Accounting / Bookkeeping Basics: Cash Flow, Functions  And Working Capital For Effective Accounting

Cash Flow in Detail
In the case of cash, this is free of judgment but is most likely to not givethe precise value of a firm’s performance.It is important to know that a business perceives flow of two entities, that is the profit flow and cash flow within the business, and both are derived at differently. Cash flow involves inflow and outflow, doesn’t leave room for any creativity while cash moves in and out of a business. Profit flow allows legitimate ways of adjustment to arrive at the true value of profit, cash shows reality by the movement of money, at least this is how it is designed to be perceived. For any new project introduced by the firm, it needs cash and approval of budget from the finance director who decides if the firm has substantial cash to run the project. A firm doesn’t go  bankrupt when it incurs losses, but it does when it is running out of cash to settle its debts and liabilities.
Although cash flow does not say much about a firm’s performance or its level of success or failure, it is vital as it determines short term viability for the firm to operate. If we are considering a 12 year plan for a firm, unless we see to it that the firm has cash to operate for every of the 12 years. If not it will not work. Managing cash is there key to operating a business. This is rather a continuous process of generating the apt flow of cash rather than holding cash still and saving it for the rainy days. This obviously means that cash needs to be used to purchase equipment for the firm. If cash does not flow and is saved on every little bit of equipment, then machinery could get outdated over time and this can cause problems to the success of the business.
Although bankers perceive to aid entrepreneurs with cash to start a business, in reality they do not give cash without maximum benefit they go into agreement a lender. Going overdraft can cause entrepreneurs to become overly dependent of bank manager’s decision to further settle a loan payment. Bank lending usually works on a certain working capital ratio which companies struggle to meet. However, since they like to keep  up  to  loan  covenants,  they  operate  under  these   set   ratios. However, this causes decision making power to shift to banks who then monopolize the business.

Why do we need Cash?

Let us look into each purpose more carefully.

Paying Bills: The company needs to have cash to settle bills when they are due as paying on time is an important factor that builds and maintains the reputation of the firm. It can also create a long term good impression to suppliers at times when the business is running low.
Paying Suppliers: Suppliers provide on credit under specific timings for settlement based on government rules or at time privately negotiated between firms and suppliers. Usually payments are agreed to be made at the month end following the month of delivery. The current trend of businesses permitting customers maximum time to pay is causing companies to struggle.
Paying interest accumulated from loans: - Bankers expect payments to be made regularly to settle accumulating interest and part of the principle loan that they have lent a firm. Taking the right amount of loan is vital for any business to operate. Knowledge of Accounting and cash flow can give an approximate idea of how much the firm is able to repay monthly. Excessive loans can bring down a company to bankruptcy when banks eventually decide to stop lending. This causes further problems where the company suffers to settle the existing loans.
Paying tax: Governments keep track of businesses and how they make money. The tax authorities will request tax payment in cash when they discover that the profit has reached a certain threshold that is becomes liable to tax.
Working Capital Inflation: Inflation has an effect on working capital. Let’s consider a case where you have 500 items of inventories at the beginning of the year, the cost of each being $1.00 each. If the remaining stock at the end of the year is 500 but the cost has risen to $1.05 each due to the increase in price of raw material and labor caused by inflation by 5%. This is the extra cost of $25 for stock has to be put into the business in terms of cash that was earned throughout the year.

Optional payments: For this, companies have a choice to think and decide the right time to purchase and to pay. Few months could be better on cash flow than others.
Companies need to be careful not to commit to dealings below at a time that cash flow is low.
Capital expenditure: Non-current assets are purchased by cash. There are options to buy in instalments or loans thus creating a cash reserve to operate the business. Companies usually allocate a budget every year to control capital expenditure and they weigh their choices and invest very carefully as once spent, the payments are quite irreversible.  This can have a significant effect on the cash flow. For example, if an employee is hired, he has to be paid. Therefore cash is already committed to. If the company wants to acquire a building, then cash is already spent on local councils. Suppliers can be paid monthly but when deciding to buy a new property, the decision is optional and depends on management

