Cash flow tracks the net change in money held by a business within a specified period. Positive cash flow refers to incoming cash such as revenue from sales, equity financing, and borrowing, while negative cash flows refer to outgoing cash, including expenses, losses, and debt (Bamford & Bruton, 2019). Besides calculating profit, cash flow analysis is essential as it considers the timing of cash receipts and payments rather than just comparing the revenue and expenses.
Cash flow ensures that a new business has sufficient funds to timely pay for financial obligations that fall due given limited access to credit for lack of credit history. Having more sales than expenses does not reflect a business’s ability to timely pay its financial obligations (Bamford & Bruton, 2019). For example, sales on credit may take a longer time, mainly 30 to 90 days, or the purchaser may default, hence rendering the sales uncollectible. Inventory also limits the efficiency of converting sales to cash. Expenses incurred in the production of goods in inventory or on credit have to be paid long in advance before cash from sales is received (Bamford & Bruton, 2019). Cash flow ensures that a business does not suffer a crisis of inability to timely pay financial obligations despite generating profit. Inability to timely pay financial obligations may cause a profitable business to file for bankruptcy.
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To avoid consistent requests for debtors to extend repayment time or finally file for bankruptcy, a business needs to accurately forecast future cash flows. The risk of unreasonably expanding the financial obligations is especially real during times of rapid business growth (Bamford & Bruton, 2019). During periods of rapid growth, a business incurs higher costs to enhance the production of goods/services, but cash generated from sales is receivable in the future (Bamford & Bruton, 2019). Constant cash flow monitoring and projections are critical during such times to align the financial obligations with expected cash inflows. Businesses may take advantage of credit card charges as they allow for interest-free cash float such that a business may pay financial obligations without a cash outflow (Bamford & Bruton, 2019). Other strategies such as offering discounts for sales on cash and just in time inventory management may also encourage cash payments and reduce costs, respectively.
References
Bamford, C.E., & Bruton, G.D. (2019). Entrepreneurship the Art, Science, and Process for Success . McGraw-Hill Education.
