a year where the business reported great profits, but you asked yourself: “where’s the money?”
The key difference between cash flow and profit is that cash flow is based on the actual movement of cash into and out of your business – cash in the bank (also known as liquidity); while profit is a measure of financial performance (gain or loss) based on pre-defined accounting rules (the International Financial Reporting Standards also known as IFRS is the global standard for these rules).
Liquidity measures the ability of a business to pay their debts as they become due with the assets available to them. Cash on hand is the most liquid of assets. Thus, a business with a strong cash flow is easily able to pay its debts in the ordinary course of business.
Profit versus Cash Flow
The diagram below shows the relationship between net profit and cash flow
The table below explains the impact of components of financial statements on net profit and cash flow:
What can a business do to improve liquidity?
A business improves liquidity by optimising the sources and uses of cash.
cash flow from operations – should ideally be a source of cash, but is dependent on the businesses ability to generate positive cash flow
cash flow from investing activities – this is cash that is invested in the fixed assets (capital expenditure) of the business; typically a use of cash
cash flow from financing activities – this is cash that is generated from or paid to the providers of finance to the business; either shareholders (paid in capital, or paid out in dividends) or lenders (generated through loans or paid out through repayment of the loans); typically a source of cash
Cash flow from Operating Activities
The table below explains ways in which a business can improve its cash flow from operations:
Cash flow from Investing Activities
Invest in the correct capital equipment and related manufacturing processes, with a continuous improvement plan. This should be done with the ultimate goal of improving operational efficiencies. For example a correctly set-up manufacturing process will reduce manufacturing time (resulting in lower manufacturing cost), lead times (resulting in lower stock holdings) reducing cost of sales and improving profit margins.
Due to the large cash flows required to replace or upgrade plant and equipment, capital intensive businesses should develop CAPEX forecasts over the long term that takes into account fixed asset life-span as well as changes in manufacturing processes and technology.
Cash flow from Financing Activities
Finance can be obtained from the following sources:
Both have advantages and disadvantages. These are as follows:
A business should consider the best fit for its circumstances and raise finance accordingly; this will generally be a combination of debt and equity.
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