Cash flow: the Complete Guide to Optimizing Business Finance

Cash flow is a metric crucial to assess the financial health of a company. Refers to the cash that comes in and out of the company in a given period of time, which allows us to understand their ability to cover expenses and pay debts. There are different types of cash flow, such as the operating, investment and financing. Each provides specific information on the financial activity of the company and its ability to generate cash. 

What is the cash flow

Cash flow is a measure of financial essential for assessing the economic health of a company.

Definition of cash flow

Cash flow refers to the movement of cash into and out of a company during a particular period of time. This financial indicator reflects the company's ability to generate cash through its operations, investments and financing activities.

Importance of cash flow for a company

Cash flow is crucial for the survival and growth of any company. A positive cash flow allows businesses to cover their operating expenses, pay off debt and reinvest in their growth. Some of the most important reasons why the cash flow is vital include:

• Facilitates financial planning and strategic decision-making.
• Helps to maintain the solvency and financial stability.
• Provides a clear overview of the capabilities of investment and expansion.
• Allows you to detect and anticipate problems financial potential.

Difference between cash flow and other financial metrics

The cash flow is distinguished from other financial metrics such as revenue, profits, and net profits. Below are some key differences:

• Income: Represent the total amount of sales or revenues generated by a company before deduction of any expenses. The cash flow, in contrast, focuses on the real money that enters and leaves the company.
• Net profit: Is the amount remaining after deducting all costs and expenses of the total income. Although the net benefit provides an overview of the profitability, it does not necessarily reflect the available liquidity in cash, as the cash flow.
• Gross profits: Are total revenue, less the cost of goods sold. Unlike the gross earnings, the cash flow includes all income and expenses in cash, offering a complete picture of the liquidity.

Types of cash flow

The cash flow is categorized into different types according to the nature of the activities that generate it. These types help you to understand in detail the movements of cash within a company.

Operating cash flow

The operating cash flow reflects the cash generated or used by the company through its core operations and daily activities.

Activities directly related to the operation

Include all those daily activities that are necessary to keep the business in operation, such as production, sales and administration.

Examples of operating revenue

• Sales of products or services
• Revenue accounts receivable
• Income from activities auxiliary operational

Examples of operating expenses

• Payments to suppliers
• Salary costs
• Costs of production
• Office and administrative expenses

Cash flow from investment

The cash flow of investment refers to the cash used in the acquisition and sale of long-term assets.

Investment activities

Include all those actions related to the purchase and sale of fixed assets, financial investments, among others.

Examples of capital investments

• Purchase of machinery and equipment
• Acquisition of land and buildings
• Investments in research and development projects

Examples of realisations

• Sale of fixed assets
• Divestment of subsidiaries or participations
• Settlement of financial investments

Cash flow from financing

Cash flow from financing is related to the activities that affect the capital and the funding structure of the company.

Financing activities

Include all of the operations performed to obtain or return funds, through loans, the issuance of shares, among others.

Examples of sources of funding

• Bank loans
• Issuance of shares
• Corporate bonds

Examples of financial payments

• Repayment of loans
• Payment of dividends to shareholders
• Payment of the interest on the debt

Cash flow net

Cash flow net is the sum of the operating cash flow, investment and financing. Represents the net income and output of money in a given period.

How to Calculate Cash Flow

Calculate the cash flow of a company it is essential to understand your financial health. There are two main methods for this calculation: the direct method and the indirect method.

Direct Method

The direct method focuses on recording the cash inflows and cash outflows in a detailed way.

Advantages of the direct method

• Provides a clear view and detailed cash transactions.
• Easy to understand for the majority of the managers and owners of companies.
• Allows you to quickly identify the sources of income and expenses.

Limitations of the direct method

• It can be laborious and time-consuming, especially for companies with large transactions.
• Requires a registration system for effective accurate and constantly updated.

Indirect Method

The indirect method adjusts net income with changes in assets and liabilities.

Advantages of the indirect method

• Provides a broader view of the relationship between earnings and cash flow.
• It is less time-consuming than the direct method, which is based on the financial statements exist.
• Useful to identify discrepancies between net income and cash-flow.

Limitations of the indirect method

• It does not provide a specific breakdown of the cash inflows and cash outflows.
• You can be more complicated to understand for those who have no experience accounting.

Practical examples of Calculation

To better illustrate both methods, you may consider the following examples:

• Direct Method:
  • Cash inflows: cash sales, collections from customers, investment income.
  • Cash outflows: payments to suppliers, wages, and tax.
• Indirect Method:
  • Start with the net profit.
  • Add: depreciation and amortization.
  • Adjusting for changes in assets and liabilities other than cash: accounts receivable, inventories, accounts payable.

