Understanding Cash Flow


by Leticia Elizondo

Cash flow refers to the movement of cash in and out of a business.  Watching the cash inflows and outflows is one of the most pressing management tasks for any business owner. 

The term “cash” refers to: cash, checks, money orders, and checking accounts.  Cash inflow includes the cash you receive from customers, lenders, and investors.  The outflow of cash includes those checks you write each month to pay salaries, suppliers, and creditors.  Cash is used for meeting normal salaries, suppliers, and creditors.

Cash is also used for meeting normal cash obligations like paying bills, is held as a precautionary measure for unanticipated problems, and for potential investment purposes.

Cash flow analysis shows whether your daily operations have generated enough cash to meet your obligations, and it shows how major outflows relate to major inflows.  As a result, you can tell if inflows and outflows from your operations combine to result in a positive cash flow from operations or in a negative cash flow.  Understanding this will lead to better control of cash flows, and will allow adequate time to plan and prepare for the growth of your business.

You should always keep enough cash on hand as an added cushion for security to cover your expenses.  It is unwise, however, to keep more money on hand than is necessary to cover your obligations.  Excess cash should be invested in an accessible, interest bearing, low-risk account such as a savings account, short-term CD, or Treasury bill.  Keeping excess cash on hand reduces both the growth and the return on investment.

Many small business owners consult with the Small Business Development Center, CPAs, private business consultants, and lenders in an effort to address their working capital needs.  Most owners believe the solution to their problems is a line of credit or a lump sum of cash to sustain the growth.  The real solution, however, lies in understanding the operating cycle, also known as the cash conversion cycle, and its impact on cash flow.

Good accounting can reduce your expenses by producing your own summary statistics and projections.  With the help of a personal computer and a good financial-management package, you can successfully project your future activity, as well as use the “what if” analysis to test various management decisions.

Operating Cycle:

The operating cycle can be defined as the system through which cash flows, from the purchase of inventory through the collection of accounts receivables.  It measures the flow of assets into cash and is, in effect, a “business stopwatch.”  For example, the operating cycle may begin with both cash and inventory on hand.  Except for cash sales, when some of your inventory is sold, accounts receivable increases, but your cash does not.  Typically, you pay for the inventory you have purchased 30 days after it is received.  When the payment for inventory is made, both cash and accounts payable are reduced.  Thirty days after the sale of inventory, receivables are usually collected, which increases cash.  Now your cash has completed its flow through the operating cycle and is ready to begin again.

The operating cycle is simply the sum of days of sales outstanding (DSO) and days of sales in inventory (DSI), less days of payables outstanding (DPO).


To illustrate the use of the operating cycle, consider the following: Company A has an average daily sales of $1,000, and 100 percent of sales are on credit with 30-day terms, inventory is turned in weekly, and payables are due in 15 days.  The operating cycle for Company A is:

30 days +7 days-15 days= 22 days.

Company A needs $22,000 in cash to sustain its operations at the current level ($1,000 X 22 days).  As the company grows, so will the need for cash to sustain the growth.  This cycle will force the company to constantly seek financing.  To avoid such a problem, the company should make policy changes that would reduce their operating cycle, and hence their need for capital.  Three possible solutions exist: reduce days of sales outstanding, reduce days of sales in inventory, or increase days of payables outstanding.

Days of sales outstanding can be reduced by offering incentives to repay sooner than later, or even prepay.  Typical incentives can be 2/10 net or 30 or 50 percent down payment.  Factoring can also be used to days of sales outstanding since the factor is going to pay immediately upon the purchase of accounts receivable.

Days of sale in inventory can be reduced by locating closer suppliers to reduce the delivery time, and hence the required safety inventory level.  Just in Time inventory is another method to reduce inventory.

Days of payables outstanding can be increased by negotiating better credit terms.



A plan is necessary:

Good management of cash flows is simple.  It involves knowing who, where, and how your cash needs will occur, the best sources for meeting needs, and being prepared to meet these needs when they occur.  A good rule of thumb is to have enough cash and compare actual figures to past months.  It is important to project your monthly cash flow to identify and eliminate deficiencies or surpluses in cash.  When cash flow deficiencies are found, business financial plans must be altered to provide more cash.  When excess cash is revealed, it might indicate excessive borrowing or idle money that could be invested.  The objective is to develop a plan which will provide a well-balanced cash flow.

The achieve a positive cash flow, you must have a sound plan.  Cash reserves can be increased by:

Collection of receivables

Tightened credit requirement for customers

Extending credit terms with suppliers

Maintaining control of inventory

Increase in borrowing

Increase in profit