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What is Cash Flow Management?
Cash flow management refers to the process by which an organization maintains control over the inflow and outflow of funds. The fundamental goal of cash flow management is to ensure that the incoming flow of funds is always greater than the outgoing so that the business sits on a surplus. Cash flow management also serves the ancillary function of ensuring the surplus funds are invested or held wisely to reap optimum returns on capital blocked. Money or cash is the lifeblood of any business. When the cash stops circulating, all the critical operations can come to a standstill.
However, it is important to understand that cash flow is not synonymous with profits. A business may have positive cash flows and still be loss-making. Cash flow management must be thought of as an intervening tool between payment to vendors or banks and receipt from customers. It seeks to seamlessly coordinate the payments and receipts in a manner that the payment to vendors is possible as per their credit terms after considering the payment cycle of customers.
The ultimate goal of cash flow management is to ensure that the business does not run into cash shortages. A business must not be overdue in payments to creditors. Similarly, it must not have long-standing debtors on its books. The emergence of such cases is a signal for the cash flow manager to take charge.
Importance of Cash Flow Management
As per a research study conducted, 82% of the businesses fail due to poor cash flow management. This statement alone suffices in emphasizing the importance of good cash flow management. However, let us evaluate more deeply how a good cash flow management system aids in operational success.
Solvency and Credit Worthiness
Positive cash flows please bank and financial institutions. A positive cash flow means the business enjoys steady and predictable cash flows. Banks prefer extending credit to such borrowers. The payment of the next installment is certain and reliable. Not to mention, the cash flow health also contributes to the credit score affixed on a company. Companies with an impressive credit rating will be in a better position to raise funds from the open market or seek foreign investment. It is noteworthy how mere management of cash at the operating level can be leveraged to fetch such humongous benefits.
Enabling Capex and Investment
The crux of a good cash management lies in maintaining positive cash flows over time. The theory advocates that the inflow should always exceed the outflow to sit on a surplus. Instead of being kept idle, these surplus funds could be invested to reap returns. This would be a classic case of “letting your money make money for you”. Furthermore, a business that regularly invests and sets apart a sum would also be able to incur a capex purchase. And all this just from efficient cash management! A good cash flow management system thus, also lifts the pressure off the funds flows from operating activities to purchase capital expenditure.
Boosts Vendor and Employee Relations
An efficient cash flow management system ensures funds are always at the disposal of the manager. By timing the receivable and payables perfectly, a business will always be in a position to honor the vendor obligations on time. A business paying up on time is successful in building a relationship of trust with the vendor. It will also be possible to negotiate better credit terms with a satisfied vendor.
Additionally, an efficient cash flow management ensures timely disbursement of regular expenditure such as salaries. Regular salaries keep the employee morale high and they are less prone to ditch the employer for better opportunities elsewhere. Better control over cash movement also keeps the cases of petty theft and embezzlement under check.
Cash Flow Indicators
The EBITDA is used as an indicator of financial health and earning potential of a business. It represents the raw earnings by eliminating the leverage and tax expenses involved. The elimination of tax, interest, and depreciation creates an even playing field. Though this may seem to be a vague number, it facilitates peer to peer comparison of organizations. It is, therefore, possible to judge a business purely on its core competencies.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
The EBITDA is indicative of the operating efficiency of the business. This formula indicates the earnings generated with the core activities before taxes and interest are bought into the picture.
Free Cash Flow to Firm is indicative of the cash available with the business after having met external obligations. It is generally used to determine the ease with which the business can pay the dividend to its shareholders and cover its fixed debt servicing charges. The FCFF is also an important variable when it comes to valuation of the business- it is discounted to arrive at the present value of the future cash flows.
FCFF = Net Income + Non-Cash Charges (Depreciation) + Interest X (1 – Tax Rate) – Long-Term Investments – Investments in Working Capital
The FCFF is a very important indicator of the firm’s financial health. Unlike EBITDA It accounts for the tax and investments. Thus, revealing in a true sense the profitability of the firm.
Free Cash Flow to Equity, as the name suggests is the cash available to the equity shareholders after payment of all expenses and debt service charges. Dividends indicate the actual outflow of cash to shareholders. On the contrary, FCFE indicates the pool of cash available at the disposal of shareholders. FCFE is similar to Earnings per share in the sense that both indicate the final amount attributable to the shareholders.
A significant point to be understood is the addition of borrowings to FCFE. The borrowings, though a debt, represents an inflow of cash that would be used for furthering the objects of the business. The spend of this amount remains at the discretion of the equity shareholders. It is thus appropriate to include cash flow from debt in FCFE since it forms a part of the total pool of cash dispensable with the owners.
FCFE = Net Income + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
There is an important point of distinction between FCFF and FCFE. FCFF indicates the cash available to all the providers of capital to a firm. That is, equity and debt sources of funds are put in the same bracket. On the other hand, FCFE indicates the cash available only to the ownership (or equity) of the firm.1–3