“Cash is king,” is a well-worn cliché but an ever relevant and crucial principle for business health.According to SCORE, a business mentoring group to small businesses, cash flow problems are the major reason why many small businesses fail each year. Neglecting, or simply not paying adequate attention to your company's cash position can quickly jeopardize an otherwise profitable business.
The goal of this article is to provide some keys to good cash management by demystifying the Cash Flow Statement and revealing how it facilitates the cash management process.
What is a Cash Flow Statement?
The Cash Flow Statement is one of the three key financial statements, serving as a bridge between the other two - the Income Statement and the Balance Sheet - a general overview of financial statements was addressed in an earlier blog post. It shows the change in cash position over the course of a reporting period and is divided into three categories: Operating, Investing and Financing Activities. This segmentation is extremely helpful in providing insights into the health of the business. Before delving into the sections we will explain some of the mechanics of developing the Cash Flow Statement, and for the purpose of this article, we start with Financing Activities and end with a focus on Operating Cash, perhaps the most important cash flow segment.
Never take your eyes off the cash flow because it's the life blood of business.
Richard Branson, Founder, Virgin Group
Cash Flow Statement Mechanics
The Cash Flow Statement answers several key questions, including:
How much did cash change over the period?
What’s responsible for the change?
Is the Change in cash a “source” or a “use” of cash? A “source” increases cash while a “use” reduces cash.
Changes in cash stem from two areas:
Net income (NI) – derived from the Income Statement, this is the profit (or loss) of revenues over expenses, representing the difference between what you collect (source) from your operating activities and what you spend (use) to generate that revenue. However, this is not a perfect measure of cash. Because NI is largely derived on the accrual basis (GAAP) of accounting, there are revenue and expense items that are not cash activity so NI must be adjusted to arrive at a true cash basis.
Changes in Assets and Liabilities – Balance Sheet changes are either a source of cash or a use of cash.Increase of an asset is a use of cash and increase of a liability is a source of cash. If this concept sounds counterintuitive these examples should clear up any misunderstanding. Growth in accounts receivables is a use of cash because the company delivered a product or service without getting paid, therefore using cash resources to produce the service (wages, supplies) but not receiving the cash as yet. Conversely, growth in accounts payable, a liability indicates the company got the use of services or products without paying for them yet.Once the loan is paid, the resulting action is a reduction in a liability and is a use of cash.
Financing Activities
Financing activities outlines the sources and uses stemming from the Long-term Liabilities and Equity sections of the Balance Sheet, aptly covering the long-term capital structure of the firm. This include:
Increases or decreases in long-term external debt - new borrowing increases debt and is a source of cash, while debt repayment is a use of cash.
Owners’ activities such as new equity infusion (source of cash) or dividend distributions (use of cash).
Investing Activities
This is almost exclusively the acquisition or disposal of fixed assets. However, the effect of depreciation is not included in this section.
Purchased assets – the amount of the increase in the asset is a direct use of cash.
Capital lease – standard cash flow computation would treat the increase in leased equipment as a use of cash, but since there was no matching cash outlay the corresponding increase in liabilities would be computed as a source of funds, thus roughly offsetting to zero net cash flow.
Asset disposal/sales – proceeds from asset sales would be a source of funds.
Operating Activities
Operating cash flow reflects cash generated or used by the day-to-day business activities. This section starts with net income and includes adjustments that are designed to convert the accrual basis net income into a cash basis net income. There are two sets of adjustments:
Adding back non-cash items to net income. Chief among these is depreciation, which is a non-cash item that reduced the net income number. Amortization amounts would be similarly treated.
Incorporating changes in current assets and liabilities. These items: accounts receivables (AR), accounts payables (AP), inventory and accrued expenses - are directly connected to net income generation. Incorporating the changes in these items will complete the conversion from accrual basis to cash basis net income. To further amplify:
a. A growth in accounts receivables indicate that net income included amounts that were not collected, so that portion must be deducted from net income.
b. Conversely, a growth in deferred revenue indicates that the firm received cash that was not included in the net income number. This amount must be added to net income to reflect this source of cash.
Key Takeaways
Operating Activities
A healthy business requires consistently positive cash flows from operations. This starts with delivering great products and services at a profit-generating price, then actively invoicing and driving collections to reduce AR and increase cash. Extend AP where possible, but not to the extent of alienating valued suppliers.
Investing Activities
Investing activities, even though a use of cash, is necessary for the long term sustainability of the business. Old equipment with frequent breakdowns is costly from a maintenance perspective and affects efficiency. New and improved equipment can pay for themselves with more efficient and reliable production. Fixed assets is typically a large cash outlay and may be financed by loans or lease arrangements, as the periodic payments are more manageable from a cash flow perspective than a lump sum payment from existing cash (interest expense implications should be considered).
Financing activities – loans and equity - make sense for strategic events such as major fixed assets outlay, an acquisition, product or office expansion, but should be avoided for operating purposes, except in dire emergencies.
Study the Cash Flow Statement on a regular basis, to understand the key drivers of cash flow. Use the information to course correct as needed:
Is NI at desirable levels to support operating needs and leave surplus for debt servicing and dividends?
Is there room to improve AR, to drive increases in cash flow generation?
Is the business too reliant on financing activities?
The Cash Flow Statement is a look-back tool. It works best in tandem with a good cash forecast, with the two connected by regular variance analysis. This combination is an ideal tool for cash flow planning, analysis and improvement.
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