Cash Flow

This essay covers important topics related to the management of cash flow within companies. Cash is defined as currency in corporate accounts, short term investments or commercial paper that's easily convertible to cash. A steady cash flow enables a business to pay its employees and vendors and to invest in new projects and opportunities. Companies face many risks associated with running out of cash; without a ready supply of cash, businesses cannot repay loans, provide goods and services to customers or invest in future growth opportunities. Businesses are required to file a statement of cash flow as outlined by the Financial Accounting Standard's Board Statement of Cash Flow (FASB statement 95). Trends in cash management are evolving to meet the opportunities offered by global markets and to mitigate risks associated with cash shortfalls. Emerging topics in cash management include more active methods of forecasting company cash flow. Other factors that will impact cash management forecasting include: Improved technology, centralization of corporate forecasting, tighter regulatory controls, and new statistical techniques for cash flow analysis.

Keywords Cash Flow Statement; Cash Management Forecasting; Cash; FABS Statement 95; Financing Cash Flow; Free Cash Flow (FCF); Internal Rate of Return (IRR); Investment Cash Flow; Net Present Value; Operation Cash Flow; Present Value; Regression Analysis

Finance > Cash Flow

Overview

Without the proper accounting of cash flow intake and outflow over time, businesses would be operating at great risk of coming up short on liquid capital. Having a tally of cash on-hand, what's coming in (accounts receivable) and what's going out (accounts payable), allows a business to meet expenses and plan future operations. Depending upon the size and complexity of the business operation, a firm is likely to want to project future cash flow in the short-term (12 months) or long-term (5-10 years). Small business with limited access to credit may find that they must forecast cash flow needs for a number of weeks or months. In all cases, cash flow management requires planning and projections into the future and should take into account reasonable risks that might cause a company to fall short of cash.

History of Business Cash Flow Reporting

Originally, businesses were required to file a statement of changes in financial position, or a funds statement. In 1961, Accounting Research Study No. 2, sponsored by the American Institute of Certified Public Accountants (AICPA), recommended that a funds statement be included with the income statement and balance sheet in annual reports to shareholders.

By 1963, the Accounting Principles Board (APB) had issued its Opinion No. 3 as a guideline to help with preparation of the funds statement. While the funds statement was not mandatory for many, businesses saw its value and began to use it regularly. In 1971, Opinion No. 19 (Reporting Changes in Financial Position), also issued by the APB designated the funds statement as one of the three primary financial documents required in annual reports to shareholders. The APB also said a funds statement must be covered by the auditor's report, but did not specify a particular format for the funds statement.

That flexibility came to an end in late 1987, with the Financial Accounting Standards Board's (FASB) issuance of Statement No. 95, which called for a statement of cash flows to replace the more general funds statement. Additionally, the FASB, in an effort to help investors and creditors better predict future cash flow, specified a universal statement format that highlighted cash flow from operating, investing, and financing activities. This format is still used today (Managing Your Cash Flow, 2005).

Cash flow statements provide essential information to company owners, shareholders and investors and provide an overview of the status of cash flow at a given point in time. Cash flow management is an ongoing process that ties the forecasting of cash flow to strategic goals and objectives of an organization.

This article outlines some of the most common strategies, challenges and issues related to managing cash flow. Issues and challenges include: Maintaining good customer and vendor relations while managing accounts payable and receivable, and paying close attention to the time lag between cash inflows and outflows.

The newest trends in cash management forecasting are also covered in detail. Current methods of forecasting cash flow typically involve the use of regression techniques which don't take into account many business operational variables. This essay details some of the current trends in cash flow forecasting that involve improved computer applications, new statistical methods, the centralization of the forecasting function and other significant developments.

Applications

FASB Statement 95

FASB Statement 95 Statement of Cash Flows governs the format of a business's reporting of cash flow. Statement 95 encourages enterprises to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method). Enterprises that choose not to show operating cash receipts and payments are required to report the same amount of net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities (the indirect or reconciliation method) (FASB, 2007).

The following are cash flow measurements required by the FASB:

• Cash Flow Statements: The cash flow statement acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the company's cash transactions (the inflows and outflows) during the given period.
• Cash Flow from Operating Expenses: Measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistently positive cash flow from operations. Think of "normal operations" as the core business of the company.
• Cash Flows from Investing Activities: Lists all the cash used or provided by the purchase and sales of income-producing assets.
• Cash Flows from Financing Activities: Measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases (Essentials of Cash Flow, 2005).

Cash flow from investment and financing activities are fairly straightforward as outlined by Statement 95. However, Statement 95 allows businesses to report using one of two different methods when it comes to reporting cash flows generated or consumed by operations: The direct method and the indirect method.

