Effective cashflow management is critical to any businesses survival and growth. Understanding your businesses underlying cashflows will help identify potential changes to your business processes that will improve cashflow, profitability and business value

A firm's ability to reliably spin-off positive cashflows from the firm's routine business operations is one of the key factors business owners and potential investors look for.

Cashflow Defined

Cashflow is typically defined as the net change in your firm’s cash position from one accounting period to the next. If you generate more cash than you consume, you have a positive cashflow. If you have greater cash outflows than inflow, you have a negative cashflow. Thus, your cashflow is a key indicator of a firm’s financial health.

Understanding Your Cashflow Statement

Operating cashflows illuminate a company's true profitability. It's one of the purest measures of cash sources and the use of cash within a business and is the launching pad for complementary financial statements and reports.

Operating cashflow is a fundamental part of your cashflow statement. Your cashflow statement illustrates the fluctuations in cash compared to less volatile equivalents such as shareholders' equity and the balance sheet.

Your cashflow statement details both where cash is being generated and consumed in the business over a set period of time.

By taking the net income figure from the firm’s income statement and adjusting it to display variations in the firm’s working capital defined as payables, receivables and inventories as reflected on the balance sheet, the firm’s operating cashflow line item illustrates the sources of cash spun off during the reporting period.

Cashflow Sources

A business’ sources and uses of cash are typically split into categories covering operations, investments and financing activities.

1. Operations: Reflects a firm's operational cash inflows and outflows, the net effect of these defines a firm’s operating cashflow position
2. Investments: Shows changes in the businesses’ cash position from the divestment or acquisition of property, plant and equipment or other typically longer-term investments
3. Finance: Captures changes in cash levels from the share buyback schemes or bond issues, together with interest payments and dividend distributions to shareholders.

Operating Activities

A firm’s operating activities comprise its routine core commercial activities within the business that generates cash inflows and outflows. These operating activities typically include:

1. Sale of goods and services recorded during an accounting period
2. Supplier payments covering goods and services consumed during the production of outputs recorded during an accounting period
3. Employee payments or other expenses incurred during an accounting period.

To establish the significance of underlying material changes in a firm’s operating cashflows, it is useful to be familiar with just how a firm’s cashflow is estimated. Two models are generally used to tally cashflow generated by operating activities. These are the Indirect and Direct models.

Direct Method: Uses information derived from the income statement based on cash receipts and cash outgoings generated by the businesses’ operations.

Indirect Method: Adopts the firm’s net income and derives its OCF by incorporating those line items used to determine the firm’s net income but which did not affect the firm’s actual cash position.

Operating Cashflows

Your operating cashflow is a very useful assessment tool as it assists business owners to understand the firm’s fundamentals. For many owners, the OCF position is considered to be the cash component of net income, as it purges the firm’s income statement of non-cash related items and non-cash based expenditure such as amortization and depreciation and changes to the firm’s current assets and liabilities position.

Operating cashflows is a more accurate indicator of underlying profitability than measures of net income, as it is less open to massaging the operating cashflows to window dress profitability.

Cashflow As A Business Diagnostic

A cashflow statement is much more than simply a snapshot of your business’ financial health. They can also be used as a powerful management tool to affect positive change within your organisation.

Business owners can use a cashflow statement to evaluate their firm’s strengths and weaknesses, helping them to chart a savvy and more efficient path forward. Used the right way, a cashflow statement can show an owner how efficiently the business is harnessing its cash while identifying which areas are absorbing more cash than they generate.

This information can be critical to ensuring the firm’s survival while providing a point of focus for growth initiatives. Cashflow is also a useful indicator of how efficient an internal business process is and how dynamic a firm’s products or services are.

By identifying changes to a firm’s internal business processes that will improve the firm’s underlying cashflow, profit, and business value, a business owner can drive innovation, lift productivity and effectiveness levels and cull under-performing products.

When a firm enjoys robust operating cashflows with more cashflowing in than flowing out, the owners know they have a healthy business. Companies with solid operating cashflow growth are more likely to enjoy predictable net income levels, together with an enhanced ability to pay suppliers and reinvest in the business.

Robust operating cashflow also provides more opportunities to expand the business and to cope with fluctuating economic conditions, turbulence in their industry or adverse weather events.

Final Observation

A firm’s operating cashflow is simply one aspect of a firm's cashflow position. Cashflow is also one of the most insightful measures of a firm’s financial viability, underlying profitability and its long-term prospective outlook. Cashflow measures a company’s incoming and outgoing cashflows over a nominated accounting period. Cashflow is also a useful tool for identifying inefficient processes and under-performing products or services. If you truly identify with the "Cash is King," mantra, then robust operating cashflow is one of the most reliable key indicators to look for when assessing a firm.