The term cash flow can be defined as the movement of cash in and out of the organization. Organizations are able to track the amount of cash flow they have by using the statement of cash flow which consist of the operating, investing, and financing activities of the organization. According to the IAS7, cash flow from the operating activities can be prepared using the direct or indirect method. Cashflow of an organization is basically about the inflow and outflow of cash.
When preparing the cashflow statement of an organization using the indirect method, we start by recording the profit a firm makes before paying tax, which is also called the operating profit. An increase in assets is said to be an outflow of cash because more money is been paid out to purchase a particular asset that can be used in an organization, while a decrease in the asset of an organization is an inflow of cash. In situations like this, probable money has been received in exchange for assets been sold by an organization.
Equity and Liabilities are being treated differently while calculating the cash flow of an organization. An increase in Equity and Liability is said to be an inflow while a decrease is an outflow.
Equity and Liability are said to have a positive relationship with cash such that an increase in Asset =decrease /outflow of cash and vice versa.
What happens if you don’t monitor your cash flow?
Failing to monitor and manage your cash flow properly puts your business at risk and could lead to a range of different problems. Here are some of the main issues you might face:
- Too much stock – If you suddenly receive high demand for a product, it’s tempting to order a high volume of material to service that demand. However, if that demand then changes you could be left with far too much stock and potentially, debt from ordering the materials. Ordering too much stock might also leave you lumbered with materials that become obsolete and difficult to sell.
- Long payment terms – Lengthy payment terms can often leave you with long stretches of time when no money comes in. Any unseen issues, from a fire at the office to replacing a laptop, can then be problematic due to a shortage of cash while you wait for the money to arrive. There’s also the possibility of bad debt, which is when customers do not pay at all.
- Overspending – It’s very tempting to go on a spending spree when you win a new client – snapping up everything from fancy orthopaedic chairs to an office ping pong table. However, you need to remember that you haven’t got the money until they’ve paid you. Spending money that you don’t have is never the best idea.
- Overtrading – Just as with stock, it’s easy to get carried away with your business outlook after securing a big order. Employing more staff or expanding to more locations might seem like a good idea to grow your business, but you need to have the cash flow to back this up. While your profits can vary, your rent and salaries won’t, meaning that you need to be able to withstand short term pressure on your finances if you want to grow your personnel and premises.