• The direct method reports inflows of cash (e.g., from sales) and cash outflows for payment of expenses (e.g., purchases of inventory).
• The indirect method which begins with the net income number, a mixture of cash (e.g., cash proceeds from sales) and non-cash components (e.g., depreciation) and removes non-cash or accrual items, then adjusts for the cash effects of transactions not yet reflected in the income statement (e.g., cash payments for inventory not yet sold).

However, only the direct method reports actual sources and amounts of cash inflows and outflows; the information investors need to understand to evaluate the liquidity, solvency, and long-term viability of a company.

Although the standards generally allow managers to select either method for reporting cash flows, the overwhelming majority have chosen to use the indirect method; the approach that provides the least useful information for investment decisions (Direct- versus Indirect-Method Reporting for Cash Flows, 2007).

Current Challenges to Companies Managing Cash Flow

According to Brian Hamilton, CEO of Sageworks, "Businesses don't fail because they are unprofitable; they fail because they get crushed on the accounts receivable side" (Feldman, 2005).

Companies that run short on cash have to use credit cards or lines of credit to fund operations and pay bills. Lack of cash can cause damage to relationships with vendors and banks result in missed market opportunities, and an overall hit to a company's reputation. Running short of cash can result from poor forecasting, unforeseen risks and poor internal management of cash flow. One of the biggest reasons that businesses run short on cash has to do with unrealistic expectations about how quickly cash will come in the door.

Companies need to be realistic about the length of time it will take to get paid — if one assumes payment in 30 days and it takes 60 days to get the cash, then adjustments to "cash in hand" figures need to be made. Corporations are becoming slower to pay vendors; companies want to make more of their cash which means that they are holding on to it longer. Many businesses are also revising their payables to 45-60 days instead of the previous standard of 30 days (Feldman, 2005).

The lag between the time you have to pay suppliers and employees and the time you collect from customers is the problem. The solution is cash flow management and the idea is to delay outlays of cash as long as possible, while encouraging those who owe you to pay quickly.

Creating a cash flow projection is a preemptive action that is meant to alert a business owner or management to the possibility of a cash crunch before it strikes. Projecting cash flow is not a difficult undertaking, but it does require that accurate and timely information regarding payables and receivables be documented. The following information needs to be considered:

• Customer payment history;
• Assessment of upcoming expenditures;
• Patience of vendors (terms of payment);
• Assume that receivables will arrive at a non-constant rate.

Once the above points have been considered, as accurate a figure for cash inflow and outflow as possible should be calculated.

Gather cash inflow information from salespeople, service representatives, collections, credit workers and your finance department. In all cases, you'll be asking the same question: How much cash in the form of customer payments, interest earnings, service fees, partial collections of bad debts, and other sources are we going to get in, and when?

(How to Better Manage Your Cash Flow, 2003).

Gather cash outflow information. Have a line item on your projection for every significant outlay, including rent, inventory (when purchased for cash), salaries and wages, sales and other taxes withheld or payable, benefits paid, equipment purchased for cash, professional fees, utilities, office supplies, debt payments, advertising, vehicle and equipment maintenance and fuel, and cash dividends (How to Better Manage Your Cash Flow, 2003).

Strategies

There's no question that in today's business environment, cash flow management must be a required company activity. Cash flow management means more than tracking where your dollars are, it also requires working with vendors, partners and bankers to insure that cash is always on hand.

• Set up a line of credit before you need it. Banks are not the only source of credit. Sometimes a company's suppliers are more vested in a company's viability than the bank and may extend payment terms to mitigate a cash shortfall.
• Ask your best customers to accelerate payments and offer a discount if they pay quickly.
• Ask your worst customers to pay and ask them often; offer steep discounts if they are willing to pay up.
• In many cases, negotiated agreements can be worked out with vendors; vendors are managing their cash flow too.
• Consolidate vendors and negotiate more favorable terms — this strategy will allow a company to hold on to working capital longer.

Issues

This article has reviewed some of the challenges that face businesses in managing cash flow. Organizations, both large and small, are becoming adept in cash management practices through better accounting of cash and improved customer and vendor management tactics. The global business landscape demands even greater levels of diligence in tracking company cash flow through cash flow management forecasting. The benefits of deliberate and well planned cash management forecasting cannot be overstated.

Benefits of Forecasting

Precise forecasting can help companies guarantee payments to suppliers on specific dates, allowing a company to secure better credit terms. Another benefit from cash flow forecasting is a firm's ability to optimize working capital. By tightening up payment plans and investment activities, many companies are actually able to minimize the amount of cash they need on hand. Good forecasters are adept at "extracting" cash from operations and improving cash flow. Cash management is about knowing where cash is and when it will be needed. If cash is not going to be needed right away, a savvy forecaster may be able to move cash from one investment area to another and thus create value through higher returns-while still maintaining access to the liquid funds. Another benefit to cash management involves debt. Covenants or restrictions on debt financing often require that a minimum cash balance be maintained. Violations of the covenant could lead to higher interest rates, penalties and loan terminations. Overall, good cash management can help to improve or maintain a company's financial reputation.

