Why company cash flow is a window into financial health


Why company cash flow is a window into financial health

September 15, 2023
Article written in partnership with Begbies Traynor.

Your cash flow paints an important picture of the financial health of your business. Even profitable businesses can fail if they don’t manage their cash flow situation carefully. It sounds counterintuitive, but most people know of or have heard of businesses that failed because they grew too quickly. Why? Because their cash has been stretched too thin. And when you don’t have money in the bank, what might otherwise be a small issue, such as a late payment or an unexpected bill, can quickly become a big problem.

Here we’ll take a look at why cash flow is so important and what it can tell you about the financial health of your business.

What is cash flow?

Cash flow is the money that flows into and out of your business over a set period. Ideally, you want a positive cash flow, which means more money is coming into the business than going out. If you have a positive cash flow, your business should be able to pay its staff, bills and suppliers and invest in growth. On the other hand, if you have a negative cash flow, you may have to rely on alternative sources of income to pay your debts, which could have implications for your growth.

Profit and turnover are two of the first metrics we think of when assessing the financial performance of a business. But while generating a good profit might be a long-term goal, cash flow is a more important metric to track on a day-to-day basis, as it offers a better insight into its short-term financial health.

The role of the cash flow statement

The cash flow statement is one of three core financial statements, along with your balance sheet and your profit and loss account. It reports the cash flowing into and out of the business over a specific time period - it could be a week, month, quarter or year.

It also shows you how your cash has increased or decreased over time. And importantly, it identifies where you have spent money and why there have been changes in your cash balance, which is information other financial statements don’t provide.

A cash flow statement splits your cash inflows and outflows into three main activities:

  • Operating activities - This is the inflow and outflow of cash from regular business activities, such as your sales revenue, rent, interest and any commission you might receive. Outflows include wages, stock, office costs and transport.
  • Investment activities - This is the cash you make or lose through long-term investments. It includes income from the sale of assets and the money you spend to purchase buildings, land and equipment.
  • Financing activities - These are the inflows and outflows derived from debt and equity transactions. Inflows can be money you borrow or money you raise through the sale of shares. Outflows can be dividend payments or the interest you pay to service your debts.  

What does company cash flow say about your business?

While your cash flow statement can provide you with a useful snapshot of your cash inflows and outflows, you need to dig a bit deeper to get a real insight into your business’s short-term health. That’s where a cash flow analysis comes in.

A cash flow analysis allows you to determine where you can make changes to better utilise your cash and grow your business more effectively. It also helps you spot cash flow patterns and trends that could be problematic.

Net cash flow

Calculating your net cash flow is a simple but necessary first step in your cash flow analysis. It represents the total change in your business’s cash holdings over the period.

A positive net cash flow demonstrates the business’s ability to perform its operations, invest and grow. That said, if you have positive net cash flow but negative operating cash flow, it can still be a worrying sign. It suggests money from elsewhere is being used to cover your operating expenses.

While a negative net cash flow might initially cause concern, you should look more closely to determine where the cash inflows and outflows are coming from. For example, a positive operating cash flow and negative investing cash flow show that the business is making money that you are using to invest and grow. However, the concern here could be that you are investing too much in the business and not holding enough cash.  

Operating cash flow

Your operating cash flow is an important figure on your cash flow statement. It shows you the cash you generate from your business activities alone and a positive figure is a good indicator of your business’s overall strength.

Calculating your operating cash flow ratio can provide further insight. It will tell you whether you have enough cash in the bank to pay your debts and interest.

Operating cash flow ratio = cash flow from operations / current liabilities (short-term debts + accounts payable)

A figure over 1 suggests good financial health, while anything less than 1 suggests you could have cash flow issues.

Free cash flow

Free cash flow is also worth looking at. This is the cash that’s left over after you have paid all your expenses and reinvested in the business. Free cash flow is indicative of a healthy business, as you have spare cash to pay off debts, pay dividends to shareholders and create a cash reserve for a rainy day.

How well are you managing your cash position?

Looking more closely at your cash flow can provide a window into the health of your business and help you identify and resolve issues before they become a problem. It can also inform many of your decisions, such as when to invest, when to control stock levels and when to cut back on unnecessary expenses.

Consequences from an insurance perspective

Lauren Williams, Development Executive for Trade Credit Insurance at Specialist Risk Insurance Solutions (SRIS) adds:

“Cash flow and profit are the two key metrics to ensure a business succeeds. Although profit is important, cash flow is key to ensure the smooth running of the business to meet its financial obligations.

Having slow payers or non-paying customers can severely impact a business and put financial pressure that sometimes results in businesses failing to succeed.  We are seeing increasing demand for customers taking Credit insurance due to experiencing longer payment periods and changes in their client’s payment behaviours.

In Q2 a leading insurer reported that late payments stand at an average 50% of all B2B invoiced sales for UK companies, a rise of 25% on last year. The level of bad debts increased by 80% and now affect 9% of all B2B sales, an indication of serious cashflow issues.”

If you would like to hear more about how insurance can help with this issue, get in touch with our expert team to find out more.

Source: UK: Concern about low-growth landscape fuels insolvency fears | Atradius

About the author: Keith Tully is a partner at Real Business Rescue, company rescue, restructuring and liquidation specialists with 30 years of experience in supporting company directors in financial difficulty. Keith operates widely across the North West of England and leads our Liverpool office.

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