Cash flow is very vital to the health of a company. One expression that is commonly used in businesses is "cash is king” ( Kokemuller, N.d). What this means is that the most critical focus for a company or organization is cash flow. Cash inflow is essential as it helps businesses meet their immediate and short-to-medium term needs ( Kokemuller, N.d) . Positive cash flow enables companies to pay their bills on time. Firms with negative cash flows ought to make adjustments in their business operations to ensure that it generates more cash. Along with debt management, strong cash flow helps businesses operate in a strategic, proactive way ( Kokemuller, N.d) . This is because it gives companies the comfort and the capability to invest in growth. Cash flow is also vital as it gives businesses greater flexibility in making critical decisions or addressing future financial challenges.
How cash flow differs from Profits
Cash flow and profits are both important elements of a company but are two different parameters. In order to ensure success in the short term and long term, businesses ought to make profits while also operating with positive cash flow. Cash flow refers to the money flowing in (cash inflow) and out (cash outflow) of a business (Brooks, 2013). It is the money a business needs to meets its obligations. A company can make profits and still not have adequate cash flow. Also, a business can have a strong cash flow, but that does not mean the business is making a profit. On the other hand, profit refers to the net income of a business (Brooks, 2013). According to Brooks (2013), profits is an accounting measure of periodic performance. In order to survive, a business ought to be profitable.
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Estimating Cash Flow
Seven issues ought to be put into account when carrying out a comprehensive cash flow estimation process. These issues include “sunk costs, opportunity costs, erosion, synergy gains, working capital, capital expenditure, and depreciation or cost recovery of assets” (Brooks, 2013). Each of the issues stated above plays a significant role when estimating cash flow. Sunk costs are retrospective costs that an entity has incurred, or the entity will incur, and which it can no longer recover (Brooks, 2013). Although these costs are included in the income statement, they are not relevant cash flows and therefore, they should not be taken into account when evaluating a capital budgeting proposal.
With regard to opportunity cost, businesses tend to miss one benefit when choosing one alternative over another. For instance, a company can decide to use a piece of idle equipment rather than selling or leasing it. The opportunity cost, in this case, is the value that could be realized by either selling or leasing the equipment.
Erosion costs are costs that arise when a new product or service competes with revenue generated by a current product or service offered by a company (Brooks, 2013). In such cases, revenues from current products or services are lost and thus ought to be taken into account in the incremental cash flows. Synergy gains arise when two entities merge or combine, increasing in the value of the combined entities (Brooks, 2013). This is because the sales will increase. Working capital refers to the capital available to a business in its day-to-day operations (Brooks, 2013). When undertaking new projects, additional cash flows arise which ought to be recovered at the end of the project. Thus, the additional cash flows ought to be shown as cash inflows.
With regard to capital spending and depreciation, a company or business usually spend capital to purchase depreciable assets. Each year, the company is allowed to expense a portion of the cost of the asset acquired. The depreciation expense of the asset should be recorded in the income statement, while the accumulated depreciation should be recorded in the balance sheet (Brooks, 2013).
Cash Flow Projection
Projecting the cash flows of a new product help businesses to estimate the expected cash inflows and outflows (Brooks, 2013). More to this, it gives firms insight to keep on top of the business's financial health. From the projection, the business would be able to tell if it will make profit or losses from the new project. When projecting cash flows for a new product, it is vital to include the operational, financial, and investment activities in the analysis (Brooks, 2013).
References
Brooks, R. (2013). Financial management: Core concepts (2 nd edition). Pearson Education, Inc.
Kokemuller, Neil. (n.d.). Importance of Cash Flow to a Business. Small Business - Chron.com . Retrieved from http://smallbusiness.chron.com/importance-cash-flow-business-57376.html . Accessed 27 th September 2019.
