The Cash Flow cycle

Basic principles exist in the area of finance. One is that a company finances and operation are integrally connected. Company activity, method of operation and competitive strategy all fundamentally shape the firms financial structure. The reverse is also true: decisions that appear primarily financial in nature and significantly affect operations e.g. the way the company finances its assets can affect the nature of the investments it is able to undertake in the future.

A cash flow production cycle can be drawn up that illustrates the close interplay between operations and finances.

For simplicity suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets and is now ready to begin operations. To do so the company uses cash to purchase Raw materials and hire workers, with these inputs, it makes the product and stores it temporarily in inventory. When the company sells the item, the physical inventory is back to cash. If cash sales it happens immediately, otherwise, cash is not realized until some later time when the account receivable is collected. This movement of cash to inventory, to acc receivable and back to cash is the firms operating or working capital, cycle.

Another ongoing activity is investment. Over a period of time, the company fixed assts are consumed in the creation of products. It is as though every item passing through the business takes with it a small portion of the value of the fixed assets. The accounting for this is by continually reducing the values of the fixed assets and increasing the value of the merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity, the company must invest part of its received cash in new fixed assets. The objective, always, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that was initiated with.

The discussion is complicated by including accounts payable and expanding the use of debt and equity to generate cash. But two basis principles must stand out:

1. financial statements are an important window to reality. A companies operating policies, production techniques, inventory and credit control systems fundamentally determine the firm’s financial profile. If for example, a company requires quicker payment on credit sales, its financial statements will show a reduced investment in accounts receivable and a change in its revenues and profits. This linkage between company operations and finances is our rationale for studying financial statements. We have to understand company operations and predict the financial consequences of changing them.

2. profits don’t equal cash flow. Cash and the timely conversion of cash into inventories, accounts receivable and back to cash, is the lifeblood of any company. If this is severed or disrupted, insolvency can occur. Yet profitability is no assurance that its cash flow will be sufficient to maintain solvency. For example a company may loose control over its accounts receivables by allowing customers more and more time to pay or the company consistently makes more merchandise that it sells.

Then although the company is selling at a profit, its sales may not be generating sufficient cash soon enough to replenish the cash outflows required for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. Factoring and a factoring company assist in managing this type of risk. Another example is when a company is managing its inventory and receivables carefully, but rapid sales growth is necesating an ever larger investment in these assets. Then although the company is profitable, it may have too little cash to meets its obligations. The company is literally “growing broke”. Factoring assists in matching the rapid sales growth by pumping money into financing further inventory and receivables at the same rate as the company is growing. So it may never “grow broke”.

That is why an entrepreneur must be concerned at least as much with cash flows as with profits.