Acquisition of other Firms: This is done by offering cash to  the other firm or buying shares. They may alternatively offer shares or loan notes in exchange to purchasing shares from a company. However, cash attracts more investors as this gives the real value as opposed to company shares that could only offer perceived value. Although cash offers are usually lower, research shows that acquisition is usually agreed by cash as compared to those issued by shares. In cases where an acquisition is made with exchange of shares, it is usually down with a part payment of cash that helps to finalize the deal. Cash acquisitions are very rare these days owing to the large sum of money that has to be settled that is also taxable by governments.
Paying dividends: They are often paid to owners and shareholders in cash. Alternatively,  some  agree  to  be  paid  with  additional shares. Paying dividends through shares helps to retain cash. Dividends are settled also to maintain confidence in the stock market. If dividends remain constant over time, then this is word of warning. If it gets lower then this is something that needs immediate action to be taken. If companies fail to settle dividends as they did as a trend for a couple of years, then this will result in shareholders selling out. Therefore dividends are considered to be compulsory payments that have to be settled mandatorily. Failure to do so exposes the company to everyone around as failing and will be losing their image, reputation and credibility

Sources of Cash
We have understood, so far, the importance of cash to run a business. Now we are going to see where cash can be obtained  from. Cash can be high only when the business is operating well. We already mentioned about the concept of high risks yielding higher returns. Therefore the more the investment and borrowings, the higher is the expected return from shareholders and bankers.

So how is cash put into a business?

1. Shareholders invest directly or indirectly into the business. Setting aside a part of the profit is an effective way to increase cash. This can be done by utilizing the profits that are gained by cash flows and saving some than to  distribute  all  amounts  as  dividends  to shareholders. Therefore by this retention, shareholders are indirectly investing more into the business. Another option is for shareholders to agree on more shares in the place of cash dividends

Shareholders may choose to buy more shares if the company  has created a good reputation for returns in the past.
Either ways, the investment of the business rises thus leading to higher returns and more cash generated.

2. From Bankers and Lenders: Here cash is obtained by borrowing in short-term such as overdraft or long-term such as bank loans. Overdrafts are charged high on interest, although bank loans can be agreed at a lower rate of interest. Long term loans should be settled at the end of the agreed term while overdrafts can be settled anytime the company has money to pay. If banks have agreed for a certain period of loan, then they cannot decide later to demand return earlier. They often agree for loans based on an asset as security.
 

A viable plan for a firm would be to retain a higher portion of non- current asset than its loan or approximately 1.5 times higher value of current assets than its current liability. This mitigates potential risk of non-payment of bank loans and keeps the business in a safe position.
Other than banks, other large companies issue debts in the form of debentures where investors can buy and sell stock as loans. If it is agreed that loan stocks cannot be redeemed, the yearly interest alone is payable. Here the cost of cash is high and also greater tendency for the company to become insolvent.

3. The underlying principle here is that the lower the inventories and debtors or the higher the creditors, the more cash within the firm. A vital factor here is the loss of opportunity when inventories are not sold. It just shows the performance of the company to be under- performing.

Another factor that plays a part on increasing cash  flow  is   by   reducing   debtor’s   payment   period. However, again if there’s competition offering longer credit periods, customers can easily balk a business and change its suppliers. Suppliers can be requested longer periods of credit. However, they may agree only if they manage to negotiate a higher price.

4. Selling a business: When a company is unable to return the loans, they tend to sell their business, wholly or partly. The hitch here is whether someone will be willing to pay a high price for what they know you want to  sell. They are at higher bargaining power and one might be in a position to sell out of compulsion. This is now acquisition takes place. The cost in selling a business is where the business stops generating cash from the part that is meant to be sold. So valuing this loss of cash is the factor that determines the price you could sell the business for.

Forecasting and Managing Cash – Inflow, Outflow and Balance Sheet
Cash of a business could be managed efficiently if a plan is strategized foreseeing the future of the firm’s growth. Owners should be able vision the future to identity what they need to do now to gain foresee potential success and mitigate risks that could hinder the way of progress.
Forecasting cash flow is a short term focus that looks at how the business could manage in case of any unforeseen financial difficulties. Although Cash management may be short term, it plays a vital role in handling a situation of crisis in the business.
Cash Flow Management is the most essential part of accounting that determines the success of a business. It is through this information that a bank could approve a loan.