Cash flow is to a business what gas (or battery charge) is to a car.
If you want to go far, you will need to keep a close eye on it. This means that cash flow should be a high priority for every entrepreneur, especially if you are a startup.
While your brand and sales leads are important, you are better placed to first sort out what any accountant will refer to as “free cash flow”.
In simple terms, it is the amount of money coming into your business that overly covers the entirety of your expenses. Without such cash, your business may not survive long enough for you to worry about all those other things.
Sources of Cash Flow
There are three major sources of cash flow in any business. Financing, Investments, and operations.
They are the impactful sources of cash that determine whether your business is strong enough and grows steadily. They inject cash into your business in the following ways;
- Operations. This is the most convenient way to inject cash into your business.
It refers to using internal business money to finance various activities. With this method, you avoid acquiring debt or issuing equity which is essentially selling off some of your company shares.
However, it is affected by factors such as your customers delaying payments making you late on settling the business costs and supplier payments.
In such instances, your business could run out of cash. The other factors that affect cash flow from include changes in accounts receivable, accounts, and inventory changes
- Investments. This refers to the money generated by selling off assets.
This includes obsolete or excess business equipment, investment securities, or real estate.
This, however, only makes sense for companies with excessive or huge amounts or obsolete equipment. Otherwise, selling an essential asset to finance an unrelated project can be perilous
- Financing. This essentially refers to the money your business gets when you borrow loans or draw down on credit lines to finance various projects.
There is also the option of selling some ownership of the company or stocks, or by selling issued bonds to investors. For existing loans, you can refinance them to generate more cash flow
How to Read a Cash Flow Statement
If your company earns $1 million it does not directly mean that it is cash available for your business.
There are numerous accounting aspects that may have to be met before you can determine how much profit the business has incurred. This is why you should learn how to read and analyze various business documents.
The cash flow statement is one of such documents and it indicates how your company spends and receives its money. It can allow you to determine how well your business will operate in the short and long term, depending on the amount of money it has flowing in and out.
The cash flow statement is broken into three sections representing the various cash flow activities:
operating, financing, and investing. Therefore, by looking at each section, you can determine the total cash it generates and makes sound financial decisions. The ideal situation is where your business’s net income is routinely lower than the operating income to ensure that your company remains solvent and grows seamlessly.
There are two means to calculate your business’s cash flow;
- Direct. This is the first method and it relies on the transactional details that affected cash during the financial period.
To use this method, you should add all the cash collections arising from operating activities and less the total cash disbursed to operating activities
- Indirect. This is the second method which mainly relies on accrual accounting. Here the cash paid from or received into the business is recorded as either revenue or expense at that time.
The accrual entries and alterations thus cause cash flow variations between operating actions and net income
Your company’s cash flow statements can tell the phase your business is in.
It shows whether the company is rapidly growing as a startup or whether it has reached the stage of maturity and stability.
You can then approach investors if there is a need to and use such information to your advantage when negotiating a deal. You can also determine the departments that are contributing to the overall well-being and health of your company and those that have snags.
Positive cash flow typically means that there is more money flowing into your business than outside over a specified period. However, this does not always translate into profitability.
Your company can have positive cash flow but zero profits and at other times it could be profitable without having positive cash flow.
Negative cash flow, on the other hand, means that more money is flowing outside the business than that coming in. It is not an indicator of zero or negative profits and it may be caused by income and expenditure mismatch.
How Does Depreciation Affect Cash Flow
Depreciation is the scenario where an asset loses its value over time depending on its useful capacity. Its impact on cash flow is indirect rather than direct because it impacts the business’s tax liabilities. That then lowers cash outflows from your income taxes.
Depreciation appears as an expense in your company’s income tax return.
It means that you will report a reduced amount of taxable income to the government hence lowering the total cash outflow from your company. Put simply, the lower the taxes you have to pay, the higher the net income your company will report. This means that your business’s cash flow statement will end up with a higher figure.
How to Calculate After-Tax Cash Flow
It factors in the influence that taxes have on profits. The general way to calculate this cash flow is to add depreciation back to the net income. The formula is;
After Tax Cash Flow = Net Income (Earnings After Tax) + Depreciation + Amortization + Other Non-Cash Charges
Your business needs cash flow to survive as such is the cash available to pay for all expenses.
It is can be obtained from three main sources which are operating, investment, and financing activities. The cash flow generated from operations is convenient but is affected by factors such as late payments from customers.
To generate cash flow from investments you should only sell excessive or obsolete equipment to prevent lags in other essential projects. Financing-generated cash flow may decrease your total ownership of a business.
There are direct and indirect means to interpret a cash flow statement which can indicate either positive or negative cash flow. You should also know how to calculate and subtract depreciation for higher cash flow.
Do you struggle with generating cash flow? What sources of cash flow do you have or pursuing to add to your investment portfolio?
Share with us using the comment box below. We love to hear from you
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Frequently Asked Questions (FAQs)
- What are the Critical Parts of a Company’s Financial Statements? The three essential parts or business documents are the income statement, the cash flow statement, and the balance sheet
- What Can Cash Flow not be an Indicator of? It does not indicate whether a business made a profit or a loss
- What are Cash Equivalents in a Business? They are the temporary investments that are very easy to liquidate and also marketable securities that are easy to convert to known cash amounts
- What is Accelerated Depreciation? This is where a company increases its total taxable income by adding increasing depreciation valuations in the short term