Negative cash flow is defined as a situation when an organization’s operating cash outflows are greater than operating cash inflows in a specific period. This situation shows that the business is spending more money than it is earning through operations, investment or financing activities.
Key Takeaways
Understanding Cash Flow
- Operational Activities: Refers to cash outflows to meet the day-to-day activities of the business in terms of employee salaries, rent, energy bills, and raw materials.
- Investment Activities: Refers to cash that is employed in the procurement of other assets such as machines, land, buildings, or securities.
- Financing Activities: Refers to cash flows for borrowing or repaying a loan, issuing or repurchasing of shares, as well as paying out dividends.
Implications of Negative Cash Flow
- Short-term: A company may need to manage working capital from its cash resources or seek other funding sources to cover the deficit.
- Long-term: The negative cash flow can lead to insolvency if it reaches the point that a business cannot pay its debts, hence causing the cash flow problem.
Can Negative Cash Flow Be A Good Thing?
It is possible that a business made a net profit, but had negative cash flow.
Gaining revenue implies that the company or a particular segment has generated some income, whereby this income may not be actual cash in the firm at a specific period. The actual movement of cash may occur at a later date, though.
For example, a company manufactured products and recorded sales and profits on the income statement but did not make a sale and earned cash. Here they settled for a payment term that is 60 days, so their payment will be 60 days later. It could also be operational factors that led to this kind of situation.
Stakeholders suffer losses in one particular month while obtaining profits in another month. Again, a business could be profitable, yet the money could be locked in accounts receivable or fixed assets. Further, several factors and errors result in such companies operating under the condition that they spend more than they earn.
To understand what results in negative cash flow, the business needs to know some common cash flow problems most enterprises encounter.
Therefore, is negative cash flow bad for a business? To determine this, the business has to identify the type of negative cash flow it is experiencing.
Three Types of Negative Cash Flow
Companies may face different types of negative cash flow, depending on the situation or company size.
Initial Negative Cash Flow
Initial Negative Cash Flow is usually faced by new and growing businesses because they spend a lot of monetary capital on advertising resources to establish brand awareness and gain a better standing in the market in which they are operating.
This can lead them to have an excessive cash outflow, though such investments can sometimes generate a lot of cash in the long term. This is very encouraging to investors who are in search of a business organization that offers relatively high returns.
As this kind of negative cash flow is temporary, it is not considered a negative sign for businesses.
A new company will have different expenses and capital expenditures to establish its business activities. Some of them depend on loans or investments to finance their projects. Therefore, even a growing company has negative cash flow in its growth stage.
After the customer base is established, the company’s inflow should start surpassing its outflow.
Temporary Negative Cash Flow
In addition to negative cash flow at the time of business establishment, it is possible to face temporary negative cash flow at some point.
Once the business is successfully set up and healthy, there might be an adoption of expansion plans by the firm. For this strategy to work, they might have to offer increased salaries, hire new employees, increase dividend rates to shareholders, and incur other expense factors.
These additional costs could cause the business to have negative cash flow. However, this is mostly for a short-term period.
Also, some businesses that show business fluctuation and growth during certain periods of the year may face a temporary negative cash flow. This happens to retail businesses that experience slow sales during off-peak periods and make massive merchandise purchases during peak periods.
Chronic Negative Cash Flow
When an expansion cannot explain the negative cash flow, then it is something to worry about.
If a company is constantly reporting negative cash flow, then it is either over-investing or simply using more money than it gains in the long run, and this is not good news. This can result in different things, like unpaid bills, and also an increase in the number of people being laid off.
If the source of the problem is not resolved, then it is unlikely for the business to continue to sustain itself. Such negative cash flows can indeed be highly damaging to a company’s business.
Hence, strengthening profit is not enough. There is also the need for steady cash flow. However, it is wrong to conclude that negative cash flow is the only conclusive evidence that a business is failing.
Key Takeaways for Negative Cash Flow
Negative Free Cash Flow Isn’t Always a Red Flag
Sometimes, a company might have no cash left after covering all costs because it poured money into growth-focused projects.
Profitability Despite Negative Cash Flow
A Business Can Make Money Despite Cash Flow Issues: A company can turn a profit even when it faces cash flow problems. To understand the reasons, you need to look at why the cash flow is negative.
Initial Negative Cash Flow in New Companies
When businesses first open their doors, they often see their cash flow dip into the red. This happens because they have to spend big on equipment and other things they need to grow. It’s just a phase and not something to worry about.
Temporary Negative Cash Flow in Established Businesses
Well-established firms might also see their cash flow turn negative for a short time. This can happen when they’re growing, dealing with seasonal changes, or facing unexpected market shifts.
Chronic Negative Cash Flow is Concerning
If a company keeps losing money or spending too much on new projects, leading to ongoing cash flow issues, it’s a red flag that calls for quick action.
Negative Cash Flow Example:
InnovateX is a newly founded startup tech company, and it has recently released a new product. In terms of their first-quarter cash flow, it presents a rather bleak picture. Although they earned $55,000 through sales and investments, they spent $ 85,000 on expenses, which gave them a negative cash flow of -$ 30,000.
This means that InnovateX is operating at a loss, spending more cash than it is generating. If they want to see any changes in their cash flow, they will have to seek additional sources of funding, reduce some of their expenses, or boost their revenues.In this example, InnovateX has a negative cash flow of -$30,000 for the quarter, suggesting that it has used more cash than it received. This negative cash flow will eventually force InnovateX to look for more funds, cut its expenses, or boost sales to enhance future cash flows.