Cash is King- The Importance of Cash Flow Management

January 1, 2011
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Operating any business in today’s economic environment means managing cash flow. Companies looking only at their earnings and not managing cash flow cannot and will not survive in today’s economy where short term operational loans are not often readily available. This edition of the ACA newsletter is dedicated to understanding the importance of managing cash flow. This article explains the evolution of cash flow management in business operations and addresses some key concepts related to cash flow. In related articles this author along with his ACA associates provides some useful suggestions for improving cash flow through: inventory reduction, better supply chain management, and the use of consignment inventories.

“Cash is king” is an expression often used today by the media and financial experts in analyzing a business or financial investment. It refers to the importance / necessity of generating cash from a business or investment. But what does cash flow mean in terms of managing day to day operations?

For years companies have managed their businesses using traditional financial statements like the Balance Sheet and Income Statement. With these two reports businesses could define the health of their companies by simply capturing the business transactions of the current period, and comparing the results to historical results or budgeted targets. Based on these results, companies would make changes to their operation to improve the results and meet their targets. This type of reporting came under the heading of GAAP, Generally Accepted Accounting Practice, which is widely accepted as the way to manage a business enterprise.

Beginning in the 1970’s however, we began to see significant periods of inflation. Business managers realized that even though their companies were sound “on paper”, meaning they had sufficient earnings to pay dividends to their stockholders, and encourage investment in their companies, often there wasn’t enough cash generated from operations to pay their suppliers, employees, and other monthly expenses. Because these costs sometimes exceeded the revenues in a given period, companies often found themselves short of cash and had to borrow money to operate on. As a result a new financial report called a Cash Flow Statement evolved.

With cash flow accounting we are only concerned with transactions that affect the change in cash from period to period. Cash flows into and out of the business from operations, investing, and financing activities. From an operations standpoint, cash flows into the business from the receipt of payments from our customers. Cash flows out of the operation from payments for material, labor, and overhead used in the production of goods (COGS). Any effort to defer these costs has a favorable affect on cash flow. More important, any effort to accelerate the throughput of goods through the value chain improves cash flow. By increasing throughput we decelerate the flow of cash out of the business and accelerate the flow of cash back into the business which is a key principle of Lean operations.

To illustrate: Say a company buys 6 months supply of material. The transaction is posted on the Balance Sheet as an asset, under Inventory and as a liability under Accounts Payable. When any portion of this material is consumed it is reported as Cost of Goods Sold, on the Income Statement, deducted from Inventory and posted to Accounts Receivable on the Balance Sheet. But, when we pay for that material 30 days later we are paying for the full 6 months supply which is an expense incurred in that month against Accounts Payable and an outflow of cash for the period of that expense. It doesn’t matter that we carry this inventory on the books as an asset; the cash has already been spent.

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To learn how to better manage your cash flow:

Read Lisa Anderson’s excellent article Accelerating Cash through Supply Chain Improvement, which addresses some ways in which to accelerate cash through supply chain improvements. Lisa suggests three specific areas to concentrate on: 1.) better supply chain inventory management, 2.) supply chain collaboration, and 3.) re-evaluation of your customer base. To read Lisa’s full article click here.

And, read Doug Howardell’s article Increase Cash Flow by Reducing Inventory, in which he points out that: “More companies fail for lack of cash than from lack of profit”. One of the largest drains on a manufacturing company’s cash is inventory. Reduce inventory and you will increase the amount of cash available to run the company. To read Doug’s thought provoking article click here.

To learn how to improve cash flow with consignment inventory, click here for Jim Strong’s article “Improve Your Cash Flow with Consignment Inventory”.

For more on how to improve cash flow please contact Jim Strong at JS@theACAgroup.com.

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