New Technology

Spreadsheets have been the predominant cash flow management tool for many years. Analysis of data accuracy on spreadsheets and the analysis reveals that financial data on spreadsheets is highly prone to error. Errors in reporting of company financial information sound alarm bells and makes those who are responsible for corporate compliance very nervous. Large organizations (typically early adopters of new technology) are moving to integrated financial databases such as Treasury Information Systems (TIS). Though the cost of implementation can be significant, improved efficiency and data sharing is a big benefit. Information systems can be shared across networks with multiple users accessing secure information which also makes them a superior choice to spreadsheets. Another option is a web-based treasury module that is incorporated within an ERP (Enterprise Resource Planning) system. Properly integrated treasury functions within an enterprise system can track: Account balances and transactions, cash positions, fund transfers, short-term investments and cash flow forecasts.

Centralized Forecasting

Most cash flow management to-date has been handled at a local business unit level, with each division handling cash management in their own way. The past few years have seen a significant rise in the trend toward centralized cash flow forecasting. The benefits are numerous; from a staffing stand point, it is possible to consolidate cash management personnel from across an enterprise to one central area which cuts down on personnel costs. Increased uniformity and standardization of methodologies is another benefit to centralizing cash management analysis and management. Decentralized reporting of cash flow and forecasting was often completed orally within departments. There has also been a lack of incentive for local divisions to report into a central unit, with many operating in silos. As forecasting becomes a more centralized function, companies will initiate benchmarks to monitor locally provided data and eventually will be used across units to provide incentive to managers to provide accurate and timely data for central forecasting.

Compliance

The requirements of Sarbanes-Oxley (SOX) compliance have generated more and better financial data for forecasting. The generation of more detailed and timely cash flow information was a somewhat unexpected benefit of increased compliance and regulatory laws. Compliance added significantly to the cost of tracking corporate financial data, but the careful monitoring and greater visibility of cash flow for treasury personnel has also been a windfall for increasing the accuracy of forecasting. Treasury Information Systems are becoming an essential tool for storing the growing volume of financial data. Cash flow management data can be extracted out of overall financial data, and be shared more easily. Information systems for tracking company financial data have allowed access by senior managers to data that was formerly hard to access. Integrated financial information systems allow easy access to company financial data for strategic planning purposes.

New Statistical & Economic Analyses

Most firms, to date, have used basic regression techniques to model cash flow forecasting. Regression is a useful model, but makes the assumption that the firm's business won't change over time (Germaise, 2007).

A more flexible and accurate approach to cash flow forecasting is the project-level forecast. This method forecasts cash flow patterns by project which are modeled separately rather than lumped together and reported as a firm-wide forecast. This method has the following advantages:

• Good method for modeling a small number of large projects.
• Good for modeling a changing mix of projects.
• Reveals the impact that larger projects might have on cash flow-this impact can be significant and varies by project.

Once all projects have been modeled, start dates can be estimated and project totals generated to provide a firm-wide forecast as well as the individual-by project.

Driver-based cash flow modeling is acknowledged to be the best forecasting strategy available. Driver-based models model are designed to link central business decisions and risks to financial forecasts. Business drivers are being widely used across organizations to link operational strategy with functional areas such as performance management, sales and finance. Driver-based forecasting for cash flow moved away from a purely financial model and incorporates variables that drive business.

The three main types of drivers that affect cash flow forecasting are:

• Internal: New products, new marketing strategies, expansion. Senior managers can use this information to assess if firm has financial resources to undertake internal initiatives.
• External: Factors outside firm's control such as regulatory changes or competitor price cut.
• External Macroeconomic: Also outside of firm's control such as recession, inflation, increased transportation costs.

Cash Flow at Risk (CFaR)

Cash Flow at Risk (CFaR) is defined as the likelihood that a firm will run out of cash. CFaR is just one of the modeling scenarios that define an entire universe of corporate risk and predict the chance of severe shock in an organization. The CFaR model is focused on the likelihood of risk of a disastrous event that could specifically impact cash flow. CFaR is modeled after the Value at Risk tool that is often used by financial firms to assess risk to their overall portfolios. This model can be used successfully by non-financial firms to predict the likelihood of a liquidity crisis.

