Cash Flow – The Forgotten Financial Statement
By Kerry Woodson
Ask most small business owners how their business is doing and they will usually respond with some version of an answer relative to sales. “Sales are up” or “sales are down” are typical comments. A few will take it a step farther and talk about profits but rarely will you hear a small business owner or manager talk about cash flow, one of the most important measures of business efficiency. The cash flow statement, unknown to some and ignored by others, is a critically essential instrument to determine a company’s true performance as well as a valuable tool to project future cash needs.
A cash flow statement is simply a financial report that shows a firm’s sources and uses of cash. Think of it as almost like a glorified checkbook register for your business – dollars in the door and dollars out the door are summarized in the report. This type of report is important because the profit and loss statement (P & L) can sometimes be misleading if not used in conjunction with the cash flow statement (and also the balance sheet). How can this be? Many business owners often wonder why they can be in a cash crunch when they show to be making significant profits. Some of the answer can be found in the way the P & L reports revenue and in some instances, not capturing certain expenditures. Let’s look at a couple of items.
One of the largest “discrepancies” is sales. An accrual P & L generally recognizes revenue at the time a sale is made, even if no money was received (an account receivable). At the end of the period, the boss is happy to see great performance but wonders why he/she is struggling to pay the bills. The answer is that the company has not yet received the payment for the sale, even though the costs required to deliver the product have been realized. Think of this scenario: A business is ecstatic to make a $100,000 sale but had to give the client 90-day terms. Let’s say the costs to the company are $70,000, which must be paid as incurred. On paper, the P & L would show a $30,000 profit and everybody’s happy. But the reality is that the company had to fork out $70,000 cash for this job this month and carry it until payment is received from the customer. It is situations like this one that can get a business in a bind even when business is “good” if proper preparation is not taken.
Other things the P & L doesn’t capture are items like debt principal payments and asset purchases. These items are not “expenses” and thus are not on the P & L, even though they definitely require cash. If a company has significant debt obligations, the payments can be a huge drain on cash. Likewise, if assets such as equipment must be purchased, without financing, cash will be depleted but there will be no entry on the profit and loss (other than depreciation). The cash flow statement will show these uses of cash.
As can be seen, there is much more to running a business than simply monitoring profits. Cash flow must be adequately managed to maintain a viable operation. When analyzed regularly, trends can be identified that might warrant further investigation. In addition to serving as a historical document, a cash flow projection can prove to be a valuable planning tool. It can help new businesses determine how much money they need to get started and survive the early phases. Existing companies can use it to identify potential shortfalls ahead of time and proactively plan to arrange access to additional capital before a crisis occurs.
By Kerry Woodson
Ask most small business owners how their business is doing and they will usually respond with some version of an answer relative to sales. “Sales are up” or “sales are down” are typical comments. A few will take it a step farther and talk about profits but rarely will you hear a small business owner or manager talk about cash flow, one of the most important measures of business efficiency. The cash flow statement, unknown to some and ignored by others, is a critically essential instrument to determine a company’s true performance as well as a valuable tool to project future cash needs.
A cash flow statement is simply a financial report that shows a firm’s sources and uses of cash. Think of it as almost like a glorified checkbook register for your business – dollars in the door and dollars out the door are summarized in the report. This type of report is important because the profit and loss statement (P & L) can sometimes be misleading if not used in conjunction with the cash flow statement (and also the balance sheet). How can this be? Many business owners often wonder why they can be in a cash crunch when they show to be making significant profits. Some of the answer can be found in the way the P & L reports revenue and in some instances, not capturing certain expenditures. Let’s look at a couple of items.
One of the largest “discrepancies” is sales. An accrual P & L generally recognizes revenue at the time a sale is made, even if no money was received (an account receivable). At the end of the period, the boss is happy to see great performance but wonders why he/she is struggling to pay the bills. The answer is that the company has not yet received the payment for the sale, even though the costs required to deliver the product have been realized. Think of this scenario: A business is ecstatic to make a $100,000 sale but had to give the client 90-day terms. Let’s say the costs to the company are $70,000, which must be paid as incurred. On paper, the P & L would show a $30,000 profit and everybody’s happy. But the reality is that the company had to fork out $70,000 cash for this job this month and carry it until payment is received from the customer. It is situations like this one that can get a business in a bind even when business is “good” if proper preparation is not taken.
Other things the P & L doesn’t capture are items like debt principal payments and asset purchases. These items are not “expenses” and thus are not on the P & L, even though they definitely require cash. If a company has significant debt obligations, the payments can be a huge drain on cash. Likewise, if assets such as equipment must be purchased, without financing, cash will be depleted but there will be no entry on the profit and loss (other than depreciation). The cash flow statement will show these uses of cash.
As can be seen, there is much more to running a business than simply monitoring profits. Cash flow must be adequately managed to maintain a viable operation. When analyzed regularly, trends can be identified that might warrant further investigation. In addition to serving as a historical document, a cash flow projection can prove to be a valuable planning tool. It can help new businesses determine how much money they need to get started and survive the early phases. Existing companies can use it to identify potential shortfalls ahead of time and proactively plan to arrange access to additional capital before a crisis occurs.
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