Your cash flow statement shows where your cash is coming from, and where it is going. Sometimes known as “sources and uses of funds,” this financial report is an important complement to your income statement and balance sheet. Investors want to see that you know the difference between your net income and your net cash flow, and that you understand how your business uses cash.
So your cash flow statement starts with your net income at the top. The bottom line of your income statement is the top line of your cash flow statement. So your net income sort of approximates the cash that you earned or lost in your last period, but it's not exactly right. There's some adjustments that you need to make.
Sometimes when you sell a product to a customer, instead of giving you cash they may wait 30, 60,90 days before paying you. Now that number, that sort of deferred payment, that's called an account receivable. But what it means is it did not come into your company as cash. It gets included in your revenue number, so it seems like it's part of your net profit. But for cash flow calculations you've got to reverse out that account receivable in order to figure out what really the cash is that you earned in this period.
Sometimes entrepreneurs are afraid to bug their customers to ask them for money. But to be honest, it's a just another point of contact between you and the customer. So think of it as an opportunity to engage with your customer, not just as an important opportunity to collect those receivables. If you let your receivables get out of hand, if you let customers defer paying for your products that can eat into your cash. And you may not be able to afford that. Go get those accounts receivable as quickly as you can. It's critically important for your cash flow.
The other thing that significantly affects your cash flow are your accounts payable. Again, that's the money you owe to your vendors. A lot of entrepreneurs sort of manage their cash flow by managing their accounts payable. And so if their accounts receivable are a little bit slow, then maybe they'll slow down their accounts payable to try to keep the cash flow level. So, you know, your net profit, adjusted for accounts receivable, adjusted for accounts payable, put all of that together and that represents your cash flow from operations. And that's the core cash flow of your business. That number is probably going to be pretty different than your net income. And so you want to make sure you understand what's going on there, analyze why it's different and figure out is there a problem there you need to solve.
Below your cash flow from operations is the cash that you use for capital expenditures. And then the next part of your cash flow statement is the cash from financing activities. And basically what that means is, if you raise debt or you raise equity that increases your cash. If you pay off debt or you buy back equity, that reduces your cash. You don't really want to muddy up your business processes, i.e. your operations with the cash flow related to debt and equity. So that's why we put it on a separate place in your cash flow statement.
So now you can put all of these things together, look at the revenues at the top of the income statement, flows down through expenses to your net income at the bottom of your income statement. That goes to the top of your cash flow statement. You flow through your cash flow statement to the cash at the end of the period. That flows over to your balance sheet, the cash at the end of the period in your balance sheet. So you can see that these three statements; your balance sheet, your income statement, your cash flow statement, they all tie together beautifully in the end.
It's really important that you understand the relationships between these different financial tools. When an investor comes in they are going to want to know that you really understand the elements of your income statement, the revenues, the costs, the expenses and how that generates income for your company. But they also want to make sure that you understand the difference between your net income and your actual cash flow. That requires that you really know how to manage things like accounts receivable and accounts payable. Don't just leave it to the bookkeepers and accountants, because after all it is your business.
Berman, Karen and Joe Knight. 2008. Financial Intelligence for Entrepreneurs: What You Really Need to Know About the Numbers. Harvard Business Press.
After preparing your financial statements for several months (or quarters), you should sit down with a loan officer at a bank and get a banker’s perspective on your financial performance and on your credit worthiness. But just because a banker is willing to lend you money, doesn’t mean you should borrow money. It’s just good to know where you stand.
Questions for You
Do I have a good understanding of why my cash flow is different than my net income?
What are the most important drivers of our cash flow?
Can we afford to borrow money to accelerate growth? Does our financial performance show that we are credit-worthy in the eyes of a banker?
Do I have a good bookkeeper/office manager who stays on top of the details?
Questions for Your Team
Are we managing our receivables and payables as efficiently as possible?
How can we improve our cash flow?
Tools and Exercises
Exercise: Using the Balance Sheets for the last two quarters, calculate your Cash Flow Statement for the last quarter. By doing the Cash Flow Statement calculations yourself, you will get a much better understanding of what the numbers really mean.
Exercise: Once you have prepared your own Cash Flow Statement, identify the most important sources and uses of cash in your company, and then make sure you focus on those going forward.