Wall Street analysts traditionally relied on indicators such as profits and operating earnings to signify the condition of a company’s health. With the downturn and reduction in corporate profits, analysts are now paying more attention to cash flow statements rather than just the traditional income statements and balance sheets. This has put quality of corporate earnings and managing the cash flow trail under increased scrutiny.

Cash is the lifeblood for companies, and flows into, around and out of a business. Ideally, a company’s operations should generate an excess of cash internally, while its investing and financing activities should support its expansion plans. Consequently, a self-sustaining business generates positive overall cash flow, and can pay down its debt and liabilities.

Cash Flow vis-à-vis Income

Profit is an important aspect of the performance of the business, but the generation of a profit alone does not necessarily guarantee its survival. Income differs from cash flow because revenues and expenses are measured on an accrual basis. The accrual basis of accounting typically recognizes revenue when a firm sells goods or renders services, and not when the cash is actually received from its customers, which happens later than the date of the sale.

If a firm recognizes revenue in a period before it collects the actual cash, it may need to make adjustments to its income. The cash inflow for the company will therefore be lower, as depicted in the following instances:

Uncollectible Accounts: If a company is unable to collect some portion of its sales, it will incur lower cash inflows than the revenue numbers suggest.
Sales Discounts and Allowances: In the case of discounts for prompt payment by customers, the company will receive less cash than the stated sales price.
Sales Returns: Customers may return goods. Again, the company will eventually receive cash in an amount smaller than the original sales price.
Delayed Payments: Often companies permit customers to delay payments but make no provision for explicit interest charges. The company will receive the cash later than expected, and miss out on opportunities to invest that cash into its operations.

Due to such discrepancies, companies are mandated to prepare a Statement of Cash Flows. This Statement clearly specifies the cash situation of a company, and enables an assessment of the company’s liquidity situation. This is an important analysis as most businesses go under due to lack of cash, rather than want of profits. The cash flow statement gives a clear indication of the company’s health and its ability to sustain, survive and lead.

Analysts also look for a relationship between cash flow and net income change over time. With this, analysts can determine if there has been a change in business conditions, or in the company’s accounting policies and estimates.

Working Capital

Working capital is the cash that companies use to fund their operations. In essence, working capital is the net of the cash flows that occur within the working capital cycle, in and out of operations.

A certain investment in working capital is necessary for a company to run its normal operations. For example, a company’s credit and distribution policies determine its optimal level of receivables. The nature of the cash production process and the need for buffer stocks determine the optimal level of inventory. And, as accounts payable is a routine source of financing for a company’s working capital, payment practices in the industry determine the normal level of accounts payable.

With adequate working capital management, companies can fund research, acquisitions strategy, company shares buyback and dividend programs, in addition to just funding operations. Thus, working capital is not only a driver of operations and balance sheet data, it is also a driver of revenue, expenses, cash flow and customer service.

A company’s net investment in working capital is a function of its credit and collections policies (receivables), payment policies (payables etc.), and expected growth in sales (inventories). In interpreting a company’s cash flow from operations after working capital, it is important to keep in mind the firm’s growth strategy, its industry characteristics, and its credit policies.

Cash Flow: The Crystal Ball for Future Performance

Now that the economy has slowed down, the cash flow statements of publicly traded companies are receiving increased scrutiny to find indicators for future risk to the company’s health.

The cash flow statement pulls data from the income statement and balance sheet, along with some other items. The cash flow statement tracks the cash coming in and flowing out of a corporation, and is organized in three parts:

Cash from Operating activities. This alerts analysts of declines in future sales and earnings. Among other things, analysts use this information to sniff out signs of operational issues, for instance difficulty selling off inventory or collecting receivables.
Cash from Investing activities – returns on investments and/or capital expenditures. Analysts focus on the changes in the company’s capital expenses and returns on its investments from year to year.
Cash from Financing activities – cash infusion from banks and shareholders. Analysts concentrate on finding out if the company is having any troubles getting new financing from the debt and the equity market.

Illustrations of how the Statement of Cash Flows shines light on future performance:

Generally, companies record the revenue that drives earnings when customers receive the merchandise, but before they pay for it. The Statement of Cash Flows reflects how much cash is actually collected. So, if earnings soar, but cash collections stall, a red flag goes up that future earnings could be at risk of bad debt.
At the heart of “Cash from Operating activities” are changes in current assets and liabilities. Accounting experts pay much attention to accounts receivable – what customers owe the company. When receivables rise at a faster pace than sales, the company may be having trouble collecting what it is owed. Since cash isn’t flowing in as it should be, a rise in receivables shows up as a negative number on the cash flow statement. In such cases, companies end up running a surplus in “Cash from Finance activities”. This is an acceptable practice for fast-growing businesses that can reach profitability in a foreseeable time-frame. However, if the financing is from selling assets, it is a clear indication of operations that hemorrhage cash.
Another cash flow indicator that can signal an unhealthy company is a faster growth of inventories than increase in sales. This situation results in reduced cash inflow and can indicate weak demand. Also, if accounts payable increase, then cash balances with the company increase. By delaying payments to creditors, a company can free up cash.

