Since accounting practices are closely intermeshed with cash flow, let us talk about accounting systems. This can be of two types: cash based and accrual based.
Cash Based Accounting
In the cash based accounting system cash flow is easy to calculate with the help of the till and the cheque book. However, it is too simple a method as it may not take into account other economic realities.
Accrual Based Accounting
The accrual based accounting system takes it for granted that all accounts are paid in cash.
In fact, both cash based and accrual accounting systems can tend to present an inaccurate picture regarding the real status of the cash flow situation.
In accounting, revenue must ideally be recorded when the activity from which it is generated is completed. Usually, this happens once a product or service is delivered.
Sometimes there is a time gap between the completion of the activity and actual payment received, waiting for the payment before it is recorded misrepresents the situation.
Another misrepresentation occurs when inventory is entered as expenses when the supplier’s payment is made. Here inventory is not accounted as an asset. If this inventory is used during on accounting period and the payment for it is made during another, it would be going against a basic accounting principle, which states that expenses and revenue related to the same period must appear in the same financial statement.
Thus, cash based accounting works in businesses with simple operations where cash accounting does not violate any accounting principle.
Many businesses use accrual based accounting where rather than recording expenses based on cash flow, it records flow of value. There is a vast difference between cash flow and value flow, so it is necessary to fully understand what exactly happened. In order to assess a company’s value, regardless of its size, cash flow is more crucial than value.
For whatever purpose the company is being valued, what matters is the company’s ability to generate cash flow in the future, indefinitely. The company’s worth will be determined by its cash flow. When the cash flow’s growth rate is steady with low risk to it, its value increases.
It is important for every individual holding a responsible position in the company to have a solid knowledge of the dynamics of cash flow and its issues. Each of these individuals must be aware of his or her work efficiency in influencing the company’s cash flow.
It is imperative for every member of the organization to develop a cash-flow mindset. One might think that hiring a financial profession is a major expense, but without one, a company may not be able to survive tough times.
The management team especially must make it their goal to ensure that they understand cash flow dynamics and how it impacts their department. For example, someone who is in sales would influence the cash flow in a different way from someone who handles purchases, production or service. Since each work profile’s influence is different, it is necessary to know its impact on that particular department.