What the Heck is the Cash Flow Statement?

Sep 28, 2020 by Roger Scherping

I talked recently with an entrepreneur who said that he feels like he understands the Balance Sheet and the Income Statement. I said, that’s great, but what about the Cash Flow Statement? He looked at me with a completely blank expression and asked, what’s that? He said he’s not familiar with the Cash Flow Statement and never runs it as a part of his month end financial review.


Profit is not the same as cash!

The Cash Flow Statement is the most important of the financial statements, but it’s also the most overlooked. We all know that the Income Statement shows how much net income you made, and that’s obviously very important to know.

But understand this: Profit is not the same as cash! Many small business owners make the mistake of not understanding that. One of my favorite quotes comes from an experienced small business owner who told me once: “There were many years when I made lots of money, but I was broke.”

There are many reasons why your cash flow will not be the same as your net income:

  • Did you record any depreciation on your physical assets like buildings, equipment or vehicles? Depreciation is the recognition of the gradual decline in value of something you own, sort of like how your car is worth less every month. Depreciation is an expense that has no impact on your cash – you don’t write anyone a check for depreciation. Depreciation is just an accounting entry that impacts your net income but not your cash.
  • Did your Accounts Receivable or Inventory go up this year? This happens often at a growing company. Growing Accounts Receivable or Inventory means that some of your cash went to building those assets, and this increase will not impact your net income.
  • Did you purchase any equipment this year? If so, your cash went down but your income did not.
  • Did you make any loan payments? The principle portion of those loan payments will reduce your cash without impacting your net income.

Sound confusing? That’s all right; the Cash Flow Statement sorts all of this out for you.

Here’s what a typical Cash Flow Statement might look like.

Net income                                                            $100,000
Addback depreciation                                               10,000

Change in current:
  Accounts receivable                                             -20,000
  Inventory and other current assets                      -25,000
  Accounts payable                                                   5,000
  Credit cards                                                            5,000
  Other current liabilities                                           5,000
                                                                             ----------
Net change in cash flow from operations               80,000

Cash from borrowing activities:
  Long term debt                                                   -25,000

Cash from investing activities:
  Fixed assets                                                        -80,000
  Other assets                                                                  0
  Equity                                                                   -50,000
                                                                              ----------
Net decrease in cash                                             -75,000


Remember that the purpose of the Cash Flow Statement is to explain for a period of time the difference between your net income and the net increase (or decrease) in your cash flow. So the Cash Flow Statement starts with your net income and ends with your net cash flow, and the lines in between explain what happened to your cash.

In this fictitious case, the company had net income of $100,000. To that we add back depreciation because depreciation doesn’t affect cash.

Then we look at a group of accounts that often impact cash flow. I mentioned that a growing company may find that some of its cash goes to increasing Accounts Receivable and Inventory, and that is the case with this company. That’s why those two numbers are negative.

Conversely, an increase in liabilities (the amounts that you owe others) will increase your cash flow, as shown by the next three accounts.

The line that says “Net change in cash flow from operations” explains that the company’s normal operations have resulted in a net increase in cash of $80,000. This is slightly lower than the net income of $100,000, but not too different.

But next we’ll look at some longer term decisions that this company made. They paid down their debt ($25,000), purchased some equipment ($80,000), and paid some money to the owners ($50,000). The bottom line then shows a net decrease in cash for the period of $75,000.

So this company that made a profit of $100,000 actually had a decrease in their cash of $75,000. What a difference!


Understand your cash flow!

Do you see why you can’t just look at your Income Statement? Now do you understand the comment about making a profit but being broke?

You need to understand both your net income and your cash flow. That’s why we created ProjectionSmart Growth. Growth lets you model your next 12 months to see your financial future. Growth shows you both your projected budget and your projected cash flow so you can understand your projected net income and see what your cash will do.

Growth also allows you to change your assumptions and see how your business decisions impact your cash flow. Can you afford to expand your business? Can you buy that new piece of equipment? Do you need to start talking to a banker now about a loan? Model them in Growth and immediately see the results.

And Growth is the only program made for the small business owner who lacks a finance background so that they can do their own analysis. It’s simple and easy to understand. You can do your analysis in less than an hour.

Growth will bring you the peace of mind that comes from understanding your financial future.

Hope that helps. Email me if you have any comments.

Roger
 

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