Cash flow refers to the cash that comes into and flows out of a business. Cash flow can be increased in a number of ways, including selling more goods or services, increasing the selling price, reducing costs or selling an asset. If a business experiences a surplus of cash flow, it has to make a determination on the best way to use that surplus for the benefit of the business.
Cash flow is the difference between the amount of cash that’s available at the beginning of the accounting period, called the opening balance, and the amount of cash that’s available at the end of the accounting period, called the closing balance. Cash enters a business in a number of ways: sales, loan proceeds, asset sales and investments. It goes out in the form of operating expenses, asset purchases, direct expenses and the servicing of debt.
Cash flow is considered positive if the closing balance is higher than the opening balance. It’s considered negative if the closing balance is lower than the opening balance. A surplus cash flow is the cash that exceeds the cash required to cover operating expenses. Operating expenses refer to the day-to-day activities of a business. These are expenses incurred by the business but are not related to production. Payroll, employee benefits, rent and sales commissions are all examples of operating expenses.
Paying Down Debt
A business generally uses cash surplus in one of two ways. The first is to pay down debt. This is the use of a surplus gain to help reduce a potentially long-term obligation (the debt). This is especially beneficial for a company when the interest rate the business pays on the debt exceeds the expected rate of return the business will receive by investing the cash. For example, paying off a loan at 12 percent interest may actually save the business money if the expected rate of return on investing that money is only 4 percent. However, if the business may need cash in the near future, it may be more advantageous to hold onto the surplus. This may be more cost effective than using the cash to pay down debt now only to have to take out additional loans at higher interest rates in the future.
The second option a business may use instead of paying down debt is to invest the surplus. The purpose of investing the surplus is to grow that amount into a larger sum that the business can access later. Before a business considers investing a surplus, it has to look at the risk, liquidity, maturity and yield of the investment product. All investments have pros and cons. For example, an interest-bearing checking account may provide strong liquidity for the business, but the tradeoff is generally a smaller rate of return. It’s a good idea for a business to speak with a professional who can offer investment advice. Whether to pay down debt or invest the surplus will depend upon what’s best for the business and its short-term and long-term goals.