What directors need to know about cashflow: an overview

For board directors, overseeing cashflow is not just a financial responsibility but a strategic one. Directors must ensure that their organisations have the liquidity necessary to execute business plans, respond to market changes, and pursue strategic objectives. This requires a deep understanding of the company's cashflow dynamics, including the sources and uses of cash, how to use metrics to measure cashflow, and how to identify and mitigate potential risks.

This is the first of a series of three articles exploring directors and their cashflow responsibilities within an organisation. The second article is What directors need to know about cashflow: metrics and red flags.

Why understanding cashflow is important

Understanding cash flow statements is critical for board directors because it provides a comprehensive view of a company's liquidity and financial health, which neither the balance sheet nor the profit and loss statement can fully convey. While the balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time, and the profit and loss statement outlines revenue, expenses, and profit over a period, the cash flow statement reveals the actual cash generated and used during that time. This is crucial for assessing the company's ability to generate cash to meet its obligations, invest in growth, and return value to shareholders.

Cashflow is the lifeblood of any business. It refers to the movement of money in and out of a company's accounts, encompassing all transactions related to operating, investing, and financing activities. Unlike profit, which is an accounting measure of earnings after expenses, cashflow measures the actual liquidity available to meet the company's obligations. Positive cashflow ensures that a business can pay its employees, settle debts, reinvest in operations, and seize growth opportunities.

The significance of cashflow management becomes particularly evident in times of economic uncertainty or business downturns. Companies with strong cashflow management can weather financial storms more effectively, maintaining operational continuity while others might struggle to stay afloat. Furthermore, robust cashflow management enables businesses to capitalise on strategic investments, such as acquisitions or expansion initiatives, thereby fostering long-term growth and competitive advantage.

Board directors hold a fiduciary duty to act in the best interests of the company and its shareholders. This encompasses ensuring sound financial management and oversight, of which cashflow management is a key component. Directors must regularly review cashflow statements, assess the company's liquidity position, and evaluate the financial impact of strategic decisions. This proactive approach helps prevent cashflow issues from escalating into crises that could jeopardise the company's financial health and stability. 

A director's cashflow responsibilities

The role of board directors in cashflow oversight involves several key responsibilities:

• Strategic Planning and Budgeting: Directors must ensure that the company's strategic plans and budgets are aligned with realistic cashflow projections. This includes scrutinising assumptions underlying revenue forecasts, expense budgets, and capital expenditure plans to ensure they are achievable and supported by adequate cashflow.
• Risk Management: Identifying and managing cashflow risks is a critical aspect of a director's role. This involves analysing the company's cashflow patterns, identifying potential vulnerabilities, and implementing risk mitigation strategies. For instance, directors should be aware of the risks associated with high customer concentration, seasonal revenue fluctuations, or reliance on short-term borrowing.
• Performance Monitoring: Regular monitoring of cashflow performance against budgets and forecasts is essential. Directors should review cashflow statements and key liquidity ratios to assess the company's financial health and identify any deviations from expected performance. This enables timely corrective actions to address emerging issues.
• Governance and Controls: Establishing robust governance frameworks and internal controls is vital to ensuring effective cashflow management. Directors should oversee the implementation of cashflow policies and procedures, conduct periodic reviews and audits, and ensure that appropriate checks and balances are in place to prevent fraud and financial mismanagement.
• Stakeholder Communication: Effective communication with stakeholders, including shareholders, lenders, and regulators, is crucial. Directors must provide transparent and accurate information about the company's cashflow position and liquidity management strategies. This builds trust and confidence among stakeholders and supports the company's financial credibility. 

Cashflow fundamentals

Cashflow is the net amount of cash and cash equivalents being transferred into and out of a business. It encompasses all financial transactions that affect the company's cash position and is categorised into three main components: operating cashflow, investing cashflow, and financing cashflow. Each component provides valuable insights into different aspects of the company's financial activities.

Operating cashflow

Operating cashflow, also known as cashflow from operations, measures the cash generated or used by a company's core business activities. It reflects the company's ability to generate sufficient cash to maintain and grow its operations.

Key elements of operating cashflow include: 

Operating cashflow is a crucial metric because it indicates the company’s capacity to generate cash from its primary business activities. Positive operating cashflow suggests that the company can cover its operating expenses and invest in growth, while negative operating cashflow may signal underlying operational issues or inefficiencies.