Cash flow and its relationship with the liquidity business

Cash flow and liquidity, business are intrinsically linked, as the two concepts determine the ability of a company to operate without problems.

Importance of liquidity

Liquidity is crucial to the survival of any company. Refers to the ability of a company to meet its financial obligations in the short term. A good liquidity allows companies to pay their suppliers, employees and other operating expenses without facing any interruptions or difficulties.

A proper liquidity management ensures that the company has enough cash or assets readily convertible to cash to meet their immediate needs. The lack of liquidity can lead to insolvency, even if the company is profitable in the long term.

Liquidity indicators related to cash flow

There are several financial indicators that are used to measure the liquidity of a company, and many of these are directly related to the cash flow. Some of the more important include:

• Liquidity Ratio current: This ratio is calculated by dividing the current assets among the current liabilities. A ratio is high it indicates that the company can cover its short-term debt with its current assets.
• Ratio acid test: This indicator is more conservative than the liquidity ratio current and excludes inventories from current assets. It is calculated as (current assets – inventories) / current liabilities.
• Ratio of cash flow from operations: This ratio measures the ability of a company to generate enough cash from their operations to cover their operating expenses. It is calculated by dividing the cash flow from operations among the current liabilities.

The relationship between cash flow and solvency business

The positive cash flow is an indicator of solvency of the business. Solvency refers to the ability of a company to meet its financial obligations in the long term. A company solvent has more assets than liabilities and able to pay its debts as they become due.

A positive cash flow and consistent reinforces the solvency, as it ensures that the company has enough cash to pay its long-term debts. On the other hand, a negative cash flow term can endanger the solvency, potentially leading to insolvency.

The proper management of cash flow and financial planning proactive are essential to maintain the solvency and avoid financial problems serious.

Free cash flow

The free cash flow is a metric crucial to measure the financial health of a company, since it shows the amount of cash available after you cover all the operations and capital expenditure.

Definition of free cash flow

The free cash flow refers to the cash that a company generates after deducting the expenses of operation and investments in fixed assets. This metric provides a clear view of how much money the company has available to distribute to shareholders, pay down debt or reinvest in the business.

It is a key measure to evaluate the company's ability to generate cash in the long term and is calculated by subtracting capital expenditures from operating cash flow.

Calculation of free cash flow

To calculate the free cash flow, the operating cash flow and is set against the investments in fixed assets and other capital expenditures required to maintain the operations of the company. The basic formula is:

• Free cash flow = operating cash Flow – capital Expenditures

Operating cash flow includes the income generated by the sale of products and services, while capital expenditures include investments in property, plant and equipment.

Below is explained how to obtain each one of these components to perform the calculation below:

Operating cash flow

Includes all of the cash inflows generated by the core business activities of the company. To obtain this value, are deemed to be sales revenue less the cost of goods sold and operating expenses such as wages and rents.

Capital expenditures

Are investments in tangible and intangible assets that will be used during more than one accounting period. Examples of these expenses include the purchase of machinery, equipment, properties, and expenditure on research and development.

Uses and applications of free cash flow

The free cash flow has several important uses in the management and financial evaluation of a company. Among the most common applications are:

Evaluation of the feasibility of projects

The free cash flow allows you to analyze whether a project can be self-financing and generate sufficient profit to justify the investment. It is an essential tool in the strategic decision-making.

Planning of future investments

Provides management with a clear idea of how much money there is available to make new investments without compromising the financial stability of the company. It helps in the long-term planning and in the definition of investment priorities.

Helps in the management of human and material resources

The free cash flow may also influence the decision making related to the allocation of human and material resources. Allows the company to adjust their recruitment strategies, acquisitions, and other operating expenses on the basis of the availability of cash.

Utility of cash flow in the decision making

Cash flow is vital to take strategic decisions in a company. Allows the evaluation of projects, investment planning and management of resources.

Evaluation of the feasibility of projects

The analysis of the cash flow is crucial to determine whether a project is viable. When you review the flow of input and output of cash, it is possible to predict whether the company will have sufficient resources to fund new initiatives. This involves estimating the future income and compare these with the projected expenditures.

The feasibility assessment includes considering:

• Initial costs of the project
• Operating costs recurring
• Expected revenue in the long term
• Payback periods of the investment

This analysis allows to identify possible deficits and adjust strategies to ensure the financial success of the project.

