Devika Bade
21 Mar 2023
Cash flow is the lifeblood of any business. It’s the money that flows in and out of your business from operations, investments, and financing. Understanding how much cash you have in your business, or a business you are analyzing, is crucial. If you can’t answer that to the last accounting period (at least), then you’re not on top of your finances.
The Importance of Cash Flow: Cash is king in any business. It’s the most liquid asset a company has and is a key indicator of financial health. Without sufficient cash, a company may struggle to pay its bills, invest in growth, or even stay in business. Therefore, understanding your cash position is non-negotiable.
How to Calculate Cash Flow: Calculating cash flow isn’t as daunting as it may seem. First, determine how much cash has increased or decreased over a specific period. Then divide this by the number of months in that period. This gives you the average cash flow (or cash burn) per month. This number is vital as it gives you an idea of how much cash your business generates or uses each month.
Dealing with Positive and Negative Cash Flow: Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges.On the other hand, negative cash flow indicates that a company’s liquid assets are decreasing. If your cash flow is negative, there’s an additional calculation to make. Divide your cash balance by the average monthly burn rate to figure out how many months of cash you have left. This number represents the length of your runway and is crucial if you’re burning through cash. For entrepreneurs, the three essential cash-related numbers are current cash balance, cash burn rate, and months of runway.
Understanding the Economic Architecture of a Business: A business with a simple economic architecture is one where its monthly operating income (or losses) are roughly equal to its cash flow (or cash burn). While this isn’t a necessity for a healthy business, it does provide comfort in understanding the business’s financial health.
Spotting Red Flags in Cash Flow: Companies may attempt to hide ongoing expenses in one-time charges, inflating their earnings. This practice is a red flag and should be watched out for.
Working Capital Intensive Businesses: Businesses that are “working capital intensive” have non-cash current assets and liabilities that grow rapidly in relation to revenues. This situation means you’re financing other parts of your industry’s food chain, which can quickly deplete your cash reserves.
Verifying Revenues: Ensure that the revenues are real. Companies operating fraudulently may inflate revenues by shipping products to people who aren’t going to pay. If a company’s profits remain steady while cash decreases and accounts receivable grow rapidly, it’s a sign of fraudulent activity.
Working Capital Financing: The availability of working capital financing can determine whether a business model can operate successfully. In times when debt is flowing freely, businesses with high working capital needs can thrive. However, when cash is tight, these businesses may struggle.
In conclusion, understanding and managing cash flow is critical for any business’s survival and growth. It requires constant monitoring and analysis to ensure financial health and sustainability.