By Barbara Nuss, CPA, Profit Soup
The Statement of Cash Flow Has the Answer
Any seasoned business owner or advisor has seen it happen. The business showed a handsome profit at the end of the year and mysteriously the cash balance plummeted. The first question the owners, accountants and lenders ask is, “where is all the cash?” The Statement of Cash Flow is an underutilized report that answers that vexing question.
Profit and Cash Are Not the Same Thing
Before we get to the report, let’s start with the premise that profits and cash are not the same thing. Here is an example:
Imagine your Income Statement (or Profit and Loss , P&L) shows $100,000 of profit after tax at year-end. Hooray! But you don’t have $100,000 in cash because you spent money on things that were not expenses on your P&L. Things like loan payments. The amount you paid on the principle was used to reduce the loan amount on the balance sheet. Only the interest included in the payments was an expense on the P&L.
Let’s say you paid down $60,000 of your loans. Even though you had a profit of $100,000, you only had a net cash increase of $40,000 because $60,000 was used to pay off debt. Profit and cash are not the same thing.
That’s why the Statement of Cash Flow is so important. It reconciles the differences, giving you a view into your business you cannot get any other way.
The Statement of Cash Flow Shows the Differences Between Profit and Cash
The Statement of Cash Flow starts with the cash you had at the beginning of your report period (the month, quarter or year, you decide). Then it adds the profit from the P&L to the beginning cash.
Wait! Wait! We just said, “more profit doesn’t necessarily mean more cash!” Read on. After the profit comes all the reasons this is true. The rest of the statement details the differences between profit and cash as if to say ‘but it didn’t’ help your cash balance because…”
The Statement of Cash Flow shows those reasons (the differences between profits and cash) in three buckets: operating activities, investing activities and financing activities:
Operating Activities: This bucket includes changes in current assets and current liabilities, like accounts receivable, accounts payable, and inventory. For example, when you need more inventory to operate, it consumes cash. You must spend cash to buy inventory, but it is not an expense because you still have it. The expense only shows up as cost of goods sold when you sell the item. Growing inventory uses cash. When you sell off more inventory than you purchase, it produces cash.
Investing Activities: This bucket includes changes in fixed assets and other assets (assets other than current assets). Investing in these things uses cash. For example, if you purchased equipment, you may have written a check for it, but the purchase is an asset on the balance sheet, not an expense on the P&L, because it still has value left. It’s just not cash. The operating activities section will show how much depreciation occurred. Depreciation is an operating expense you didn’t write a check for, so the impact goes the other way.
Financing Activities: This bucket includes changes in your funding, whether from debt (other people’s money) or equity (owners’ money). If you borrowed to buy that equipment, the loan proceeds provide cash. Owner contributions of capital also add to cash, and owner distributions, dividends or withdrawals reduce cash. This includes any payments to or on behalf of owners that were not reported on the income statement as compensation or business expenses. These are all shown as financing activities in the Statement of Cash Flow.
Timing Can Drive Big Differences
For many businesses, the biggest differences between profits and cash are caused by timing differences. That is, the sale (or expense) was earned (or incurred) during the report period so it is on the P&L, but you haven’t collected (or paid) it yet so there’s no impact on cash. The inventory example we outlined earlier is an example of a timing difference. If a business carries accounts receivable, this also causes a timing difference.
For example, you make a sale this month, but you don’t collect the cash. Instead, you carry an account receivable. It might be 30 or more days before you collect the cash. You make the sale in a different month from when you collect it. You have profit but no cash.
When accounts receivable and inventory increase because of these timing differences, they use cash. When they decrease, they provide cash.
When Sales Grow, the Differences Between Profit and Cash Get Larger
At the beginning of the year, you collect some of the sales from the prior year. Cash benefits but sales and profits don’t. Those sales weren’t on this year’s P&L. At the end of the year, you have sales that you don’t collect until next year. But when you grow, you have more uncollected at the end of the year than you had at the beginning of the year. Sales are growing but the profits are used to pay for the increasing accounts receivable.
Current assets and current liabilities grow as sales grow. If revenues increase, your year-end accounts receivable, inventory and accounts payable will also grow unless you can manage them more efficiently – that is, turn them to cash faster.
Hot Tip: Regularly review and discuss reports with your team that show how efficiently current assets and liabilities are managed: accounts receivable aging, accounts payable aging and your favorite inventory reports from point of sale.
Keep expanding and the differences between profit and cash get larger. That’s why larger businesses need more funding. A strong, profitable business can justify additional financing for the timing differences and the equipment investments. An astute business investor manages the growth by watching more than just sales, profits and the bank balance. They review a Statement of Cash Flow along with their balance sheet and P&L every month.
Sounds Great, but I Don’t Have a Statement of Cash Flow
With most accounting software, producing the Statement of Cash Flow is as simple as entering the report dates and clicking the box to print. You can use it to gain insights on your profit to cash differences for a month, a quarter or a year. You decide. It’s best to run the report for the same range of dates as your income statement and include with your regular monthly financial review packet. Discuss your insights with your leadership team or your CPA during the year. Not just at year-end!
Monitoring the differences between profits and cash builds an intuitive sense about your business that will serve you well. Predicting timing differences is essential to determining how much funding you will need to grow so you can head off cash shortages before they occur. Your Statement of Cash Flow is your “go to” report for gaining these insights.
Just like many things, the hardest part is just getting started. Once you use it regularly and get familiar with it, you’ll wonder how you ever got by without it.
See related blog and video, How Does Cash Flow
Listen to Barb’s podcast on this same topic, Talking About the Statement of Cashflow. It’s part of Profit Soup’s Small Business Podcast Series from Profit Soup and the University of Louisville YUM! Center for Global Franchise Excellence.