Cash Flow, Bank Reconciliation, and Profit Explained

Introduction: Why Financial Literacy Matters

A friend who holds a position of authority in a company should be aware of all accounts that the company maintains at the bank. Just because he is not a CEO or CFO does not mean he should remain ignorant about banking — about what constitutes profit and what does not, or how to reconcile money in the bank. Simply having money in the bank means nothing unless what appears in those accounts is fully understood within the ongoing flow of cash in and out.

Banks and Cash Management

The main reason for business failure is poor cash management; it is also likely the most frequent stumbling block for those who pursue the entrepreneurial route in business. Understanding the very basic concepts of cash flow can therefore help anyone who is unsure whether the money sitting in a bank account represents profit or not.

Cash vs. cash flow: Cash in the bank is money, but it is not inventory, and it is not what others owe the company (accounts receivable) — nor is money in the bank the same as property. Accounts receivable can in time be converted into cash, but it cannot ordinarily be used to pay bills, such as payments to suppliers or vendors. Cash is what a company has on hand to keep the business running, but cash in the bank is not categorized as "profit." Over time, profits are "of little value if they are not accompanied by positive net cash flow."

Cash flow refers to the movement of cash into and out of a business. It is vitally important to understand that keeping a close eye on cash inflows and outflows is one of the most pressing management tasks for anyone in business. Cash outflow refers to money spent — usually by check — to pay company salaries and to pay vendors and creditors such as banks holding a company mortgage. Cash inflow, on the other hand, reflects money received from investors, customers, and lenders.

Positive cash flow: Having a positive cash flow means that inflows have exceeded outflows. While this is a straightforward concept, it is not the only indicator of good financial health — but it is certainly one important sign.

Negative cash flow: This occurs when the outflow of cash is greater than the inflow. The critical question for any manager or employee overseeing cash flow is why there is a negative cash flow. Is the accounts receivable portion of the ledger lagging because customers have not paid their bills and collections have been poorly managed? Or is there too much obsolete inventory sitting on the books, because someone in the company has failed to move that inventory off the cash flow pages?

Understanding the Three Components of Cash Flow

According to standard business finance principles, cash flow can be broken into three distinct components:

Operating cash flow: This is what companies refer to as "working capital" — the cash coming in from sales of the product or service that the company generates as a natural part of its regular business function.

Investing cash flow: When a company invests in its own plant infrastructure, in equipment, or in other fixed assets using cash outside of its normal day-to-day operations, that activity is classified as investing cash flow.

Financing cash flow: This category covers cash moving to and from external sources, such as lenders, shareholders, or investors. Cash used to issue stock or to pay a dividend to a shareholder falls under financing cash flow.

Practicing good cash flow management begins with a cash flow projection. Savvy business owners and entrepreneurs understand that this means planning for both short-term cash flow (monthly or even weekly) and long-term cash flow (up to three to five years). Such projections help manage daily cash flows and provide clear numbers when addressing ongoing business needs.

Conclusion

A company that stays up to date with its spending and its receipt of funds, keeps valid records, and avoids poor cash management is likely to be a successful company, assuming everything else is sound in its business plan.

Works Cited

Accounting Coach. (2012). Bank Reconciliation. Retrieved November 11, 2015, from http://www.accountingcoach.com.

Basic Accounting Help. (2010). Basic Accounting Concepts / Foundation of Basic Accounting Concepts. Retrieved November 11, 2015, from http://www.basicaccountinghelp.com.

Findlaw.com. (2011). The Importance of Cash Management. Retrieved November 11, 2015, from http://smallbusiness.findlaw.com.

Tool Kit. (2009). The Difference Between Cash Flow and Profit. Retrieved November 11, 2015, from http://www.bizfilings.com/toolkit.