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Cash flow

Cash flow refers to the movement of cash into or out of a business, a project, or a financial product. A business has cash-outflow and cash-inflow and so long as the inflows exceed the outflows things will be fine!

Cash flow is usually measured during a specified, finite period of time and is usually split into 12-month periods, although it can be a shorter period for day-to-day management of a business. Most cash forecasts are split into measurable 12-month periods and then projected out for anything up to five or seven years. Although many businesses prepare three year cash flow forecasts, which suffice for most situations.

The measurement of cash flow can be used to determine a project's rate of return or value which is aside from the profit or loss of that same project. The timing of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value which help to determine problems with a business's liquidity.

As noted above a business being profitable does not necessarily mean being liquid and a company can fail because of a shortage of cash, even while profitable, as most businesses measure profits using accrual accounting concepts this does not necessarily represent the economic reality. For example, a company may be notionally profitable but generating little operational cash due to slow or bad paying customers or because the company is paying it's suppliers before it's customers pay. In such cases, the company may derive additional operating cash by issuing shares, or raising additional debt finance from the owners of the business or from bank finance.

A well prepared cash flow can be used to evaluate the 'quality' of income generated by accrual accounting. Good quality income would be 'Cash' income when products or services are sold for cash so that inflow is immediate, whereas low quality income is where the company has to wait several months before the cash is received by the business.

If a business has bad cash flow or if the income is made up of large portions of low quality income the business would be deemed to be of a higher risk. When investors or banks look at a business cashflow they will use cash flow forecasts to evaluate the risks associated with that company when deciding whether or not to invest or lend. The level of risk might not necessarily mean the company does not get the investment or bank loan, but the terms of the receipt of funds may be different, for example the interest rate on the loan will be higher to represent the level of risk.

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