In every business there is money coming in and money going out, this is known as cash flow.
This exists in the form of inflows (money being made available for a business) and outflows (money paid out by a business).
Businesses may receive cash inflows for a number of reasons. Cash comes into a business primarily through the sales of products (i.e. the business’ turnover). However, money may also come through in the form of a bank loan, so that the business can buy necessary items. Furthermore, the owner’s own funds will have been invested into the business when it is first started.
There are a number of reasons why a business may have a cash outflow:
– When starting a business, a number of one-off start-up costs will cause an outflow, such as paying for business premises.
– Businesses must pay tax on both their profits and sales.
– A lot of businesses will need to purchase raw materials for their products, both when they start up and when they’re trading.
– If a business has taken out a loan from a bank, then they will have to make interest payments when paying the loan back.
– Likewise, if a business is leasing building space, then one outflow will be in the form of rent payments.
– Finally, most businesses will have employees, meaning they have to pay them wages.
As part of a business plan and a way to prepare for the future a business may choose to use a cash flow statement. A cash flow statement is table showing the historical flows of cash in and out of a business. It is used as a record of the business’s trading and is often used to plan for the business’s future.
Cash flow statements and forecasts are usually split into three sections. Cash inflows will usually be the first section, and equal the total cash inflow when added together. Cash outflows will be the second section, and equal the total cash outflow when added together. The third section shows the net cash flow, the opening balance and the closing balance.
The third section of a cash flow statement also includes the the net cash flow. Net cash flow describes the flow of cash in and out of the business, and can be calculated using the difference between total cash outflow and total cash inflow.
Opening balance is the amount of cash a business has at the beginning of the month. Closing balance is the amount of cash a business has at the end of the month and can be calculated using the sum of net cash flow and opening balance.
Cash flow forecasts and statements are important to businesses for two main reasons: to show when a business may be tight for cash, and therefore highlight ways in which to avoid cash shortages becoming an issue.
For example, they can be used when applying for loans, as a bank is more likely to approve a loan if they can see a detailed forecast of a business’s cash flow, thereby reducing the associated risk. Furthermore, cash flow statements and forecasts will provide details of where a business’s cash is going and when.
If however a business doesn’t have enough cash to pay its costs then it will become insolvent. This means that it is unable to meet any financial responsibilities and must then lawfully stop trading.
If a business becomes insolvent it will go into administration, which means it is under the control of a receiver, or in receivership. A receiver will try to pay off a business’s debts by selling it.
However, often insolvent businesses are difficult to sell as many will doubt their potential success. If this happens, a receiver will often shut down a business and sell off any of its assets (such as equipment and office space) to raise money for these debts, which will then be paid to those the business owes money to.
So as you can see having a healthy cash flow is not only advantageous to a business, but without one it can cause the business to collapse altogether!