The business cycle is the alternating periods of economic growth, recession, or depression. Various macroeconomic factors dictate the length and severity of each. A recession is when a country’s GDP falls below its potential GDP for an extended period.
Negative cash flow occurs when you collect less money from customers than your costs to serve them as well as holding inventory for them such as raw materials, labor, overhead and interest expenses associated with purchases that are not being used at the time incurred, so they are just sitting on the balance sheet; i.e., idle inventory costs more to hold than it would if sold immediately.
Why Free Cash Flow is Negative?
1. Business is experiencing a downturn
It is the most common reason why Free Cash Flow is negative.
You are limited to your profits, which are the lesser of your sales revenue or the cost to purchase something from you. Your fees are fixed and not subject to constraints like price increases, technological advances, or changes in the overall business cycle. Your business’s output continues to decline even as it makes a profit.
If your cost of goods sold goes up or customers’ disposable income goes down, then an increase in selling prices requires you to sell fewer units at higher prices, reducing your net income and causing a reduction in sales revenue.
2. Expensive investments
It is a risk that a business becomes exposed to when it has increased in size or has high fixed costs. Most companies know that their money in equipment, buildings, or research and development will eventually be needed to make more money. Still, they don’t make those investments until quarterly earnings reports show that their expenses exceed the sales revenue generated at those prices.
For example, say Sally’s business incurs an investment to build a new office building with a $1 million price tag. This year’s net income is $100,000 because her net sales were only $7 million.
3. Inaccurate budgeting
Businesses tend to underestimate expenses during bad economic times, which leads to negative Free Cash Flow. It can be good if the industry realizes that it needs to account for those costs to avoid bankruptcy or significant financial losses. The problem comes when companies don’t have money because they believe they have enough cash due to low sales but high profits.
4. Businesses that fail to invest in their long-term survival
Investing in the future is the best way to reduce negative Free Cash Flow. After all, investing today is an expense, but it’s an investment in your quality of life tomorrow and many years later. If you look at big businesses, you will notice that companies that continue to build up cash on hand often go out of business or get bought out by other more successful companies because they are not able to keep up with the advancements in technology or changes in customer demands for their products or services.
5. A high liquidity ratio
It is usually a good thing. It means that the company has a lot of cash sitting around in short-term investments, and not much of it is tied up in its inventory or long-term assets like property, plant, and equipment (PPE) or your goodwill on the balance sheet. Most businesses like to see their current ratio above 1:1, meaning they can turn their inventory into cash within one year if needed.
6. Stock buybacks
The use of stock buybacks to avoid paying a dividend caused businesses to go out of business and make shareholders poorer during the financial crisis of 2008. According to this article from CNN Money, shareholders were unhappy because companies were buying back their stocks at an alarming rate, which reduced the number of shares being sold on the market, lowering their value, and depressing their price as well as raising their cost for investors who want those shares in their portfolio since they are trading at a lower price.
7. Uncompetitive market conditions or products that have no demand
It is a tough one to deal with. There are always changes in the business cycle, changing customer tastes and preferences, new technologies that lower your production costs or increase your productivity, and even changes in your industry that can force you to change how you do business.
It is a case where you need to re-evaluate your business plan and goals for the future. If it’s not working out for you, then perhaps this is not the type of business that best fits your skillset or experiences.
Final Verdict
Negative cash flow, either in a given period or for a portfolio, reduces the return rate during that period. It highlights that internally generated funds are insufficient to pay capital expenditures and support cash requirements associated with working capital projects. In all cases, net income must be positive before positive cash flows can be achieved. Net income, marginal profit, and free cash flow are all important metrics within the financial management process. Each measurement tool allows the firm to evaluate various assets in both a qualitative and quantitative manner.