Cash flow: what it means and why it’s important
Cash flow is a financial measure in the world of business economics. It is one of the most important indicators for both smaller and larger firms, assessing their stability, aiding their relationship with banks and suppliers and enabling them to plan better.
In this article, we’ll have a detailed look at the meaning of cash flow, how to calculate it and why it’s so useful.
Cash flow: what is it?
Very briefly, cash flow is the difference between a business’ total income and total outgoings over a certain period of time (it can be calculated on a weekly, monthly, quarterly or yearly basis). It is therefore a dynamic measurement that reflects how the firm’s liquidity is evolving.
In practice, cash flow indicates the change in a business’ liquidity, i.e. the total net financial resources available to it. This is how you calculate it:
(cash inflow) – (cash outflow) = cash flow
The difference between cash flow and net income
Cash flow and net income may seem like very similar quantities, but they often don’t match. It’s therefore worth knowing the difference between the two.
Net income is the difference between revenues and costs based solely on invoices: the invoices issued for revenue and invoices received for costs. Cash flow, meanwhile, monitors the actual invoices paid, and therefore the flows of money and resulting change in the liquidity available to the business.
In an ideal world, in which all payments from customers and all payments to third parties happened instantly, the cash flow and net income would be identical. In the real world, however, payments are often deferred: for example, suppliers may allow invoices to be paid after 60 days. And the same thing can happen with incoming payments.
Cash flow calculation example
Let’s look at a simple example of how to calculate cash flow.
Imagine, for example, that in a year, a single company – for example an online shop – sends out invoices worth a total of £50,000, of which £40,000 is paid. The invoices the business is due to pay to suppliers for goods and services amount to a total of £35,000, but some payments are delayed, so the cash outflow is only £20,000.
The business’ cash flow that year is:
£40,000 (cash inflow) – £20,000 (cash outflow) = £20,000 of cash flow.
The operating profit, meanwhile, would be different, as it only takes invoices into account:
£50,000 (revenue) – £35,000 (costs) = £15,000 of operating profit
Why calculating cash flow is important
Although you don’t have to calculate your cash flow, it is undoubtedly one of the most important indicators of a business’ performance besides its net income.
Indeed, making a profit does not always mean increased liquidity for the business, and similarly an operating loss does not immediately result in reduced liquidity.
Cash flow is therefore important because:
- It gives an idea of the actual amount of liquidity available to the business;
- It helps you evaluate the business’ stability;
- It simplifies the relationship with banks and suppliers;
- It allows you to monitor the actual, short-term availability of liquidity.
And watch out for negative cash flow. A company that doesn’t monitor its cash flow may find itself in a state of illiquidity: where it cannot pay its costs, even only temporarily. This situation can be avoided with careful planning.
DISCLAIMER: This article attempts to explain cash flow in an informative style and tone; this should in no way be taken as constituting legal or financial advice. We recommend you contact an accountant or professional adviser for updated information tailored to your precise circumstances.