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What is cash flow, and why should I care?

Posted on: August 13, 2012 | Author: ATB Business & Agriculture

Money flows into your business, money flows out of your business. That’s your cash flow in a nutshell. As long as more money comes in than goes out, what’s the big deal? Well, the way you manage that flow of money has a significant impact on the health of your company. Timing is critical.

First, let’s look more closely at the cash-flow cycle.

The cash-flow cycle

cashinhand.png

Cash inflows: This is the cash that comes into your company. You get cash inflows when you borrow money (financing), collect payment for your products or services (operations), or earn income on investments (investing).

Cash outflows: This is the cash that goes out of your company. You create cash outflows when you pay for expenses, investments, and loans.

Cash on-hand: This is the cash that you currently have available for use in your business.

The REAL cash-flow cycle

It’s only in diagrams and dreams that your cash flow ever really looks like the one above. In real life, it can be much messier. As often as not, your cash outflows happen before your cash inflows. You may not collect payment for 30 or 60 days after providing service, or you may need to purchase assets or inventory in order to fulfill a sale. If you’re paying out more than you’re getting in at any point, it creates a cash-flow gap. Even though you may end up profitable (after the expected cash inflow), a cash-flow gap creates real financial problems if you don’t have the cash on-hand to pay out expenses.

Components of your cash flow

To really understand your cash flow, you have to understand the various components that impact it. And to manage your cash flow effectively, you need to optimize each of these components with your cash flow in mind.

Accounts receivable:The sales you’ve made that have not yet been paid for by the customer.

Credit term: The time limits that you set for your customers to pay for your products or services.

Credit policy: The guidelines you use when deciding whether or not to extend credit to a customer, and on what terms.

Inventory: The extra supplies or products that your business keeps on hand to meet the sales demands.

Accounts payable: The amounts you owe to your suppliers that are due for payment at some point in the not-too-distant future.

Closing your cash-flow gaps

You want to avoid cash-flow gaps as much as possible. Once you understand all of the components that impact your cash flow, you can see how changes to certain elements in each of these areas can create or minimize cash-flow gaps. To do this, you’ll design a cash-flow forecast. A cash-flow forecast is simply a prediction of your business’s cash flow over a period of time.

Identifying cash-flow gaps before they happen makes it easier to minimize or eliminate them. To avoid cash-flow gaps, you can try lowering your upcoming investment in inventory, improving your account collections, or getting a short-term loan.

Other articles you may be interested in:
Designing a cash-flow forecast
3 easy ways to tighten cash flow gaps

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