Importance of Cash Flows in Business Planning, Budgeting and Forecasting

While profit is a vital indicator of the performance of a business, the generation of a profit does not necessarily guarantee the company’s development, survival or leadership. Adequate cash balances enable a company to have more flexibility in implementing its strategy. Thus, when planning and budgeting for business expansion, it is more important for the company to forecast likely cash requirements in working capital than to project profitability and market share.

Sales revenues, the costs involved and the profits from them, do not necessarily coincide with associated cash inflows and outflows from the sale. While the sale may have been secured and the goods delivered, the related payment may get deferred, or may not happen. The net result is that cash receipts often lag behind cash payments and, while profits may be reported, the business may be experiencing cash shortfall. Given such uncertainties, it is important for the company to have a good sense of cash flow when planning and making forecasts.

Companies need a budgeting system that allows them to incorporate actual cash flow data with projection assumptions, and that can be tracked and altered as business conditions change. The budgeting system should allow users to easily revise budget targets and to quickly determine how those revisions will affect overall corporate performance. Companies should then consistently communicate changes in cash inflow and outflow within their organizations in order to create a trickle-down effect in all aspects of planning, including setting targets, strategy and tactics.

Cash Flow Management: Gaining a Grip on the Working Capital Cycle

Effective cash flow management means controlling cash inflow and outflow factors so that the business always has sufficient cash resources to meet its financial obligations and to generate profits. As internal working capital is the best and most accessible source of cash, improving cash flow processes around receivables, payables and inventory, can result in both better control of working capital and also a better cash position.

Many companies are focusing on receivables – one of their largest untapped cash resources. Faster billing, proactive collections follow-up, proper dispute resolution, reduction of claims/chargebacks and bad debt, as well as improving A/R staff efficiency, are top agendas for CFOs today.

Likewise, gaining better control of payables, reducing the cost of A/P operations and increasing days payable outstanding, without straining supplier relationships, is a priority in companies aiming to optimize working capital.

Most financial managers use Key Working Capital indicators, like inventory turnover, days sales outstanding, days payables outstanding, current ratio, quick ratio, days working capital, etc., to get quick indications of cash flow performance.

But, beyond DSO, DPO, DWC etc., financial executives seeking to improve corporate health require answers to a number of important questions, for instance:

How is the company’s internal cash flow generated?
Is cash flow from operations positive or negative? If negative, is it because the company is growing, or is the company having receivables collection problems?
Can the company meet its short-term financial obligations, like interest payments and payables, from operating cash?
How much cash is the company investing in growth? Does the company utilize internal cash flow to finance growth or rely on external financing?
Does the company pay dividends from internal, free cash flow, or does it have to use costly external financing resources?
What type of external financing does the company rely upon – equity, short-term debt, or long-term debt?

In order to critically analyze such areas, the executives require a sophisticated and efficient method of dealing with all of the financial and accounting data stored in their systems. They also need the ability to track and compare key performance indicators over time to identify trends and drive better business decisions.

Just as supply chain software solutions have automated the physical supply chain to help plan, forecast and manage inventory, cash flow management solutions can automate financial supply chains around receivables and payables to more effectively manage cash flow cycles. Leading solutions can deliver state-of-the-art functionality for effective and integrated management of cash flow. And companies focusing on improving working capital and cash flow management are increasingly adopting these solutions to improve financial performance.

The best cash flow management solutions help CFOs manage the invoice-to-cash cycle by automating receivables portfolio analysis, collections, deductions management, as well as the procure-to-pay cycle, automating payables portfolio analysis, supplier management, electronic settlements and payments, and back-end procurement and expense management.

Conclusion

In the current economy, keeping an accurate pulse on cash flow is a key element of success. Early and accurate forecasts of working capital requirements can help companies better plan for their operational needs and avoid cash flow surprises that can have the potential to result in the collapse of the organization.

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Veena Gundavelli was the founder and CEO of Emagia Corporation, a leading provider of cash flow management solutions that streamline and automate cash flow processes for Fortune 2000 enterprises. Emagia solutions allow companies to realize significant benefits including maximizing cash conversion efficiency, facilitating strong internal controls for financial reporting and improved returns from cash flow management. World-class enterprises use Emagia solutions to strengthen and accelerate corporate initiatives around cash flow management, Six Sigma, shared services, and Sarbanes-Oxley compliance. Emagia products seamlessly integrate with SAP, Oracle, PeopleSoft, Baan, JD Edwards, Geac, BPCS, QAD/MfgPro and other back-office financial systems. Emagia software solutions can be deployed using standard enterprise license models as well as its unique hosted offering.