Why does cash flow matter to the health of a business?

Cash flow makes or break a business. Positive cash flow has quickly turned struggling startups into market leaders, while negative cash flow (more money going out than coming in) has made long-established companies file for bankruptcy just as quickly.

In fact, sustained, positive cash flow is so important to the operations, stability, and growth of a business, that it’s a more significant indicator of financial health than profitability. That’s because a business may show strong profits on an income statement but still struggle to manage cash effectively, making the business more prone to financial instability.

Maintaining a positive cash flow is crucial for a variety of reasons:

• Operational continuity  with the funds to keep the business running smoothly, maintaining supplier reliability, and meeting short and long-term financial obligations to operate without interruption
• Creditworthiness  to lenders and investors who view sustained, positive cash flow as a strong indicator of financial stability, successful repayment, and future financing opportunities
• Growth and expansion  by having the funds necessary for constant reinvestment in the business, including opening new locations, researching new innovations, or launching new products and services
• Risk mitigation  by having sufficient cash reserves to overcome unexpected expenses or market downturns, while at the same time preventing debts from piling up towards bankruptcy
• Financial decision making  by monitoring cash flow in real time to understand a constantly changing financial picture and make more informed choices about spending, financing, and investing

What are the basics of modern cash flow management?

Cash flow management involves analyzing and optimizing the timely movement of cash into and out of a business, ensuring enough cash for daily operations as well as long-term needs and strategic objectives.

Cash flow management involves different departments and business functions, along with established best practices:

Cash flow forecasting

These forecasts incorporate historical data, market trends, and business projections to predict future cash inflows and outflows on a monthly, quarterly, or yearly basis. They help a company anticipate periods of cash surplus and deficit to inform strategic decisions and planning activities.

Liquidity management

A company must maintain enough liquid assets—such as cash, money market accounts, securities, bonds, deposits, or accounts receivable—to cover daily expenses and unexpected costs. To prevent cash crunches, good liquidity management also requires an adequate cash reserve, as well as access to lines of credit and short-term loans as backup liquidity sources.

Budgeting

The budgeting process incorporates revenue projections, expense estimates, capital expenditures, and other financial data into a detailed plan to help control costs and allocate resources efficiently. The process includes reporting on best-case and worst-case scenarios as an additional safeguard against unexpected cash shortfalls.

Receivables and payables management

By focusing on efficient invoicing, prompt payment incentives, and robust follow-up of overdue accounts, companies speed the conversion of sales to cash. And by strategically adjusting payment terms and methods with suppliers and other creditors, companies ensure optimal cash outflows while maintaining good supplier relationships and discounts for timely payments.

Inventory management

Excess stock ties up cash unnecessarily, while stock shortages limits cash inflows due to lost sales, so balancing inventory levels is a key cash flow management best practice. Keeping inventory levels balanced requires accurate demand forecasts, real-time inventory monitoring, and just-in-time inventory management to reduce holding costs.

What’s in a cash flow statement?

A cash flow statement is like a detailed checkbook for a business, helping decision-makers quickly see what money is coming in and going out, so they manage money wisely and reduce financial risk. It summarizes the amount of cash and cash equivalents entering and leaving the business, so stakeholders have a clearer picture of its financial health.

The consolidated cash flow statement reports on cash transactions across three main activities: operating activities, investing activities, and financing activities.

Operating activities

Cash transactions generated from core business operations that indicate whether a company has sufficient positive cash flow to maintain and grow operations:

• Cash receipts from sales of goods and services, fees, commissions, royalties, and other revenue income
• Cash payments to suppliers for goods and services, employee payroll, and operating expenses

Investing activities

Cash transactions from the acquisition and disposal of long-term assets and other company investments:

• Sale and purchase of investment securities, property, facilities, and equipment
• Loans issued and loan payments received

Financing activities

Cash transactions related to owner and shareholder equity as well as the company’s debt servicing:

• Proceeds from issuing stock shares, other equity instruments, and loaned funds
• Payments for stock and equity repurchases, shareholder dividends, and loan installments

What are cash flow statements used for?

Cash flow statements are a key planning resource for predicting future money needs and avoiding future debt and financing issues. A history of positive cash flow statements also demonstrates creditworthiness.

Banks and other investors look at cash flow statements to decide if they want to lend money to a business. Business owners and potential investors are able make more financially informed planning decisions about starting new projects, expanding the business, or needing to cut costs.

How is cash flow analyzed?

Cash flow analysis is the examination of cash inflows and outflows to gain insights into the financial health and operational efficiency of a business. By understanding where cash is coming from and where it’s going, stakeholders make more informed decisions, improve liquidity, and identify potential issues before they become critical problems.

Steps in cash flow analysis

The gathering of all relevant financial data, including past and current cash flow statements, income statements, and balance sheets is a prerequisite to effective cash flow analysis.