Planning of future investments

A proper management of cash flow and facilitates the planning of future investments. To know the availability of cash in different periods is key to deciding when and how much to invest in new assets or projects.

Some aspects to consider in the planning of investments are:

• Determination of periods with surplus cash
• Identification of opportunities for cost-effective investment
• Assessment of risks associated with each investment
• Planning of the necessary funding

This information allows for an informed decision-making, minimizing risks and maximizing the return of investment.

Helps in the management of human and material resources

The cash flow is also an essential tool for the efficient management of human and material resources. Ensures that the company can meet its obligations to pay and supply without any problems.

For the management of resources, it is important to consider:

• Payment schedule payroll
• Purchase and replenishment of inventories
• Negotiating terms with suppliers
• Maintenance and renewal of equipment

In this way, an effective management of cash flow and contributes to the operational stability and the satisfaction of employees and suppliers.

Cash flow positive vs. negative cash flow

The cash flow positive and negative provide crucial information about the financial health of a company and its ability to meet its financial obligations.

Consequences of a positive cash flow

A positive cash flow indicates that the company generates more cash than it spends during a particular period. This scenario is favourable for several reasons:

• Financial solvency: A company with positive cash flow can cover its operating expenses and to pay off debt without problems.
• Investment capacity: Companies can invest in new projects, acquire assets or to expand without the necessity of resorting to external financing.
• Best's credit rating: A good management of cash flow can improve the credit rating of the company by facilitating the access to loans and lines of credit.
• Distribution of dividends: A positive cash flow allows for the distribution of dividends to the shareholders, encouraging investment in the company.

Consequences of a negative cash flow

A negative cash flow occurs when expenses exceed revenues in a given period. The implications can be significant:

• Risk of insolvency: The lack of liquidity may hinder the fulfillment of financial obligations, including payments to suppliers or employees.
• Dependence on external finance: To cover the shortfall, the company may need to resort to loans, increasing their debt levels and generating additional interest.
• Restriction on investments: The lack of liquidity may limit the ability of the company to perform a crucial investment for growth and development.
• Deterioration of the financial picture: A negative cash-flow constant, can negatively affect the perception of the company on the part of investors and creditors.

Strategies to improve cash flow

To improve the cash flow is essential to the financial health of any company. Here are some effective strategies:

Optimization of collection

• Credit policies: Establish clear policies and strict on credit to customers, including limits and payment terms.
• Accounts receivable management: To perform a rigorous monitoring of accounts receivable and implement collection procedures efficient.
• Incentive payment in advance: Offer early payment discounts to encourage customers to pay before the due date.

Control of expenditure

• Tight budget: Develop and follow a strict budget that allows you to manage and reduce unnecessary expenses.
• Review of contracts and suppliers: Negotiate better terms with suppliers and review existing contracts to find savings opportunities.
• Reduction of operating costs: Implement measures of operational efficiency that help to lower the cost without affecting the quality of the product or service.

Improvement in inventory management

• Inventory optimization: Maintain optimal inventory levels to reduce costs of storage without affecting the ability of demand response.
• Technology in inventory management: Use systems of inventory management to provide real-time information for informed decision-making.

Tools and software to manage cash flow

To properly manage the cash flow of a company is crucial to maintaining your financial stability. There are various tools and software designed to facilitate this task.

Accounting Software and its importance

Accounting software is an essential tool to monitor the cash flow. These programs allow you to record, classify and summarize all financial transactions in a systematic manner.

The importance of accounting software lies in its ability to provide detailed financial reports. These reports include statements of income, balance sheets and, of course, cash flow reports. Use an accounting software, you can effectively simplify the daily management of business finance and to ensure the accuracy of the data.

Specific tools for cash flow

In addition to the software general ledger, there are specific tools designed to manage cash flow in a more detailed manner.

• Tools for forecasting cash flow: Allow you to plan and predict future revenues and expenses.
• Applications of management of collections and payments: Help control the accounts receivable and payable, optimizing cash management.
• Treasury Software: Specialized in the management of liquidity and in the optimization of financial resources within the company.

How to choose the best tool for your company

Choosing the right tool can make all the difference in the management of cash flow. It is important to consider several factors before making a decision.

• Specific needs: Identify the specific needs of the company, as the forecast box, control payments and collections, or integration with other systems.
• Ease of use: Opt for a tool that is intuitive and easy to use to ensure their correct implementation and use.
• Cost: Evaluating the cost of software in relation to the benefits that it offers. It is important to find a solution that fits the budget of the company.
• Support and updates: Make sure that the tool is equipped with a good technical support, and receives frequent updates in order to adapt to changes in the financial environment.