Private Equity & Firm Debt

Firms financed by private equity (PE) deals as leveraged buy-outs (LBOs) typically carry a very heavy debt burden, with as much as 60%-80% debt financing. These firms are required to make substantial interest payments and even a small liquidity crunch can spell disaster for a company holding this much debt. Cash flow forecasts keep buyers informed of cash flow risk scenarios. The accuracy of cash flow models in this case is absolutely imperative for buyers to make informed decisions about risk. Multiple cash flow outcome methods should be run to insure that none is overly optimistic or pessimistic; both potentially to making financial decisions. PE managers state that accurate forecasting; along with openness to investors, are the most critical factors in managing cash flow in an LBO. It is a good idea to run cash flow models in times of economic expansion and not wait until an economic downturn; the term "forecast" implies that these models are most useful in predicting future events.

Payment Systems

Several of the trends in cash flow forecasting favor the use of electronic payments and payment cards over checks. Many companies manage cash flow on very tight schedules by holding onto cash as long as possible and encouraging customers to pay quickly. This method helps to keep a maximum of cash on hand. Being able to move funds electronically in and out of cash accounts helps firms stay on top of cash flow.

Some of the benefits are obvious and listed below:

• More timely and predictable schedule;
• More secure transactions;
• Allow for more precise forecasting;
• Can strengthen relationships between vendors/customer by allowing them to manage their own cash flows better.

Conclusion

This paper has discussed many issues related to tracking, managing and reporting business cash flow. All companies are required to submit a statement of cash flow as part of their required financial statement. FASB Statement 95 provides guidelines for reporting cash flow. A Business's Statement of Cash Flow reports cash flow in three areas: Business operations, financial activities and investing. Businesses are managing their cash flow very carefully these days. Careful management of accounts receivable and payables is essential in keeping cash on hand. Companies are negotiating better terms with vendors while creating incentives to get customers to pay up.

Businesses operate in global markets and are often open for business 24/7. Cash management forecasting is an essential function within large multinational organizations. Some best practices for cash management forecasting include:

• Technological innovation. Systems move toward an integrated TIS (treasury information system) or ERP.
• Employ driver-based forecasting; simulations or regressions.
• Payment methods. Integrate electronic payment system with customer and supplier accounts.
• Focus treasury staff's attention on analysis of cash flow variability not just data collection.
• Incorporate forecasting into operational planning. Larger firms are doing a better job and a gap is widening between large and S/M enterprises.

Cash shortfalls can be very costly to an organization. Firms that are debt-laden can easily become financially constrained and default on debt payments. Projects may be delayed and new business opportunities can be missed because there's no cash to fund them. Securing emergency lines of credit are expensive; a line of credit should be set in a time when there is no cash crunch. Lastly, having a steady, adequate and predictable cash flow is the best protection against business insolvency and failure.

Terms & Concepts

Cash: Refers to currency, checks on hand, and deposits in the bank. Cash equivalents are: Short-term investments, temporary investments (treasury bills, certificate of deposits or commercial paper). Cash equivalents can easily be converted to cash.

Cash Flow Statement: Records the company's cash transactions (the inflows and outflows) during the given period. It is one of the four main financial statements of a company. The cash flow statement breaks the sources of cash generation into three sections: Operational cash flows, investing and financing.

Cash Management Forecasting: A prediction of the amount of money that will move through an organization.

FABS Statement 95: Requires that a statement of cash flows classify cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category (FASB).

Financing Cash Flow: Measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases (Essentials of Cash Flow, 2005).

Free Cash Flow (FCF): Refers to cash that is available for distribution among all the security holders of a company. They include equity holders, debt holders, preferred stock holders, convertibles holders, and so on.

Internal Rate of Return (IRR): A capital budgeting method used by firms to decide whether they should make long-term investments. A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account).

Investment Cash Flow: Lists all the cash used or provided by the purchase and sale of income-producing assets.

Operating Cash Flow: Measures the cash used or provided by a company's normal operations.

Net Present Value: The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

Present Value: The current worth or future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

Regression Analysis: A statistical measure that attempts to determine the strength of the relationship between one dependent variable (usually denoted by Y) and a series of other changing variables (known as independent variables). The two basic types of regression are linear regression and multiple regression (Investopedia, 2007).

Table 1: The table below shows the general format for a statement of cash flow

Bibliography

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Suggested Reading

Kagan, P. (2006). Cable kings of cash flow. CableFAX's CableWORLD, 18, 14-14. Retrieved September 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23327569&site=ehost-live

Kintzele, P. (1990, February). Implementing SFAS 95, statement of cash flows. The CPA Journal. Retrieved September 27, 2007, from http://www.nysscpa.org/cpajournal/old/08209170.htm

Krell, E. (2003). BPM accelerates as short-term forecasting slows. Business Finance. Retrieved September 27, 2007, from http://www.bfmag.com/magazine/archives/article.html?articleID=13962&pg=1

Weiss, N., & Yang, J. (2007). The cash flow statement: Problems with the current rules. CPA Journal, 77, 26-31. Retrieved September 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24310856&site=ehost-live