MaRS Library Manage your cash flow: Operations, investing and financing
Read time: 4 mins
Read the highlights
- Cash flow is critical to a business so you must manage your cash flow wisely.
- Cash flow stems from operations, investing and financing activities, and normally moves from negative to positive as you grow past the startup phase.
- The cash flow statement in the financial statements helps you see whether the company is growing.
- When facing multiple demands for limited cash, there are three key considerations (interest rates, penalties and borrowing covenants)—avert the worst scenario first.
Cash is the lifeblood of any business and is always in short supply. For this reason, you need to manage your cash flow to ensure that you get the maximum benefit out of it to grow your business. Cash flows stem from operations, investing and financing activities.
Cash transactions: Operations, investing and financing
All cash transactions―cash in (receipts) and cash out (disbursements)―fall into three categories: operations, investing and financing.
- Operations: Cash flows from operations. This refers to the net cash received in the form of revenue from sales or service, less cash spent on expenses of running the business.
- Investing: Cash flows from investing. This refers to cash spent on items to be used over multiple years to increase efficiency or profitability for the business (e.g., equipment, technology and investments in business relationships or joint ventures). Negative cash flows are investments in, or purchases of, these assets. Positive cash flows are divestments of, or sale of, these assets.
- Financing: Cash flows from financing. This refers to money received as debt or equity (e.g., bank loans, capital contributions from shareholders). Incurring debt and receiving contributions are shown as positive transactions. Paying off debts and paying shareholders are shown as negative transactions.
Startups and cash flow
During the startup phase of a business, it is normal to see negative operating cash flows, negative investing cash flows and positive financing cash flows. The startup will be obtaining financing cash to start the business and will be using these funds to make investments for the future of the business. There likely will be a few years of operating losses resulting in negative cash flows while the company has expenses but little revenue.
Growth-stage companies and cash flow
At the growth stage, it is normal to see positive operating cash flows, negative investing cash flows and neutral financing cash flows. The company will start generating some income and will use the resulting cash to continue investing in assets for the future of the company. These investments will likely be to a lesser extent than during the startup phase, as many earlier investments should still be used and beneficial to the company. Financing will likely be neutral as the company will require fewer injections of cash to stay afloat now that it is generating cash from operations. However, the company will likely not be repaying substantial amounts as it should be using this money to reinvest in the business.
Later-stage companies and cash flow
In later-stage companies, it is normal to see positive operating cash flows, neutral investing cash flows and negative financing cash flows. Cash generated from profitable operations can be used to repay debt and pay dividends to shareholders.
Cash flow statement
The cash flow statement in the financial statements will show net cash transactions in each category for that specific time period, which is helpful for business owners to track trends to ensure the company is moving from a startup phase to a growth-stage or later-stage company.
Allocating limited cash: Interest, penalties and borrowing covenants
Often a company faces multiple demands for its cash but has only a limited amount. There are three key considerations when deciding where to allocate the cash:
- Interest rate: Pay off the liabilities with the highest interest rates first. This sounds intuitive, but when multiple claims are being requested (with some more vocal than others), this can be overlooked. Take advantage of interest-free periods, as some suppliers may give terms of payment (30, 45 or 60 days) that are interest-free. If this is the case, make other payments first.
- Penalties for late payments: Where penalties for late payments are steep, it is crucial to pay these before the penalties are assessed.
- Borrowing covenants: When obtaining financing (e.g., bank loans), the lender may require that certain conditions (such as liquidity) be met at all times. If these covenants are broken, the lender may have the right to demand full repayment. This will mean the debt has to be classified as short-term on your balance sheet and this can negatively affect on your liquidity ratios, which may cause further breaches and problems from investors and lenders. The combined effect can cripple a business at the worst time.
Avert the worst scenario first
When allocating limited cash, if all three of the above scenarios are being considered, the worst must be averted first. This usually (but not always) means preventing broken covenants, then preventing penalties and then paying off debt with the highest interest rate. The possibility exists that if the situation is discussed with the lender, they may allow the company to break a covenant and forgo their right to collect the principal for a short period. Make sure this is approved first, but if it is, penalties and high-interest rate liabilities become the priorities.