Once all that data is validated and accessible, the steps below are typical in a company’s cash flow analysis process:

1. Prepare a cash flow statement by categorizing the collected financial data into operating, investing, and financing activities for the time period to be analyzed
2. Analyze cash inflows and outflows across different periods of time to identify patterns and trends such as consistent time periods of cash shortages or surpluses
3. Calculate key metrics like the operating cash flow ratio which measures the ability to cover short-term liabilities with the cash generated from operations, or cash conversion cycle indicating the days between paying suppliers for inventory and collecting from customers for inventory sales
4. Review findings to determine the overall sustainability and health of a company’s cash flow, including the adequacy of cash reserves as well as identifying any new concerns or opportunities
5. Inform strategic decision-makers with recommendations and insights based on the analysis above, as well as historical and “what-if” cash flow scenario analysis

Software solutions play a central role in making cash flow analysis simpler, faster, and more robust—from automating cash flow statements and alerts to tracking key metrics in real time with visual, interactive dashboards.

How is cash flow measured?

Cash flow is measured by various formulas depending on the type of business activity—operating, investing, or financing. The results of these calculations are reported in the relevant section of the cash flow statement.

Net operating cash flow calculation

Operating cash flow (OCF) represents the cash generated or used by a company's regular business operations. There are two methods for calculating net OCF, the direct method and the indirect method:

OCF direct method calculation

All cash sales, payments, and collections received from customers

minus

All cash paid out to suppliers, employees, landlords, and other operating expenses

OCF indirect method calculation

Net income (profit after expenses)

plus

Non-cash items (depreciation and amortization) in the income statement

minus

Non-operating gains (such as from sale of assets)

plus

Non-operating losses (such as from sale of assets)

plus

Changes in working capital as follows:

minus

Increases in accounts receivable and decreases in current liabilities

plus

Increases in accounts payable and decreases in current assets like inventory

While both methods provide the same result for operating cash flow, they differ in level of detail and effort. The indirect method for OCF calculation is the more commonly used method by companies because it uses line items already calculated in the income statement and balance sheet.

The direct method delivers a clear, more straightforward view of cash inflows and outflows because it’s calculated directly from every cash transaction. However, consolidating all those transaction records is often very time and labor intensive.

Net investing cash flow calculation

Net investment cash flow

Cash inflows from the sale of investments, property, plant, and equipment

minus

Cash outflows from capital expenditures (cash spent on acquiring, upgrading, and maintaining physical assets)

Free cash flow calculation

Free cash flow

Capital expenditures

minus

Operating cash flow

Net financing cash flow calculation

Net financing cash flow

Cash inflows from proceeds from issued debt and equity as well as other borrowing sources

minus

Cash outflows from repayment of debt, repurchase of equity, dividends paid, and payments required under lease agreements

Total cash flow calculation

Total cash flow

Net operating cash flow total

plus

Investing cash flow total

plus

Financing cash flow total

How is cash flow used in different companies?

For small, midsize, and large companies alike, cash flow management plays a critical role in the financial health and overall success of a company. Across industries, cash flow is used to optimize operations, inform strategic decisions, manage risk, and ensure long-term financial stability.

Here are some examples of different cash flow management scenarios by industry:

Cash flow scenarios in manufacturing

• Timely supplier payments for raw materials and components to ensure disruption-free production or to take advantage of early payment discounts
• New machinery and technology investments to improve production efficiency and drive automation across the production line
• Production increases to ensure there’s enough stock to meet anticipated or unanticipated spikes in demand
• Plant and facility expansions to meet growing demand, compete in new markets, and reduce production bottlenecks
• Financing offers to ensure ready supply and boost sales with favorable payment terms to key suppliers and credit extensions to key customers

Cash flow scenarios in healthcare

• Clinical trial and innovation research investments to discover and develop new drug therapies and treatment protocols
• Patient care programs, including community health clinics, wellness initiatives, and financial assistance for underinsured patients
• Bulk purchasing of medical supplies and pharmaceuticals with more favorable terms like volume discounts and extended payments
• Gap funding to support clinical operations between the time healthcare services are provided to patients and reimbursed by insurers
• Medical equipment purchases and leases such as MRI machines or health information technology to support new services and improve quality of care

Cash flow scenarios in banking and finance

• Customer deposits and withdrawals across financial products creating constant and significant changes in cash inflows, outflows, and liquidity at scale
• Foreign exchange transactions with the buying and selling of different currencies as well as exchange rate fluctuations that significantly impact cash flow
• Derivatives such as futures, options, and forwards creating cash flow complexity due to different initial margins, variation margins, and final settlement payments
• Hedging instruments like interest rate and currency swaps to manage risk, creating cash flow timing impacts based on hedge and market conditions
• Merger and acquisition support requiring huge cash outflows to acquire companies and huge cash inflows to divest assets and subsidiaries

