The cash flow of a company refers to its capacity to generate liquidity. And, consequently, to meet the payments that arise. Therefore, it is a key indicator to understand the financial status of a business.
It is a very necessary accounting information for the Management Control of a company. And for making decisions about the management of finances and the future of the business.
What is Cash Flow of a company?
As we have said, this concept refers to a company’s capacity to generate liquidity.
What is its importance?
Its importance lies in the fact that sometimes what is shown in the accounting books does not match the financial reality. It can be the case of companies that enjoy good results but discover that they have no funds.
Despite the fact that a business has had good sales results, there is a possibility that it may have liquidity problems. This happens, for example, because it is invoiced but not paid on time. If this happens, the company’s balance sheet will be positive but the cash flow will be negative.
But the opposite can also be the case. To have a positive cash flow but a negative accounting result. This could be because, for example, suppliers have not been paid.
In short, cash flow is the indicator that measures the economic health of a company.
Its importance lies in the fact that it lets you know when you need financing. Either because your customers are late in making payments or because the overall result is negative.
How is Cash Flow calculated?
Normally the following formula is used to find the “Cash Flow” of a company:
Cash Flow = Net Profit + Depreciation + Provisions.
In other words, we first obtain the company’s net income or profit. To this result, we add the expected depreciation and amortization provisions. As well as the provisions in the given period. This is added because they are not physical outflows of money from the company. Rather, they are accounting entries of expenses. This is why we saw earlier that accounting and financial reality do not always coincide.
But also, because this concept is used when valuing a company.
Types of Cash Flow
There are three different types that are divided according to the activities they perform.
Firstly, what is called Operating Cash Flow. This is related to ordinary income, and to the direct activity of the company. This is the income obtained from the sale of products or the provision of services.
A second type known as Investment Cash Flow. This can be calculated if there are real estate and financial investment activities that generate cash flows.
Finally, the Financing Cash Flow. A company will also calculate the “Cash Flow” in financing activities when they change the equity of the business and the accumulated debts.
How to improve cash flow to achieve liquidity?
In general, there are a number of tips that can help most companies. Starting from the premise that cash needs should be monitored on an ongoing basis.
Invoice on time
It goes without saying, but it’s not always done correctly. If you want your customers to pay you on time, you must invoice on time. This ensures that you receive that revenue in a timely manner, and your cash flow will not be affected by outstanding payments.
It is important that payment terms and times are clear. Give your customers a reasonable time to pay you once the invoice is issued, and take action if there are delays in payments.
Follow-up on payments and collections
What we said to act in case of late payment of invoices.
The deferment offered in the payment of an invoice implies a risk of non-payment that can end up having an impact on our cash flow.
It is therefore important to order all our invoices and their due dates, clearly establishing payment terms with customers. This follow-up will also serve to make a correct collection forecast.
A very interesting tool is factoring. Since it is a way of financing for companies. It consists of a bank buying the invoices from us and offering us the cash in advance at an interest rate.
The advantage of this type of financing is that it is usually cheaper than a traditional credit.
But all this is just as important when it comes to our payments. We must be clear about when we have to pay.
Keeping a cash flow forecast
This does not have to be the same every year. Not even within the same year. For this reason, it is advisable to establish short-term objectives, taking into account the seasonal variations that our business may undergo throughout the year.
To do this, we can look at historical data of our company or of companies similar to ours if we know them. Applying corrective factors that take into account the current situation. Do not forget to include fixed and variable costs and, above all, make realistic forecasts.
Although it may seem logical, it is something that is not always applied. In order to keep the cash flow in a good state, it is essential to control and even limit expenses. It is necessary to begin by elaborating a budget where each one of the necessities of the company are indicated. Including the payments to suppliers, the payments for financial expenses, even the payment of taxes.
In some cases, in addition to having beneficial supplier payment terms, it may be necessary and even advisable to anticipate and request a deferment from the supplier. This way we can avoid having to ask for a punctual external financing, with its consequent financial expenses.
But it can be equally interesting to take advantage of discounts offered by suppliers when paying in advance.
The cost of storing stock can sometimes be as onerous as the risk of having to order more. Knowing at all times what stock we have and what we need to order will help us avoid tying up money in unnecessary stock.
To avoid these problems, it is a good idea to reconcile our current stock records with our bank account on a regular basis, either weekly or monthly.
Obtain credit if necessary
We usually try to avoid incurring new debt as much as possible. Logical, since we see it as a way of compromising our company’s finances. But keep in mind that a line of credit or a new bank loan can accelerate our growth.
In addition to the factoring mentioned above, a financial institution may be willing to lend money to a company on a short-term basis, if it sees that the risks are acceptable. As soon as our customer pays, we can repay the debt.
It is necessary to anticipate problems before they occur. To do this, cash is what makes it possible to cover all the payment needs that occur on a recurring basis and can help to avoid a cash stress scenario.
For this reason, the calculation of cash flow is an extremely important indicator for any company, regardless of its size.
And as it is a complex analysis, the most advisable thing to do, especially for SMEs that have fewer resources, is to turn to experts in Accounting Consulting who can help you.
Because they must be clear that it is more important to have liquidity in the cash, than to have the ability to invoice in large quantities.