With trading getting tougher, it is VERY important you take a big interest in your financial health.

Although profit is why you are in business, cashflow is even more important in the short term.  Why?

One way to value your firm is to consider the future flow of cash. Since cash today is worth more than the same amount of cash tomorrow, a valuation model based on cash flow can discount the value of cash received in future years, thus providing a more accurate picture of the true impact of financial decisions.

Decisions about finances affect operations and vice versa; a company’s finances and operations are interrelated. The firm’s working capital flows in a cycle, beginning with cash that may be converted into equipment and raw materials. Additional cash is used to convert the raw materials into inventory, which then is converted into accounts receivable and eventually back to cash, completing the cycle. The goal is to have more cash at the end of the cycle than at the beginning.

The change in cash is different from accounting profits. A company can report consistent profits but still become insolvent. For example, if the firm extends customers increasingly longer periods of time to settle their accounts, even though the reported earnings do not change, the cash flow will decrease. As another example, take the case of a firm that produces more product than it sells, a situation that results in the accumulation of inventory. In such a situation, the inventory will appear as an asset on the balance sheet, but does not result in profit or loss. Even though the inventory was not sold, cash nonetheless was consumed in producing it.

Note also the distinction between cash and equity. Shareholders’ equity is the sum of common stock at par value, additional paid-in capital, and retained earnings. Some people have been known to picture retained earnings as money sitting in a shoe box or bank account. But shareholders’ equity is on the opposite side of the balance sheet from cash. In fact, retained earnings represent shareholders’ claims on the assets of the firm, and do not represent cash that can be used if the cash balance gets too low. In this regard, one can say that retained earnings represent cash that already has been spent.

Shareholder equity changes due to three things:

* net income or losses
* payment of dividends
* share issuance or repurchase.

Changes in cash are reported by the cash flow statement, which organizes the sources and uses of cash into three categories: operating activities, investing activities, and financing activities.

The duration of the cash cycle is the time between the date the inventory (or raw materials) is paid for and the date the cash is collected from the sale of the inventory. A company’s cash cycle is important because it affects the need for financing. The cash cycle is calculated as:

days in inventory + days in receivables – days in payables

Financing requirements will increase if either of the following occurs:

*

Sales increase while the cash cycle remains fixed in duration. Increased sales increase the value of assets in the cycle.
*

Sales remain flat but the cash cycle increases in duration.

While financially it makes sense to reduce the length of the cash cycle, such a reduction should not be done without considering the impact on operations. For example, one must consider the impact on customer and supplier relations as well as the impact on order fill rates.

Now you know the differences, you should be able to sleep soundly at night

Originally posted 2008-05-09 09:50:20.