Cash coming into a business would typically be generated in one of three main ways. It could come from the sale of equity to new or existing shareholders, and thus generating some fresh investment into the business. This would provide monies that would permanently be available in order to assist with the growth of the business. Or it could come from some form of debt. This provides the business with shorter term cash to buy specific items or to provide short-term working capital, but it does need to be repaid over time, together with interest, and this can add stress to cash flow in the business.
The third main way that cash is generated is by the sale of the products or services that the business provides. This is of course best as it provides money to be spent in the business and does not need to be repaid, and nor does it entail the dilution of capital.
However the inflow of cash is generated, it needs to cover all of the outflows that the business must pay for. This would include all the items such as manufacturing or production of your products or the buying in costs of ready finished items, staff, premises, utility and other operational costs, transport and travel, taxes, rent and rates, and all the other myriad of costs associated with running your business.
The ultimate goal of every corporate business is to generate profits, even if those profits are to be ploughed back into the business or used for good causes. If a business is not profitable then, apart from in some very rare exceptions, it will not have a long term future. In simple terms, it needs to make more money than it spends over time.
But making a profit is not enough. Many profitable businesses fail every year. What is even more important than profit in the short term is cash flow. The majority of businesses fail because they cannot pay debts as and when they fall due. Banks use two different ratios to measure this. The general and more basic one is the liquidity ratio that measures the level of liquid assets, that is cash or near cash equivalents that will be available within 12 months, against payments that need to be made over the same period. The more stringent test is the acid ratio that measures cash and near cash equivalents that are available now against all payments that need to be made over the coming months.
Income and expenditure, and the timing of these events, needs to be carefully managed and coordinated, as well as controlling the level of commitments, as the business might be very profitable, and even expanding, but if it cannot pay bills on time then the whole structure can very rapidly collapse. Maintaining a healthy cash reserve, or at least access to it in need, can make the difference between continued success or failure as there will always be unforeseen circumstances that can very quickly swallow up any reserve if it is too small.
By issuing invoices on time, ensuring that aged debtors do not get out of hand, managing and controlling any potential bad debts, and of course staying on top of all expenditure, are the best ways to ensure that cash continues to flow, and your business will grow and prosper.
12th April 2022
in British English