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Analyzing the Components of Cash Flow

Posted on January 22nd, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In our previous article, “Cash Flow Management: The Secret to Success,” we provided a broad definition of cash flow and stressed its importance: the sooner you learn how to manage your cash flow, the better your chances of survival.  Furthermore, you will be able to protect your company’s short-term reputation as well as position it for long-term success.

The first step toward taking control of your company’s cash flow is to analyze the components that affect the timing of your cash inflows and outflows. A thorough analysis of these components will reveal problem areas that lead to cash flow gaps in your business. Narrowing, or even closing, these gaps is the key to cash flow management.

Some of the most important components to examine are:

  • Accrual profit or loss. As was explained in our article, “Which is More Important, Profit or Cash flow” and other articles, your profit or loss is a critical component of cash flow, and if it is a loss, over time it will act as a cash drain and threaten your company’s survival. Thus your (accrual) profit is the lifeblood of your business, NOT “just what you pay taxes on.” Do not ignore this number.  Is your mark-up too low?  Is your overhead too high?  Whatever the cause, if you are showing a loss, get to the root of it and fix it.
  • Accounts receivable. Accounts receivable represent sales that have not yet been collected in the form of cash. An accounts receivable balance sheet is created when you sell something to a customer in return for his or her promise to pay at a later date. The longer it takes for your customers to pay on their accounts, the more negative the effect on your cash flow (see “The Relationship Between Turnover Ratios and Cash Flow”).
  • Credit terms. Credit terms are the time limits you set for your customers’ promise to pay for their purchases. Credit terms affect the timing of your cash inflows. A simple way to improve cash flow is to get customers to pay their bills more quickly.
  • Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy – neither too strict nor too generous – is crucial for a healthy cash flow.
  • Inventory. Inventory describes the extra merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be used for other cash outflows (see “The Relationship Between Turnover Ratios and Cash Flow”). Too many business owners buy inventory based on hopes and dreams instead of what they can realistically sell, and ultimately, must sell it at a loss or simply write it off. Keep your inventory as low as possible.
  • Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable at some point in the near future – “near” meaning 30 to 90 days. Without payables and trade credit, you’d have to pay for all goods and services at the time you purchase them and prior to selling your product and receiving payment from your customer. For optimum cash flow management, examine your payables schedule.
  • Matching sources and uses of funds.  The general rule in corporate finance is that long-term assets should be financed with long-term sources of funds, and short-term assets should be financed with short-term sources of funds.  Long term uses of funds include plant and equipment purchases, “permanent working capital” requirements, such as that required to fund sales growth (see “The Effect of Sales Growth on Cash Flow”), or to expand its line of business.  Short-term uses include temporary or seasonal increases in inventory, accounts receivable, etc.

Some cash flow gaps are created intentionally. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerate cash outflows to take advantage of significant trade discounts.  For other businesses, cash flow gaps are unavoidable.  Take, for example, a company that experiences seasonal fluctuations in its line of business.  This business may normally have cash flow gaps during its peak season and then later fill the gaps with cash surpluses when sales (and therefore, receivables) come back down from the peak part of its season.   These types of cash flow gaps are short-term in nature, and are often filled by external financing sources. Revolving bank lines of credit, and obtaining extended terms on trade credit, are just a few of the external financing options available that you may want to discuss with your bank or suppliers.

The type of cash flow need described under “Matching sources and uses of funds” above, should always be financed with long-term sources of funds such as long-term debt, intermediate sources such as “asset-based” (accounts receivable and inventory) credit facilities, or an equity infusion. To ignore this rule by trying to support these kinds of long-term investments out of cash flow is to potentially create a severe strain on accounts payable causing them to become past due, inviting almost certain financial disaster.

Finally, do NOT take your operating losses or any of the other cash mismanagement symptoms in the above list to your bank and ask them to fix it.  Why?  Because banks are looking to your profit and cash flow in the first place to repay their loan, and an astute business lender will see right through it (see “Larry’s Debt Repayment Strategies, Inc.”). Consequently, your business management skills may become tainted in the bank’s eyes for a long time to come.


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