The Cash Flow Statement is great tool to help a business owner understand where their cash went for a period of time. Understanding your cash position and where your cash is going is essential for ongoing operations. Cash is the lifeblood of any organization. If you don’t have cash you will be out of business soon. A very basic way to understand this is to think of your personal checking account. You track deposits and withdrawals to get to the current cash balance. The Cash Flow Statement does this as well but it breaks it out into the various types of activities.
I have had clients ask me why they don’t seem to have cash when they are showing a profit on the Income Statement or make comments about why their cash changes don’t match the Income Statement. They often forget that cash coming in and out of an organization effects both the Income Statement and Balance Sheet. Looking at the Cash Flow Statement will help business owners understand where the cash went.
The Cash Flow Statement has three primary categories:
- Operating Activities
- Investing Activities
- Financing Activities
Think of operating activities as the money you need to run the business on a daily basis. This section begins with net income(loss) and then adds back non cash charges like depreciation, amortization, stock based compensation and asset impairment. These are all items reported on the Income Statement that effected the profit or loss but actually do not effect cash (cash never leaves the bank account for these activities). For this reason they are added back in this section of the Cash Flow Statement. For more details on these items read the blog about the Income Statement here.
The next part of the operating activities is the changes in working capital. This is the difference between current assets and current liabilities (both of which are on the Balance Sheet). The common accounts that are effected are Accounts Receivable (when a customer pays for goods using credit – they still owe you), inventory that has not been sold yet and prepaid expenses (an example could be insurance which is usually due in advance of its usage date).
This brings you to operating cash flow. It is the cash generated from normal business operations, similar to net income from the income statement no a cash basis.
The next section is Investing Activities.
Investing activities are funds used to invest back in to the business either for growth or to maintain assets. This is cash used beyond the scope of the normal operations of a business, like building a new factory, purchasing assets or another business. These are activities that are not part of daily operations of a company.
The next section is Financing Activities.
Financing activities are cash flows in and out of a business based on financial activity. A common thing in this area is the borrowing and paying back of debt (loans). For a public company this would also include issuing bonds or stock which produces a positive cash flow or paying dividends and buying back shares of stock which produces a negative cash flow.
The final section of the cash flow statement shows the cash the company started with at the beginning of a time period (month, quarter, year) and compares it with the cash at the end of the period. This ties to the Balance Sheet cash balance.
Here are some of the things you as a business owner or a bank or investor might look at on the cash flow to see the health of an organization:
- Net Income is negative (reflected at the top of the cash flow statement). This does happen in an organization but is this a long term issue?
- Stock-Based Compensation is more than 10% of Net Income. Stock Based Compensation is a way to reward employees without paying more in salary. This is not necessarily a bad thing. Many start up companies will do this.
- Operating Cash Flow is Lower than Net Income. Operating Cash Flow is calculated by starting with net income and adding back non cash charges like depreciation, amortization and stock based compensation. Operating Cash Flow should always be larger than net income. If it isn’t then you may have issues such as lots of unsold inventory.
- Debt Increasing – the idea is to reduce debt not increase it. The question is why is the debt increasing.
- Cash Balance Declining – Is management not spending money wisely or is the business struggling. As a business owner you need to know why the cash is declining.
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