Cash flow is the movement of money into and out of a business over a given period. It measures the actual cash generated and spent, as opposed to the profit or loss reported under the accruals basis of accounting. A business can be profitable on paper yet fail because it runs out of cash – making cash flow management one of the most critical aspects of running a company.
Under FRS 102 (Section 7), qualifying UK companies must prepare a cash flow statement as part of their annual financial statements. Small companies may claim exemption from this requirement, but cash flow monitoring remains essential regardless of size.
Types of Cash Flow
Cash flows are classified into three categories in the cash flow statement:
| Category | What It Covers | Examples |
|---|---|---|
| Operating activities | Cash generated from day-to-day trading | Receipts from customers, payments to suppliers, wages, rent |
| Investing activities | Cash spent on or received from long-term assets | Purchase of equipment, sale of property, acquisition of a subsidiary |
| Financing activities | Cash from or repaid to funders | Bank loans drawn down, loan repayments, dividends paid, share issues |
Operating Cash Flow
Operating cash flow is the most important category because it shows whether the core business generates enough cash to sustain itself. A company with consistently negative operating cash flow will eventually need external funding or face insolvency.
The operating cash flow figure is derived by adjusting the operating profit for non-cash items and changes in working capital:
| Adjustment | Effect |
|---|---|
| Add back depreciation and amortisation | Non-cash charges that reduced profit |
| Decrease in trade debtors | Cash collected faster than revenue recognised |
| Increase in trade debtors | Cash collected slower than revenue recognised |
| Increase in stock | Cash tied up in unsold inventory |
| Increase in trade creditors | Delayed payments preserve cash |
| Decrease in trade creditors | Faster payments reduce cash |
Investing Cash Flow
Investing activities typically show a net outflow for growing businesses, because expenditure on new assets exceeds proceeds from disposals. A company that consistently shows net investing inflows may be selling off its asset base, which is not sustainable.
Financing Cash Flow
Financing cash flows reflect how a business funds itself. Drawing down a new loan creates an inflow; repaying capital creates an outflow. Dividends paid to shareholders are also classified here.
Cash Flow Versus Profit
Profit and cash flow differ because of timing differences and non-cash items:
| Item | Effect on Profit | Effect on Cash |
|---|---|---|
| Credit sale made | Increases revenue immediately | No cash until the customer pays |
| Depreciation charged | Reduces profit | No cash movement |
| Stock purchased for cash | No effect until sold | Immediate cash outflow |
| Loan received | No effect on profit | Cash inflow |
| Loan capital repaid | No effect on profit | Cash outflow |
| Prepaid expense | Recognised over time | Cash paid upfront |
A common scenario in UK businesses is rapid growth leading to a cash flow squeeze. Revenue and profit increase, but cash is consumed by rising stock levels and unpaid invoices, leaving the business unable to pay its own suppliers.
Positive and Negative Cash Flow
| Status | Meaning | Implication |
|---|---|---|
| Positive cash flow | More cash coming in than going out | Business can meet obligations, invest, and build reserves |
| Negative cash flow | More cash going out than coming in | Business may need to borrow, raise capital, or reduce spending |
Short-term negative cash flow is not necessarily a problem – a large equipment purchase or seasonal trading pattern can cause temporary outflows. Persistent negative operating cash flow, however, signals fundamental issues.
Monitoring Cash Flow
Cash Flow Forecast
A cash flow forecast projects expected inflows and outflows over a future period, typically 13 weeks or 12 months. It is an essential management tool for:
- Identifying periods when cash may run short
- Planning the timing of major payments
- Deciding when to draw on overdraft or credit facilities
- Supporting loan applications (lenders routinely request forecasts)
Key Metrics
| Metric | Formula | Purpose |
|---|---|---|
| Cash conversion cycle | Stock days + Debtor days - Creditor days | Measures how quickly trading activity converts to cash |
| Operating cash flow ratio | Operating cash flow / Current liabilities | Assesses ability to cover short-term obligations from operations |
| Free cash flow | Operating cash flow - Capital expenditure | Cash available after maintaining the asset base |
Improving Cash Flow
UK businesses can improve cash flow through a combination of measures:
Accelerating inflows:
- Invoice promptly and chase overdue debts
- Offer early payment discounts
- Require deposits or stage payments for large orders
- Use invoice factoring or discounting facilities
Managing outflows:
- Negotiate extended payment terms with suppliers
- Lease rather than purchase assets
- Time capital expenditure to align with available cash
- Spread tax payments using HMRC’s time-to-pay arrangements
Reducing working capital:
- Hold lower stock levels through just-in-time ordering
- Review credit terms offered to customers
- Match debtor and creditor payment cycles
Cash Flow and Insolvency
Under UK insolvency law, a company is deemed unable to pay its debts if it cannot pay them as they fall due (the cash flow test) or if its liabilities exceed its assets (the balance sheet test). Directors who allow a company to continue trading when they know or ought to know it cannot avoid insolvent liquidation risk personal liability for wrongful trading under the Insolvency Act 1986.
Monitoring cash flow is therefore not just good practice – it is a legal obligation for directors.
Cash Flow in the Annual Accounts
The cash flow statement reconciles the opening and closing cash balances for the period:
| £ | |
|---|---|
| Cash and cash equivalents at start of year | 45,000 |
| Net cash from operating activities | 82,000 |
| Net cash used in investing activities | (35,000) |
| Net cash used in financing activities | (28,000) |
| Cash and cash equivalents at end of year | 64,000 |
This statement, read alongside the income statement and balance sheet, gives a complete picture of how the business generated and used its cash during the year.
Cash Flow and Working Capital
Cash flow is closely linked to working capital management. Working capital – the difference between current assets and current liabilities – represents the cash tied up in day-to-day operations. Efficient working capital management releases cash, while poor management absorbs it.
The relationship is straightforward: reducing the cash conversion cycle improves cash flow. Every day saved in collecting from debtors or added to supplier payment terms directly increases the cash available to the business.
To put this into practice, see our guides on cash flow forecasting basics and improving working capital.