The Business Acumen Series: The Statement of Cash Flows
The balance sheet and income statement receive a lot of attention — from management, from bankers, from investors — these are the statements everyone talks about. If you really want to know the health of your company, look at the cash flow.
Let’s explore the different areas of the statement of cash flows and the value they provide in managing your business affairs.
Cash Flows from Operations
Cash flows from operations are the heart of this statement and speak to the viability of operations. To appreciate this section of the statement, we must first understand its components; unfortunately, generally accepted accounting principles (GAAP) define operating activities by exception, i.e. under FASB Accounting Standards Codification (ASC) 230, operating activities include all transactions which are not investing or financing activities. Generally speaking, cash flows from operations arise from sales of products or services and the related costs incurred to produce those goods or render those services.
Cash flows from operations begin with net income for the period and adjust for the effects of expenses incurred during the period for which there was no current period cash outlay. For example, the cash outlay related to the purchase of equipment occurs in period, while depreciation expense is incurred over a number of periods. The depreciation expense does not represent a current period cash outlay, so it gets added back to net income. After adjustments for items such as depreciation, amortization, bad debt expense, gain/loss from sales of assets, etc., cash flows from operations are shown as the fluctuation of various balance sheet line items.
Generally speaking, if accounts receivable decreased for the period, the business experienced positive cash flows from operations; alternatively, if accounts receivable increases during the period, negative cash flows from operations are experienced. The flip side is accounts payable. If accounts payable decreases during the period, the business has net negative cash flows from the related cash outlay, whereas an increase in accounts payable represents positive cash flow from operations.
At its most basic level, cash flows from operating activities illustrates whether or not your business is generating cash from the day-to-day actions of providing goods and services to your customers and paying for the costs of materials and services from your vendors.
One mistake many small business owners are prone to is believing their business is doing well because there is cash in the bank today. The balance in the bank account changes daily and those checks you cut last week are going to clear and you may not collect those receivables on your books as soon as you think. Sometimes the cash in the bank account is simply the result of borrowings under a line of credit. The movement of the cash over time is far more critical than the balance at any given point in time.
Investing Activities
Investing activities illustrate a number of elements about the business. From here, we can see both the internal investments of the business and the outside investing activities of the business. It is important to distinguish between the two. Internal investments in the business are primarily going to appear as fixed asset additions, the buying of equipment, vehicles, building additions, and other operational assets which are critical to the success of the business. These assets are expected to generate revenue over a long period of time and therefore require careful consideration as to their purpose and future economic benefits. While it is great to be able to take advantage of the tax benefits from accelerated depreciation deductions, this aspect of purchasing assets for the business should be secondary to the long-term operational plan.
Also, do not forget to invest in your most important asset — your employees. While your people may show up as an expense for accounting purposes, your employees are valuable revenue generating assets and the economic benefits of investing in your personnel through bonuses, retirement contributions or other benefits will always outpace any mutual fund in which you could invest.
The second element in the investing area of the cash flow statement represents the outside investments of the business. These may come in the form of marketable securities, investments directly in other businesses, or loans to other entities. These types of investing activities should only be considered after necessary investments have been made internally for the benefit of the business and only when the business is generating sufficient cash flows from operations. Investing outside of the business is far more speculative than investing in your own business. The management at your company has more critical information available to make sound decisions about the future of your business than they ever will regarding the stock market at large or other companies. That said, if necessary investments have been made internally, and excess cash flows exists, it is certainly advisable to invest outside the business to ensure your cash is working for you.
Financing
The last area of the cash flow is the financing section. As denoted by the name, this areas deals primarily with the borrowing and repayment of debt, but it also covers the equity activity of the business in the form of contributed capital and distributions to the owners. Short-term obligations, such as revolving line of credit arrangements are typically presented on a net basis, i.e. the borrowings and repayments under the line of the credit for the period are netted together and displayed as either a net inflow or net outflow of cash.
GAAP requires long-term obligations, such as your term loan with the bank, to be presented gross, i.e. borrowings and repayments of principal shown as separate line items on the statement of cash flows. A business’s cash outflows for long-term obligations are generally going to be predictable over the term of the agreement and correlate closely to the long-term operational plans of the business. The short-term obligations such as the line of credit often create a trap in the cash flow analysis as previously mentioned, because the borrowings are covering short-term deficits in working capital.
While some business models essentially require a line of credit due to the timing of collecting receivables from customers while servicing payables to vendors, in many cases, the line of credit borrowings are simply a bandage, and will only stem the loss of cash from operations for so long. It is of great importance that management assesses regularly the dependence of the business on its short-term credit facilities, not least of all considering the additional cost of interest.
As we have discovered in our brief overview of the statement of cash flows, understanding the movement of cash through the business is critical to running a profitable operation. The health of your business is more than a snap shot in time provided by the balance sheet. Cash flow is the oil that greases the inner workings of the business, and if ignored, your business will seize up just as quickly as the engine of your car. Learn to appreciate the cash flow of your business before smoke starts billowing out from beneath the hood of your company.
