What is cash flow and why is it important to a business?
The term ‘cash flow’, in layman’s terms, is the amount of money that is flowing in and out of a particular business at any given point of time. Cash flow is an important entity in determining the overall health of a given business, and tends to vary depending upon its usage within a particular context. However, it is important to understand that if a company’s cash level increases during a particular period, it means that it is exhibiting positive cash flow, whereas any decline in the cash level essentially portrays negative cash flow. Although many businesses continue to operate with a negative cash flow by trading in the short to medium term and/or by delaying payments to creditors, it is only a matter of time before this approach eventually backfires. Put simply, any business organization needs to understand that it cannot survive for too long without enough cash to meet its immediate requirements.
The significance of cash flow lies in determining how the income of a particular company flows through its financial system, which again enables it to make proficient use of the available cash and thereby achieve financial success. At the same time, having better control of the cash flow also enables the company to curb any unnecessary expenditure and re-direct the cash at hand in a way that helps it to achieve the required business goals within the fastest possible time period.
What are capital investments? Why are they important to a business?
Capital investments basically comprise the total number of funding options that are available to businesses which, in turn, are likely to help in achieving their ultimate business objectives. The decisions pertaining to these investments include allotting the capital investment funds in a manner that ensures the availability of the best possible returns. One of the most important aims of capital investments is to enhance a firm’s value by helping it to take on projects at the correct time.
The importance of capital investments stems from the fact that they help businesses in taking informed decisions about various expansion plans, replacement as well as renewal opportunities. For instance, a company’s expansion plans tend to include the acquisition of fixed assets through the purchase of plant facilities and properties that indicate a good area for investment. Subsequently, when the maturity period is over and the firm expands at a slower pace than usual, the worn-out assets are replaced in order to enable the organization to revert to its full-time production and operational scenario. Renewal can act as a substitute for replacement that might involve upgrading, retrofitting and re-examining of an existent asset which also enhances a firm’s value.
Is there a relationship between cash flow and capital investment?
The relationship between cash flow and capital investment does tend to be a bit confusing at times. A wide number of investment research studies have shown that cash flow is an effective method to predict future investment. There are 3 chief interpretations of this association.
The first one states that an increase in the company’s free cash flow is a valid indicator of an increased availability of opportunities to invest in important projects. The second explanation sheds light on the fact that companies already know about potential investment opportunities beforehand but are prevented from investing in them due to limitations on their current availability of financial resources. On the other hand, this also makes it obvious that the improvement of a company’s cash flow should subsequently lead to increased availability of cash for any investments made into valuable projects.
However, an increasing amount of research in this direction has now revealed that in many cases, these above-mentioned theories fail to apply with regard to a lot of business activities conducted across different sectors. Citing an example, a recent market research study conducted on the oil and gas market has revealed that when companies have greater cash flow, they often tend to spend on existing projects that are already profitable, instead of investing the entire amount in fresh undertakings.
Another study has shown that in case a company has negative cash flow or is devoid of any free flowing cash flow, that does not always mean that the company has stopped making any investments altogether. For instance, Netflix, the American web-media company, currently reported a negative cash flow but still went ahead and expanded its business and produced the well-received ‘House of Cards’ TV series. Some studies even depict managers that often use the increased cash flow for purposes of expansion, rather than focusing on the aspect of profit maximization.
As is evident by now, it is really difficult to establish a specified and clear-cut relationship between cash flow and probable investment-based activities. Just as some companies are likely to invest even in the absence of any free-flowing cash, similarly increased cash flow does not always signify greater investment; it can simply mean that that the business is spending more per project.