The term “outflow” might seem like an overzealous way to say “payment,” but in accounting, it’s a critical concept. Accountants record purchases when they occur, NOT when cash is sent. This means they need a different word for cash movements.
This article defines outflow and provides examples for different scenarios so you have a complete understanding of the concept. While outflows may seem simple (i.e money sent from me to you), it’s easy to confuse them with payments.
So even if you feel comfortable with the theory, I encourage you to check out the examples below!
Definition
In a sentence, an outflow is a movement of cash out of a bank account that may or may not occur at the same time as the associated cost. In most cases, the term “outflow” refers to large movements on a company account. Smaller cash movements are usually called “disbursements.”
For example, a movement of $100 as consideration for the purchase of office paper would be a “disbursement,” whereas a movement of $30,000 for the purchase of a tractor would be an “outflow.”
“Out Flow” vs “Outflow”
A quick note before you read into the details. Because “out” and “flow” are two independent words, it’s tempting to write them separately. However, outflow is a compound word like fireman, bookstore, or notebook, and it is always written without a space: “outflow.”
Outflow in Accounting
To reiterate, costs are recorded as they are incurred (the time of the exchange, usually defined by a contract or Terms & Conditions), but cash movements can occur at a different time.
For example, a company may purchase legal counsel on 01-Jan-2022, but only send the cash on 25-Jan-2022. There’s mismatch in the timing.
This approach of recording costs as they are incurred is called accrual accounting, and it ensures companies report their performance as it occurs, rather than waiting for cash movements (which is often inconsistent or delayed).
Imagine, for example, a company purchases $50,000 of paper in January 2022 that is used to sell $80,000 birthday cards. However, the cash outflow for this paper only occurs in March 2022. If the company shows no payment in January but makes money using the paper, it will look as though their income has no associated costs (and the profitability will excessively high), which is not true. Here’s what this would look like on the company’s profit and loss statement:
As you can see, the cash methodology does not accurately represent the companies performance (in one months $80k profitability, and in the next -$50k profitability). The accrual method, however, shows accurate profitability in one month ($30k) and no activity in the next month.
To summarize, “outflow,” is a useful term to distinguish between purchases (which are recorded at the time of the transaction) and their related cash movements (which can happen at a later date).
Cash Outflow vs Inventory Outflow
We’ve talked about outflows in the context of cash because this is by far the most common type. However, “outflow” can also be used to refer to inventory.
Inventory represents assets that the company will sell within one year. When we say “inventory outflow,” we refer to the movement of inventory from the balance sheet to the income statement.
For example, imagine a company buys paper for $10k in January but does not sell it until March (for $15k). The inventory will be recognized in the first month, but it won’t be shown as a cost until the transaction occurs. The inventory “outflow” occurs at the time of the sale.
It’s useful to combine cash outflow and inventory outflow in one example — this will help us concretize our understanding.
Imagine the same example above, but in one scenario the company sends cash at the time of purchase and in a second scenario the company sends cash at the time of the transaction. Here’s what this would look like:
As you can see, the inventory outflow always occurs at the time of the transaction (i.e when the product is sold), but cash outflow depends on the timing of the actual cash disbursement. Money can be sent at the time of purchase, OR when the inventory outflow occurs.
Examples (Asset Purchase, Liability Payment, Equity Purchase)
So far we’ve only talked about outflows in the context of business operations (i.e the purchase of goods and services). Let’s look at three other scenarios where cash outflows are important:
- Fixed asset purchases
- Loan payments
- Purchase of equity in another entity
Fixed Asset Purchase
Imagine you run a peanut farm and you need to buy a big machine to crack open the peanuts you produce. This is a $60,000 machine that you will depreciate over time. You sign the contract on March 31st, 2022 and will pay in three installments — one at the end of April, May, and June.
Here’s what you need to do. First, you record the $60,000 asset on your balance sheet at 31-Mar-2022. You record the $60k liability as accounts payable (because there is no immediate cash outflow). At each outflow date, you reduce accounts payable and reduce cash by the respective amount. Here’s what it would look like:
Loan Payment
Imagine that you took out a loan in the amount of $20,000 to finance the first payment on the peanut-cracking machine asset. This loan has 1% interest and has a life of 3 months. You would start by recognizing the full amount of the loan and the cash it provides.
Then, you need to record the interest expense on the P&L and the principle payments, by month, on the balance of the loan. Both the interest and the principle payments are cash outflows, but only the interest expense is a cost (known as the “cost of borrowing money”).
As you can see, outflows are not always an expense! For fixed assets and loans, outflows are related to both balance sheet movements AND P&L expenses.
Equity Participation in another Entity
Now imagine you want to buy 10% of the equity in another peanut farm to benefit from its results. The company is valued at $1,000,000, so the purchase price will be $100,000. You will pay the full price at the time of the purchase (it is possible to use loans to buy equity, but that’s a more advanced scenario).
To record this transaction, you will start by recording the equity value purchased as an asset on your balance sheet. At the same time, your cash will decrease by an equivalent amount. Here’s what it would look like:
As you can see, the cash outflow occurs at the time of the purchase!
Key Takeaways
- Cash outflows are the actual transfer of cash out of a company’s account.
- They are different from purchase transactions because they don’t necessarily occur at the time of the transaction.
- Cash outflows are also called “disbursements,” but the latter usually refers to small amounts.
- The term “outflows” also applies to inventory, but inventory outflows do not necessarily impact cash outflows.
- While most cash outflows are related to business transactions that hit the P&L, they also apply to asset purchases, loan payments, and purchases of equity in other entities.
Conclusion
If you found this article helpful, feel free to check out more free content at the AnalystAnswers.com homepage!
