|
Chapter 3 -
Understanding the cash flow statement
 If you understand the cash flow statement you’ll be on your way to better cash management. Many business owners equate changes in the cash balance with net income. Net income does not equal increase or decrease in cash balance.
Why not? The short answer is that companies usually measure income on the accrual basis, and cash is simply measured through checks written and deposits made. The accrual basis considers items that don’t involve cash, such as sales to customers on credit and expenses charged on accounts with vendors or suppliers.
The cash flow statement is one of the three major financial statements, along with the balance sheet and the income statement. For a more complete understanding of financial statements, including a detailed chapter on the cash flow statement, see Commercial Carrier University’s How to Use Financial Statements.
The income statement, also called the profit-and-loss statement, starts with revenue earned, subtracts expenses incurred and leaves, you hope, a net profit. Revenue and expenses are logged when you incur them, not when you actually receive or write the checks.
Suppose you start a company and have $100,000 in sales and $90,000 in expenses in the first month. Your net income would be $10,000. But if no one pays you, and you wait another 30 days to pay everyone, not a penny flows through the company’s bank account. Your cash balance would be zero, not $10,000.
Suppose everyone follows federal rules and remits payment quickly. By the end of the first month, you might receive $50,000 in cash and not have to pay a nickel of the $90,000 in expenses, which might not be due until the 10th of the following month. At the end of the first month, you still have only $10,000 in profits, but your cash balance is $50,000. If you pay no attention to your obligation for the payables, you might spend that money and get caught in a pinch later.
Throw in equipment down payments, and the difference between cash flow and net income is further muddled. Use $20,000 of that cash to purchase a trailer. You don’t deduct anything from income (except, eventually, depreciation expense), but your cash balance is certainly smaller.
Suppose you borrow $25,000 for operating capital. That has no effect on net income, because revenue includes only earned income – not borrowed funds.
Although the income statement wouldn’t reflect all these items, they would show up on at least one of the three financial statements. Table 3-1 shows how the above transactions might look on all three statements.
Net income is $10,000, but the cash balance is $60,000. That sounds good until you realize that you can’t cover the $90,000 in expenses that are due on the 10th of the next month. If you don’t put your personal money in, you’ll have to stretch out some vendors and ask that they wait a few days. Every cash flow problem comes from attempting to “play the float,” either knowingly or, worse, unknowingly.
Keep doing this and soon you’ll have vendors demanding payment. Your first cash flow crisis is born. This may seem oversimplified, and it is. In reality, it gets much worse – and more quickly.
Table 3-1 – How items appear on the three financial statements |
Item |
Checkbook |
Other Balance Sheet Items |
Income Statement |
| Beginning balance |
0 |
0 |
0 |
| Make sales on credit |
0 |
$100,000 accounts receivable
|
$100,000 sales |
| Incur expenses on account |
0 |
($90,000) accounts payable
|
($90,000) |
| Collect on receivables |
$50,000 |
($50,000) accounts receivable
|
0 |
| Purchase trailer |
($15,000) |
$15,000 equipment
|
0 |
| Borrow operating capital |
$25,000 |
($25,000) loans payable |
0 |
Ending
balances |
$60,000 in cash |
$50,000 in accounts receivable
$15,000 equipment
($90,000) in accounts payable
($25,000) in loans |
$10,000 in profits |
How does the cash flow statement help?
The cash flow statement helps you understand the sources and uses of cash in your business, along three basic functions, or activities:
- Cash is provided (or used) by
operating activities.
- Cash is provided (or used) by investing activities.
- Cash is provided (or used) by
financing activities.
Table 3-2 shows how our example would appear on a cash flow statement.
This looks pretty healthy on the surface. But if you study it carefully, you’ll see the alarming difference between net income of $10,000 and cash provided by operating activities of $50,000. It’s good to have a positive operating cash flow. But too much of a good thing can be deceiving and unhealthy if you don’t eventually balance it with the other two categories.
Only $10,000 of this cash is yours to keep – all the rest is borrowed. Even getting that $10,000 assumes that you collect all of the remaining receivables. The confusion and cash flow “surprises” emerge when you allow the above situation to develop.
Table 3-2 – Cash flow statement |
| Cash from Operations |
Net income
Change in accounts receivable
Change in accounts payable |
$10,000
($50,000)
$90,000 |
| CASH PROVIDED BY OPERATING ACTIVITIES |
$50,000 |
CASH USED BY INVESTING ACTIVITIES
(Purchases of new equipment) |
($15,000) |
CASH PROVIDED BY FINANCING ACTIVITIES
(Proceeds of bank loan)
|
$25,000 |
| NET INCREASE IN CASH |
$60,000 |
| Cash at the Beginning of the Period |
0 |
| CASH AT THE END OF THE PERIOD |
$60,000 |
Operating activities
Cash from operations can be, and often is, negative. Especially in growing companies, the first section becomes “Cash used in operating activities.” Initial operating losses use up cash as spending for expenses exceeds revenue. As you add business, you put receivables on the books but have to pay the operating expenses. Growing companies can consume cash quickly. Without adequate loans or owner capital, a company can literally grow itself to death.
Many uses and sources of cash don’t show up in net profit. We have seen how cash can grow from early collection of receivables and delayed payment of payables. And we have learned that net profit has very little to do with cash flow. Table 3-3 shows some other sources and uses of cash from operations.
Table 3-3 – Other sources and uses of cash from operations |
| Other Sources of Cash from Operations |
Other Uses of Cash by Operations |
| Collecting and reducing accounts |
Allowing accounts receivable to grow through lax receivable through stringent collection procedures collection procedures |
| Reducing inventories |
Increasing inventories |
| Allowing prepaid expenses to be utilized |
Prepaying expenses, like insurance |
| Collecting or reducing loans |
Allowing loans or advances to drivers or employees advances to drivers or employees to grow |
| Collecting on short-term advances |
Making new loans or short-term advances to to officers and related companies officers or related companies |
| Extending payment time on accounts |
Reducing old balances of accounts payable and payable and accrued expenses accrued expenses |
| Tax refunds |
Paying income taxes |
Investing activities
Investments can be equipment, such as power units, trailers, office equipment or shop buildings. This section of the cash flow statement shows cash outflows, whether to put down payments on equipment and facilities or buy them outright. It also reflects using cash to buy stocks, bonds and other financial investments. If you liquidate an investment, it shows up on the cash flow statement as cash
provided by investing activities.
Money spent or invested in long-lived assets does not quickly affect profits because they are depreciated over time and because it takes time for them to generate cash collections. How you choose to pay for assets, however, can greatly affect cash flow. You could find yourself in a cash bind if, for example, you don’t wait until you’ve produced some cash from operations or you use your personal money to help carry the new investments.
Another stealthy cash user is investing in non-producing assets, such as loans to shareholders. This may seem like a good idea at the time, but unless you have a good cash forecasting system to prove that other uses will be covered, it can initiate a cash crunch.
Financing activities
This section reflects the activity and net changes in loans from banks and equipment financing companies. Loan proceeds provide cash; debt payments use it. Most important, this section of the cash flow statement shows the inflows and outflows of cash to the owners through dividends or shareholder loans. Most companies have cash flow difficulties because their owners undercapitalize them.
In Summary
The cash flow statement can help you understand your company’s three basic sources and uses of cash: operating activities, investing activities and financing activities. By learning the cash flow statement, you’ll be in a better position to diagnose the sources of cash flow problems.
|