Cash flow scenarios in energy and utilities

• Energy investments in solar farms, wind turbines, and other renewables to diversify energy sources and reduce carbon emissions
• Infrastructure and technology upgrades such as implementing smart grids and updating metering, safety, and control systems
• Disaster recovery and contingency reserves to cover natural disaster and major outage responses, as well as financial and market volatility
• Energy trading agreements for purchasing and selling energy at future dates and hedging strategies to manage energy price volatility
• Regulatory compliance and remediation projects to reduce emissions, environmental impacts, and meet certification and sustainability goals

Cash flow scenarios in transportation and logistics

• Fleet expansion including truck, airplane, and ship purchases and upgrades to meet regulatory standards and improve efficiency
• Fleet maintenance and fuel costs to better manage unexpected repairs and sudden spikes in fuel prices
• Building and updating warehousing, terminal, and other infrastructure with advanced storage and retrieval systems to streamline operations
• Technology investments in green logistics software, autonomous vehicles, and drones for last-mile delivery to improve sustainability
• International customs and tariff payments due to issues like new trade policies, use of unbonded warehouses, and other unplanned cash outflows

Cash flow scenarios in retail

• Seasonal sales peaks that increase revenue but also require additional inventory and staffing costs to manage the increased demand
• Online commerce support costs including logistics costs, as well as platform and payment gateway fees to support faster cash conversion cycles
• Returns and refunds accounting, including maintaining a refund liability account to ensure sufficient cash flow when refunds are issued
• Marketing and promotional activities that increase cash outflows but drive higher sales and cash inflows in the future
• Inventory management costs to avoid excess and unsold stock that strains cash flow and may lead to inventory markdowns or write-offs

What are the benefits of optimized cash flow?

Optimizing cash flow delivers significant benefits for companies of all sizes and industries. By keeping cash flow consistent, predictable, and managed in a timely manner, companies are better able to sustain the continued financial health of the business.

Optimized cash flow also gives companies the financial space they need to plan more strategically and operate more efficiently, so they’re able to reduce cost and drive growth.

Consistent liquidity and reduced reliance on debt

Effective cash flow management ensures that the business has enough liquid assets to meet its short-term obligations, such as paying suppliers, employees, and other operational expenses. This reduces the risk of cash shortages and potential disruptions in operations. By maintaining a healthy cash flow, companies avoid taking on excessive debt or using credit lines to cover operational costs, thereby saving on interest and fees.

Informed forecasting and risk management

Continuous cash flow analysis provides insights into revenue patterns, expenses, and cash trends, so companies forecast and budget more accurately. This helps them better plan for seasonal fluctuations and invest more strategically. With a clear understanding of cash flow dynamics, companies identify potential financial issues before they become critical, allowing for proactive measures and risk mitigation.

More savings and growth opportunities

With a sustained positive cash flow, companies are able to take advantage of early payment discounts offered by suppliers, thereby reducing costs, and gaining more leverage to negotiate better terms with suppliers. Companies are also able to capitalize on growth opportunities, such as expanding operations, investing in new technologies, or pursuing market expansion with less constraints and financial uncertainty.

How can cloud ERP help optimize cash flow?

Effectively managing the business—including cash flow—is challenging when companies use disconnected systems. These systems often rely on costly manual intervention, which introduces more opportunities for even costlier errors and delays.

A robust cloud ERP solution helps companies of all sizes optimize cash flow management by automating invoicing and payment processes, providing real-time financial visibility, and offering more advanced, accurate cash flow planning and analysis.

Financial process automation

Cloud ERP allows companies to automate financial reporting across the enterprise, including reporting processes that impact cash flow such as accounts payable entry, accounts receivable entry, reconciliations, and purchasing. For example, Cloud ERP helps automate the generation, delivery, and tracking of invoices for faster payments, and automate payment collection to reduce the time it takes to receive funds. AI technology within cloud ERP not only drives this automation, it also supports powerful capabilities such as delivering financial insights and forecasting to enhance decision making.

Real-time financial visibility

It’s impossible to effectively manage cash flow in real time when financial information isn’t current or reliable. Cloud ERP supports powerful visibility across lines of business down to the transaction level, making reliable cash flow monitoring possible at any level of detail and from any view. Real-time dashboards and analytics tools in some cloud ERP offerings provide instant insight into cash positions, accounts receivable, accounts payable, and other key financial metrics.

Third-party financial integration

Cloud ERP solutions also provide full integration with third-party financial institutions. Companies are able to keep bank transactions secure and synchronized with ERP data for accurate cash position updates. And by connecting with other business systems such as CRM and e-commerce platforms, a company’s financial data flows more seamlessly, so business processes like cash flow are more streamlined and effective.

Using cloud ERP to optimize cash flow management has profound impacts on the financial health and operational efficiency of a business. By maintaining sufficient liquidity to meet financial obligations and support growth strategies, cloud ERP serves as the business backbone for sustained, positive cash flow and a stable, successful business.

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