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Christopher Williams
Business Studies
Monday, 11 November, 00
Q. Explain the meaning of cash flow and why it is often referred to as the lifeblood of the business.
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Finance is the art and science of managing money. Cash flow is a major characteristic of finance and can be described as the coming in and going out of cash over a specific period. Cash is needed to assist in covering day to day expenses of a business. Various forms of cash exist including notes, coins and cheques which may be in the form of petty cash or money held in a bank account.
Negative cash flow occurs when a firm depletes all the funds in their account and need to use an overdraft facility. Positive cahsflow would describe a situation where the firm has money in the bank available to meet current expenses. Not only does cash need no be managed efficiently but poor cash flow management leads to the winding up (ceasing of operations) of a business.
Cash coming into the business is called cash inflow and its manifested in various forms. Startup capital is cash gathered by the proprietor in the initial stages of the business in order to start it. Loans, another form of cash inflow, provide quick and easy access to finance to supplement the proprietors capital. Sales receipts constitute a major form of cash inflow where the firm sells its assets (e.g. stock).
Cash leaving the firm via different means is known as cash outflow. The firm pays out for assets, wages to employees and money for repairs. Also through utility bills and advertising cost, money leaves the business. This is also true if the firm is repaying a loan. For example, a business may borrow $1000.00 from the bank and repay at $100.00 per month for twelve months. The one hundred dollars leaving every month is considered cash outflow.
In respect to the human body, an appropriate blood amount level is needed in order to assist in the well being of the body. It is the same with a business; the business needs to calculate the appropriate cash level the business must hold at any point in time. A body with a higher than required blood level, causes severe heart complications causing the person to be constantly ill. Similarly, a business holding too much cash becomes vulnerable to many negative consequences. Holding too much cash over a period of time may results in loss of purchasing power as a result of inflation (a general increase in prices). It also leads to a loss of interest that could have been gained by investing it. Opportunity costs (forgoing the alternative use of the resource) may be higher causing the firm to lose out on otherwise profitable investment opportunity.
Someone with a lower than appropriate blood level experiences negative side effects such as dizziness, frequent fatigue and general instability. A business however, is no different. Holding too little cash will lead to a shortage in working capital. Working capital is the money needed to meet day-to-day expenses of the business. If the firm does not have enough money to meet its day-to-day expenses it cannot meet its creditor's demands. This may cause suppliers to refuse to sell their goods on credit, unpaid employees to stop working or utility companies to discontinue their service. It may also result in expensive borrowing rates, as in the previous example of 0%, because of high borrowing.
These cash flow problems may be caused by various factors. Overtrading occurs when business operations (sales) increase faster than the cash being received for them. Sometimes its due to a business allowing too many goods to be bought on credit or repaying high interest loans as a result of high borrowing levels. These situations result in the business inability to pay creditors because of restricted cash. Some firms rely on seasonal trade receiving inconsistent cash inflow leading to periods of cash flow problems.
A short term solution to a firm experiencing cash shortage is to borrow money from banks, venture capitalists or extend credit from creditors. Some businesses use the overdraft facility provided by banks. They are allowed to borrow a specified amount over what they actually have in their account. Otherwise the firms current liabilities become greater than its current assets and resulting in it becoming technically insolvent. It will wind up (or liquidate which refers to selling off all assets to repay creditors) and discontinue operations.
In the long run a firm has to develop proficient cash flow forecasting. This allows the business to prepare in advance for deficit or difficult cash flow periods. Appropriate measures must be put in place to ensure that cash flow is at optimum level by training and developing a specialised unit for this purpose.
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