Cash flow is the amount of money coming into a business
minus the amount of money going out. It is a deceptively simple concept that is
far too often overlooked by small to medium sized businesses.
Cash flow is the blood that circulates throughout your company, it delivers oxygen to the extremities and keeps the heart pumping. Money comes in from investors, sales, and other sources and flows out when buying inventory, paying staff, and taking care of other business expenses. Without a consistent cash inflow, the cash outflow inevitably drains the company over time.
Cash flow is integral to determining the net present value
of a company. Calculating weekly cash flow can be used to predict future cash
flow from which the overall value of the company can be extrapolated. Using
this model, businesses can make long term strategic decisions, as well as short
term corrections.
Cash flow determines value
When cash outflow is greater than cash inflow, then the value
of the company decreases. When cash inflow is high relative to outflow, then
the business is worth more. Increasing future cash flow is integral to building
the value of any business long term, but there are also important short term
applications including:
- Servicing creditors
- Paying shareholders
- Informing bonus structures
- Reinvesting into the business itself.
Perils of ignoring cash flow
Despite the uses and benefits of a net positive cash flow,
the concept is not applied across the board. In the late 1990s, many tech
companies eschewed the net positive cash flow model, relying instead on investors
who were all too happy to jump on the tech bandwagon. When the bubble burst the
companies went under and pulled their investors with them. Webvan, a food delivery
company is endemic of the tech industry’s problematic cash-adverse philosophy.
According to Bloomberg “in 2001, Webvan drove off
a cliff into Chapter 11 only 18 months after its IPO, due to rapidly
disappearing cash reserves.”
Optimal cash flow
A low or negative cash flow current ratio is bad, but so too
can be a very high cash flow. Money flowing into a business in large quantities
with minimal expenditure means that there may be a lack of investment in the
company itself. Exactly how much of your cash flow you should reinvest in your
business is up for debate. According to Entrepreneur, some experts suggest that small businesses reinvest
as much as 50% of their positive cash flow.
Underinvestment is as dangerous as over expenditure because
it means that the company is stagnating. Increasing cash inflow allows
businesses to make crucial investments which grow their business overtime,
increasing future cash inflow.
For small to medium enterprises (SMEs), maintaining optimal
cash flow is critical to success. According to financial technology experts Daily
Fintech “A survey of 1000 British SMEs, conducted by invoice finance
provider Hitachi Capital, found
that improving cash flow was key to unlocking growth.” In fact, the survey
showed that cash flow was so important to these SMEs that “each quarter it was
included as a top three consideration for business owners, alongside reducing
overheads and market expansion.”
When cash flow is overlooked
Cash flow is one of the most important, and undervalued
aspects of a business. It determines current and future value, and dictates
reinvestment back into the company. Striking the right cash flow ratio is vital
to success now, and in the future.
Steps to take to optimize working cash flow:
- Asses your current cash flow by calculating expense versus cash inflow. You will have to make some judgement calls, but remember it is better to be more conservative and underestimate cash inflow, than to find yourself short of working capital later on due to a faulty model. Different businesses calculate their cash inflow in different ways. The Wall Street Journal reports that Procter & Gamble refer to cash flow as “free cash flows”, and PespiCo calculates “management operating cash flows”
- Focus on cash inflow and reducing long term debt during challenging times
- Reinvest your net positive cash flow into expanding your business or making it more competitive
- Create internal processes for striking the right balance between net positive cash inflow and reinvestment. Many businesses set aside a certain percentage of revenue to pursue future initiatives. This may mean prioritizing growth over profits, bonuses, or other non-core expenditures.
At JD Factors we
specialize in helping businesses get a handle on their cash flow. Contact me today for
help solving your cash flow issues and for financially viable options to
reinvest in your business.
