Cash Flow

Name

Cash Flow

Description

Equals cash receipts minus cash payments over a given period of time; or equivalently, net income plus amounts charged off for depreciation, depletion, and amortization.

Interpretation

Cash flows can be classified into: 1. Operational cash flows: Cash received or expended as a result of the company's core business activities. 2. Investment cash flows:
Cash received or expended through capital expenditure, investments or acquisitions. 3. Financing cash flows: Cash received or expended as a result of financial activities,
such as receiving or paying loans, issuing or repurchasing stock, and paying dividends. All three together are necessary to reconcile the beginning cash balance to the
ending cash balance. Cash flow can be examined to determine the short-term sustainability of a company. If cash is increasing, then a company will often be deemed to
be healthy in the short-term. Increasing or stable cash balances suggest that a company is able to meet its cash needs, and remain solvent. This information cannot
always be seen in the income statement or the balance sheet of a company. For instance, a company may be generating profit, but still have difficulty in remaining
solvent. In general, measurement of cash flow can be used, 1) to evaluate the state or performance of a business or project. 2) to determine problems with liquidity.
Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable. 3) to generate project rate of returns.
The time of cash flows into and out of projects are used as inputs to financial models such as internal rate of return, and net present value. 4) to examine income or
growth of a business when is believed that accrual accounting concepts do not represent economic realities. Alternately, cash flow can be used to 'validate' the net income
generated by accrual accounting.

Calculation

Cash Flow = Net Income + Depreciation +- Changes in Long-Term Provisions

Formula
Unit of Measure

currency

Direction of

maximize

improvement
Industry

for all industry segments

Relevance
Country
Relevance

The word "sap" has at least two meanings; one use of the word "sap" means "to weaken or destroy insidiously." Another definition, especially when
used in forestry is, "the vital juice circulating in plants/trees."
Which "sap" is your cash flow? If your cash projections and actual performance are about the same, your sap is the vital juice that makes the wheels
of your enterprise turn even faster. On the other hand, if your cash flow is delayed and inadequate, it may be hindering your growth, just as its
absence "saps" the growth and usually kills the tree.
Most of us anxiously review our profit & loss statements each month to consider the potential profits or losses. Notice the word potential is used
because the P&L is an estimate of profits. A large portion of sales revenue was probably sold on credit that becomes relatively unpredictable
accounts receivable.
Even more important than the profit & loss statement is the statement of cash flows. The statement of cash flows takes into account the actual
amount of cash that is received (inflows) and the amount paid out (outflows). The statement of cash flows determines how much money will be
available to pay all current and long-term payables on time. When more funds are needed than are accessible from internal cash flow, external
sources of capital must be tapped.
Most companies that attempt to operate their business using only internally generated cash are almost certainly doomed for mediocrity or failure.
There is a very high probability that your company will require outside capital infusions regularly, or periodically, unless you are a retailer with
huge margins, extended terms from all suppliers and cash purchases by customers.

Let's consider a fictional company called Woody Woodworkers, LLC and see what cash flow might be required. The company has revenues of about
$2 million per year. It has a 45-day inventory and its terms to customers are net 30 days. Terms from suppliers are the same as customer terms.
The company is on a three-week production/delivery cycle.
Material costs amount to about 35 percent of sales, so inventory investment is stable at about $87,500. Shipments average $167,000 per month and
are collected in about 51 days (three-week delivery cycle + 30 days receivable). About 96 days are required to receive payment for inventory items
considering the inventory term, the production/delivery cycle and payment terms. After the supplier payment terms of 30 days are deducted, the
company must carry the inventory investment for about 66 days.
Fixed and variable costs (other than COGS) must be covered for the 51 days as noted in the prior paragraph. Assume payroll and other expenses
total 55 percent of sales or about $91,000 per month. In addition to requiring 66 days of inventory investment ($87,500/month x 66 days) =
$192,000 + expenses ($91,000/month x 51 days) = $154,000, incremental cash flow needs could be as high as $346,000. Incoming and outgoing
payments will vary the amount of borrowed operating capital required. Retained earnings should be available to reduce borrowing to a modest
degree.
Cash flow should be an item that tops the priority list of daily activities. Information regarding cash availability for meeting current and long-term
liabilities should be gauged early each day. Delinquencies should be reviewed and acted upon immediately and all other problems related to cash
flow should receive action.
The following is a guide for controlling cash flow, rather than having cash flow dictate your business activities:
1.
2.
3.
4.
5.
6.
7.
8.

Produce a forecast of cash flows regularly. Both timing and amount should be included in the forecast that should be modified as conditions
change.
When internally generated cash is inadequate, arrange a line of credit for periodic and seasonal applications and/or capital borrowing for
specific capital purchases.
Monitor and adjust cash flow often; daily if possible, but no less often than weekly.
Create a comprehensive credit department that produces DSO (day sales outstanding) that is shorter than the terms allowed by suppliers.
Create a culture of collecting all receivables on time every time. Support this policy by placing delinquent customers on COD.
Replace consistently slow-paying customers with new ones that remit payments on time (and offer other quality benefits).
Improve quality and reduce errors so that delays in accounts receivable are NOT the result of poor quality or other omissions and errors. Tie
cash flow into quality and on-time delivery at every (every) production meeting.
An agenda item at every (every) sales meeting should be the dogged quest for customers that are financially healthy and remit their
payments on time. Note: There can be a constructive relationship between sales commissions and customer payments!

YOUR RELATIONSHIP WITH THE BANK

Supplemental funding is usually sought from a bank or other lending institution. Share financial information that dictates the need for long-term
capital or special cash intermittently. By making arrangements well in advance, you have the opportunity to access needed cash at appropriate
times. The bank or other lending institution becomes a strategic partner. Some business people remark that banks will loan money when you don't
need it and decline loans when you need them. Currently, there is so much competitive activity among lending institutions that most will lend
money when borrowers reasonably meet their risk limits.
The first step in maintaining a strong credit policy is to inform all salespeople and employees involved with financial matters of the importance of
cash flow. The next step is to make sure all customers are aware of the company's credit policy. Although the policy may be bent occasionally to
serve special customer (one-time) needs, the policy should never be waived or brushed aside as unimportant.
Credit policy information, including the interest rate for delinquency, should appear on delivery tickets and invoices as much as is practical. In
some states, late fees and service (interest) charges are not enforceable unless they appear clearly on most documents that customers receive. As
a matter of interest, check one of your credit card invoices and you will notice daily fees and other penalties clearly shown.
If inadequate cash is available for timely payments, some companies stretch out supplier invoice remittances. First the slow payments may be a
few days past due and the "cash discount" is allowed. Then, as the flow of incoming cash dries up, payments become more delinquent.
There is often a dilemma regarding how to deal with those customers who are chronically slow with remittances. Pulling in one direction is the
need for their frequently repetitive business, and in the other direction, the stress of not having the cash for operating the business.
A current credit report on delinquent customers is often helpful. If the credit information is more than three months old, you may want to ask for
copies of their current and past financial reports. If the company is reluctant to share financial information with you, the "red flag" should go up
immediately. At this point, you need to make a decision as to whether or not the customer is more important than the delinquent cash flow or vice
versa.
When incoming customer payments are slow, your supplier payments will also slow up if you don't have outside sources to supplement your supply
of cash. When persistent remittances to suppliers are slow, quality of service and/or products may decline. This can amplify cash flow and
profitability problems.

Establishing and maintenance of adequate cash flow is a collaborative effort of all departments in the company. Managing cash flow is not a
spectator sport.