There are three main pillars of financial reporting.
We’ve already discussed income statements and balance sheets. But what is a statement of cash flow?
The broad purpose of a statement of cash flow is to show where cash in your business is being freed up and also where it’s getting tied up. This explains why another name for the statement is “sources and uses of funds.”
The cash flow statement examines a company’s sources and uses of cash by looking at the change in position from the balance sheet at the end of the previous year to the balance sheet at the end of the current year.
The Structure of a Statement of Cash Flow
The report begins with the net profit for the year, shown at the bottom of the income statement. The report then adds back non-cash items that were subtracted from the income statement; this is usually the depreciation of assets.
While depreciation is considered an expense, it is not a cash expense, and this report is only concerned with cash. In the case of depreciation, you are writing off the value of an asset that has already been paid for. No new cash is going out of the business, so you need to reverse that expense.
Once the depreciation value is added back to the Net Income, a subtotal is generated: Cash Flow.
Next, you evaluate the changes in non-cash working capital between your current and previous balance sheets. This includes non-cash current assets (inventories, receivables) and current liabilities (payables).
- Subtract increases (add decreases) in inventories and receivables. If there is more money tied up in inventories, you have less operating cash; if you are not collecting receivables, you have less operating cash.
- Similarly, add increases (subtract decreases) in payables. If you can hold off on paying your suppliers, you will have more operating cash.
The new subtotal is called Operating Cash Flow.
Next, look at the changes in long-term investments like PP&E (Property, Plant & Equipment):
- Add the value of land, buildings, or equipment sold; subtract the value of land, buildings, or equipment purchased.
The new subtotal is called Free Cash Flow.
Finally, look at financing, which can be based on either debt or equity. You have more cash by taking on more debt or by issuing more shares. You have less cash if you pay off existing debt or if you buy back shares.
- Subtract Loans (not Payables) paid off; add Loans taken out
- Add the value of new shares issued; subtract the value of shares bought back.
The new total is Change in Cash. This is the difference in cash between now and the previous reporting period.
Good and bad cash flow
Perhaps a simpler way to look at freed vs. tied-up cash is to categorize decisions as “good” or “bad” for your cash flow.
When you pay your bills, you have less cash on hand—that’s bad for cash flow. If you receive goods from suppliers without paying for them right away, you have more cash on hand, which is good.
Similarly, if you make sales to customers but they don’t pay, that hurts your cash flow. On the other hand, if customers pay you more quickly than they did before, that frees up more cash and therefore benefits your cash flow.
The same goes for shrinking up inventories. Hopefully, you aren’t making unnecessary purchases of goods and supplies, resulting in an inventory surplus. A needlessly large inventory is bad for cash flow. When you’re evenly balancing sales and inventory, it’s good for cash flow.
Look at fixed assets. If you’ve sold some land and buildings, that’s good for your cash flow. If you’ve bought more machinery, that’s bad for it (although it is should be good for the business, of course).
And finally, if you needed funding, where did it come from? Did you borrow from the bank? That’s good for cash flow. Did you pay off your debts, paying down the bank balance? That’s bad for cash flow.
You can begin to see how a statement of cash flow works. You’re referencing it to determine, from one year to the next, whether you have gained or used up cash.
In a sense, people are in business not for business’s sake, but for money. The statement of cash flow analyzes that aspect of business success: where the money came from and where it went.
The statement indicates whether or not the operation is healthy and sustainable. For example, you can’t keep giving your customers longer and longer to pay without running out of money. You can’t keep funding a loss-making business by borrowing–the bank will eventually stop lending you money.
Profit vs. Cash
Analyzing cash flow has important implications for major business decisions. It’s possible to be profitable and to expand into a profitable opportunity, while still burdening the business with disproportionate cash outflow obligations.
In this scenario, if it takes time to ramp up production, or if money from customers isn’t coming in fast enough or if there are huge debts to pay for new equipment and stocks of inventory, you may simply run out of cash.
[Tweet “You can go bankrupt even though you’re running an operation that is profitable on paper and would have paid for itself eventually. “]
Cash flow represents the immediate financial reality. Profit is a long-term view of what’s healthy in a business.
[Tweet “Cash Flow is what helps you survive day to day. “]
Every business must monitor the relationship between profit and cash flow, especially as it pertains to the sales team. One of the ways salespeople close deals is by telling their customers that they don’t have to pay for 90 days, or six months, or a year.
As far as they’re concerned, their job is to make a profitable sale. They’re not measured by the timing of the cash flow. But the company needs the cash in order to keep functioning.
Interestingly, when customers don’t have to pay for a year, their cash flow position is aided, but the company suffers!
Conclusion
Typically, only investors request to see a statement of cash flow. They’re analyzing sustainability or looking for excess cash being generated that can be paid out as dividends.
But the fact that this report is used by only a select group does not take away from the significance of the statement. The cash flow statement offers an insightful look into the financial sources and uses of funds within the company, and into the likelihood that the business will succeed in the future.