Investing cashflow

Investing cashflow, or cashflow from investing activities, measures the cash used for or generated from investments in long-term assets. This component provides insights into the company’s investment strategies and capital expenditure decisions.

Key elements of investing cashflow include:

Investing cashflow is important because it reflects the company's commitment to sustaining and expanding its operations. Positive investing cashflow may indicate the sale of assets or successful divestitures, while negative investing cashflow typically signifies investments in future growth.

Financing cashflow

Financing cashflow, or cashflow from financing activities, measures the cash inflows and outflows related to financing the company's operations. This component provides insights into the company's capital structure and financing strategies.

Key elements of financing cashflow include: 

Financing cashflow is crucial for understanding how the company funds its operations and growth initiatives. Positive financing cashflow indicates that the company is raising capital through debt or equity, while negative financing cashflow suggests debt repayment, dividend distributions, or share repurchases.

Positive cashflow

Maintaining positive cashflow is essential for the sustainability and growth of any business. Positive cashflow ensures that the company has sufficient liquidity to meet its short-term and long-term obligations, including paying employees, suppliers, and creditors. It also provides the financial flexibility to invest in new opportunities, expand operations, and weather economic downturns.

Several key benefits of positive cashflow include:

• Operational stability: Positive cashflow allows the company to cover its day-to-day operating expenses, ensuring smooth business operations and preventing disruptions.
• Debt management: Sufficient cashflow enables the company to meet its debt obligations, reducing the risk of default and maintaining a healthy credit rating.
• Investment opportunities: Positive cashflow provides the financial resources to invest in growth opportunities, such as new products, markets, or acquisitions.
• Shareholder returns: Strong cashflow supports dividend payments and share buybacks, enhancing shareholder value and attracting investors.
• Cushion against uncertainty: Positive cashflow acts as a buffer against economic volatility and unforeseen expenses, allowing the company to navigate challenging times with greater resilience. 

Key differences between cashflow and profit

While cashflow and profit are both critical financial metrics, they represent different aspects of a company's financial performance. Understanding the differences between these two concepts is essential for board directors to make informed decisions and ensure the financial health of their organisations.

Profit, also known as net income, is the amount of money remaining after all expenses have been deducted from total revenue. It is an accounting measure that reflects the company's financial performance over a specific period. Profit is calculated using the accrual basis of accounting, which recognises revenue and expenses when they are earned or incurred, regardless of when cash is received or paid.

There are three main types of profit:

• Gross profit: The difference between total revenue and the cost of goods sold (COGS). Gross profit measures the profitability of the company's core business activities before accounting for operating expenses.
• Operating profit (EBIT): The difference between gross profit and operating expenses, such as salaries, rent, and utilities. Operating profit or EBIT, measures the profitability of the company's core operations.
• Net profit: The difference between operating profit and non-operating expenses, such as interest and taxes. Net profit represents the company's overall profitability and is often referred to as the 'bottom line'.

Cashflow, as previously discussed, measures the actual movement of cash into and out of the business. It encompasses all cash transactions related to operating, investing, and financing activities. Unlike profit, which is calculated on an accrual basis, cashflow is measured on a cash basis, recognising transactions only when cash is exchanged.

Key differences between cashflow and profit include:

• Timing: Profit is based on the accrual basis of accounting, recognising revenue and expenses when they are earned or incurred. Cashflow, on the other hand, is based on the cash basis of accounting, recognising transactions only when cash is received or paid. This difference in timing can lead to significant disparities between profit and cashflow.
• Non-Cash Items: Profit includes non-cash items such as depreciation, amortisation, and share-based compensation, which do not affect cashflow. These non-cash items can distort the true cash position of the company.
• Capital expenditures: Capital expenditures, which are cash outflows for long-term assets, are not deducted from profit but are included in cashflow from investing activities. This can lead to situations where a company reports a profit but has negative cashflow due to significant capital investments.
• Working capital changes: Changes in working capital, such as accounts receivable, accounts payable, and inventory, can impact cashflow but are not reflected in profit. For example, an increase in accounts receivable can reduce cashflow even if profit remains unchanged. 

For board directors, effective cashflow management is crucial for ensuring an organisation’s financial stability and strategic growth. By understanding cashflow dynamics, directors can make informed decisions that safeguard liquidity, support operations, and deliver long-term value to stakeholders.