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Cash flow is a term used in business finance that refers to the net amount of cash and cash-equivalents moving in and out of a business. It is a measure of a company's financial health and its ability to generate positive cash flow, which is essential for business operations, paying off debts, returning money to shareholders, investing in new opportunities, and ensuring a buffer against future financial challenges.
There are three types of cash flows:
Cash flow and profit are both important financial metrics for a business, but they measure different things. Profit is the revenue remaining after deducting all costs and expenses related to generating the revenue. It is calculated on an accrual basis, meaning it includes revenue earned but not yet received and expenses incurred but not yet paid.
On the other hand, cash flow measures the actual cash generated or used during a specific period. A company might be profitable but have a negative cash flow if it has not yet collected its receivables or has high investment activities. Conversely, a company could have positive cash flow while not being profitable if it is collecting receivables or selling off assets.
Calculating cash flow involves subtracting the total cash outflows from the total cash inflows. The formula is as follows:
Cash Flow = Cash Inflows - Cash Outflows
Cash inflows can come from sales, loans, and investments, while cash outflows can be from expenses, loan repayments, or purchases of assets.
Cash flow is crucial for a business for several reasons:
In simple terms, cash flow is the money that is moving (flowing) in and out of your business in a month. Although it does seem sometimes that cash flow only goes one way - out of the business - it does flow both ways.
Cash is coming in from customers or clients who are buying your products or services. If customers don't pay at the time of purchase, some of your cash flow is coming from collections of accounts receivable.
Cash is going out of your business in the form of payments for expenses, like rent or a mortgage, in monthly loan payments, and in payments for taxes and other accounts payable.
Cash flow is directly tied to the three financial statements of a business: the income statement, the balance sheet, and the cash flow statement. The income statement shows the profitability of the company, which may result in cash inflow. The balance sheet shows the company's assets, including its cash and cash equivalents. Lastly, the cash flow statement provides a detailed look at the company's cash inflows and outflows over a period of time.