Cash Flow-In and Out

by Nancy S. Blondin, CPA

Introduction

Cash, whether coins, bills or checks is vital to any business both large and small. The movement of cash in and out of that business is truly the lifeblood of the business organization. Managing that cash is critical to the future and success in any type of business. What do we mean by managing cash inflow or outflow? We mean handling, controlling, making use, giving direction and guidance to cash, cash transactions, and to the business organization as well.

Cash Flow in General

Cash is needed to acquire supplies, equipment and other assets that a business requires to accomplish its business purpose. Cash is needed to pay wages, operating expenses, taxes, interest and principal to creditors, and dividends to stockholders. It allows management to carry on its business. A thorough understanding of cash and how it flows in and out of an organization will allow you to answer the following questions:

1. How much cash does my business have?
2. How much cash does my business need to operate, and when is it needed?
3. Where does my business receive its cash, and spend its cash?
4. How do my income and expenses affect the amount of cash I need to expand my business?

If these questions can be answered, you are truly managing your cash flow.

Cash Needs and Policies

Why do businesses require cash? They require cash for operating transactions, precaution (unforeseen fluctuations), speculation (taking advantage of opportunities and bargains), taking advantage of trade discounts, maintaining credit ratings, and meeting emergencies. A business may have a relaxed or restricted policy on holding cash. A relaxed policy is when there is a lot of cash on hand or in bank accounts with liberal credit policies resulting in high receivables and inventory. A restricted policy is where there is very little cash on hand or in bank accounts with receivables and inventories being minimized. A business may adopt a policy, which is a combination of restrictive and relaxed policies. Any of the policies can be effective, but it is important to establish the policy best for the business.

Financial Statements

In getting control of cash flow, the first place to start is the business's financial statements. These financial statements should include a statement of cash flows. In other words, the flow on income and expense on a received and spent basis will be different from the income statement. The difference in these statements is basically the timing of transactions. It is summary of cash sources and cash uses of funds by the company. It considers several different types of transactions such as operating (cash income received and cash expenses paid), financing (cash received and repaid from loans), and investing (buying and selling of investments including sales of fixed assets).

Net Income vs. Net Cash Flow

It is important to understand that net income is not net cash flow. Net income needs to be adjusted for depreciation, amortization, changes in accounts receivable, accounts payable, inventories, and notes payable. Depreciation and amortization (non-cash items) is added to net income to determine net cash flow. An increase in accounts receivable or inventory decreases cash flow. A decrease in accounts receivable or inventory increases cash flow. An increase in loans or accounts payable increases cash flow. A decrease in loans or accounts payable decreases cash flow. Keep in mind the policies, which can affect receivables, payables, inventory, and other accounts. For example, liberal credit policy and terms affects account receivables, which in turn affects cash flow.

Cash vs. Liquidity

There is a difference between cash and liquidity. Cash is generally the most liquid assets of the business. However, liquidity relates to the ability to convert assets to cash. An analysis of liquidity and cash can be done by using ratios. Ratios such as current assets to current liabilities, working capital to sales, receivables to sales, and inventory turnover (net sales to inventory) can help to assist in determining a business' cash picture. Other ratios such as profit margins and debt to equity are important for assessing the overall health of the company. However, while ratios are helpful, they may be hard to analyze. Ratios are only averages. It is hard to compare the averages of companies in different industries. In addition, firms want to do better than average. Seasonal factors are also difficult to determine. Accounting practices differ. In addition, the question arises as to whether a ratio is good or bad according to the industry and operating philosophy of management. Caution is required when using ratios. A certified public accountant (CPA) can assist you with this analysis.

Cash Budget

In order to manage cash, review all your control procedures involving cash receipts and cash disbursements both company wide and by departments. Make sure the proper controls are in place. Foremost, you need to draft the cash budget. You need to determine based on seasonality what you expect your cash inflow and cash outflow to be. You can begin by looking at the historical information presented in the financial statements. By getting input from the appropriate company personnel and industry sources as to any changes based on future expectations, you can complete the picture. If you have a new business, you may have only industry information and your best estimate of future performance available to develop the budget. The more accurate the budget the more accurate cash flow can be managed.

The advantages of budgeting relate to the information you gather during the process. Budgeting allows management to understand the amount of cash the company needs to operate effectively. Management receives an understanding of the effect of changes in firm policy and the effect on receivables, payables, and other items that have an impact on timing and cash. In addition, one needs to understand the transactions, which affect cash balances and cash needs.

There are several factors complicating this budgeting process, including decentralized responsibilities, no forecasting system for sales and expenses, lack of current financial figures, inability to wire funds, large number of accounts, and slow billing of customers. A CPA can be helpful in helping you understand and overcome any budgeting challenges.

Techniques

How do you control cash? You control cash by synchronizing cash flows through the use of a cash budget. You can use the time such as the time from the writing of the check until it clears the bank, accelerate collections with low credit terms and high interest rates on unpaid balances, and control disbursements by making use of discounts and good purchasing practices. It may be helpful to have a line of credit in place upon which cash can be drawn if necessary. The line of credit is useful in order to meet cash needs in times of inadequate cash inflow and excessive cash outflow. The key is to find the best competitive rates on these lines. If the line of credit is used, then a repayment plan should be implemented at the same time.

Conclusion

Review all financial statements and cash flow statements including ratios monthly. Review your budget periodically and make any adjustments as necessary. The key is staying on top of the cash situation. There are several traps to avoid in managing cash flow: don't assume you can operate on too tight of a budget, that does not allow for the cash needs of the business; and don't ignore business problems but deal with them effectively and quickly. Try to plan and anticipate both external and internal factors, which may have an impact on the company's cash flow. Planning ahead is the key.

About the author

Nancy S. Blondin, CPA has a tax and accounting practice in Nashville, Tenn.

See our FAQ page here.