cash flow : Getting in Sync with the Rhythm of Cash
Cash flow : In running a business, you have to follow many rules, but one rule stands above the others : Don’t run out of cash.
As obvious as you may think this rule is, the importance and difficulty of maintaining an adequate cash balance are generally taken for granted in business management books and articles.
Numerous business chiefs disregard money until a significant issue springs up.
They assume that cash flow will take care of itself, as if cash could be put on automatic pilot.
cash flow : Nothing is farther from the truth.
If you don’t pay attention to cash, you may be in for a nasty surprise.
To control cash, you must control cash inflows and cash outflows.
To do that, you need cash-flow information, and you need to know how well your current cash balance stacks up against the short-term demands on cash.
Managers depend on regular accounting reports for financial information; in particular, their monthly income statement (also called the profit and loss, or P&L, report).
In any case, the salary articulation doesn’t give the income data you need.
You must turn to another financial statement for cash-flow information, appropriately called the statement of cash flows.
But here is where things get rather befuddling for the business manager.
The cash-flow statement lists adjustments to profit to arrive at the cash flow from making profit.
It assumes that the reader has a good basic understanding of profit accounting and, therefore, knows why adjustments are necessary to find cash flow.
But in our experience, business managers do not fully understand how their accountants measure profit, which makes understanding cash flow and why it’s higher or lower than profit very difficult.
Fitting Cash Flow into the Big Picture of Running a Business.
This topic starts by pointing out the catastrophic consequences of running out of cash.
Next, we offer a brief review of profit accounting and the assets and liabilities that are used in recording revenue and expenses.
Changes in these assets and liabilities are the reasons why cash flow differs from profit.
Then the article takes the first steps in explaining the cash flow, aspects of making profit and why cash flow is invariably higher. Or lower than the bottomline profit or loss number in the income statement.
We likewise clarify the income side of business exchanges and the essential classes of incomes.
Not Letting the Well Run Dry
One morning you arrive at your business. As usual, you’re the first person to arrive.
But none of your employees come to work.
Not one. Who will open the doors for customers? And who will sell your products? Who will start tapping on the computers?
This scenario may seem like a nightmare, but it’s not the worst thing that can happen to a business.
Here’s the real fiasco you should worry about :
One day your accountant rushes into your office and tells you that the business’s bank account balance is zero.
You have $50 in petty cash and a small amount of currency in the cash registers.
But that’s it. Your checking account is empty.
You can’t cut any checks to your vendors, who will cut off your credit if not paid on time.
You have a sizable payroll to meet in two days.
If not paid, your employees will quit.
And your bank is sure to notice that your checking account balance is zip and may consider shutting down your credit line.
It’s not a pretty picture, is it?
A zero cash balance puts you on the edge of a cliff.
One false step and you can fall off and be unable to recover.
When your suppliers, employees, and sources of capital find out about your cash problems, and they will your credibility drops to zero.
The businesses and various people you deal with depend on your ability to continue as a going business that they can rely on in the future.
Running out of cash would pull the rug out from under the reputation of your business, that you worked so hard to build up over the years.
You could lose your business to creditors or have to declare bankruptcy.
Running out of cash is an extreme, worst-case scenario, although it’s a threat many businesses face.
The purpose of mentioning it here is to emphasize its disaster potential for a business.
Running out of cash is not just a life-changing event for a business; it can be a life-ending event.
Business managers should never let their guard down regarding cash and cash flows.
Surprisingly, many business managers, small-business owners/mangers in particular, do not take an aggressive, proactive approach toward controlling cash.
Instead of learning cash flow fundamentals and techniques of controlling cash flows, they retreat into a passive mode.
But very few businesses have the luxury of sitting on hoards of cash such that they really don’t have to worry about the cash balance period to period.
Many businesses operate on a razor-thin cash balance.
Outlining Profit Accounting Basics
The best way to avoid cash-flow problems and to generate a stream of cash flow is to earn profit. Measuring profit (or loss) is the job of your accountant.
Each period your accountant prepares an income statement that summarizes revenue and expenses and profit (or loss) for the period.
To understand cash flow emanating from profit, you need to understand how your accountant records revenue and expenses.
Otherwise you’ll be confused about why your cash flow from profit during the period is different from your profit for the period.
You don’t have to delve into the technical aspects of revenue and expense accounting — just understand the basics.
This section gives you the brief overview you need to go forward with managing cash flow.
We’re optimistic that you know that profit is the excess of revenue over expenses (and loss is the excess of expenses over revenue).
We mention it simply to stress that profit accounting really refers to revenue and expense accounting.
Profit (or loss) is just the residual number left over after recording revenue and expenses for the period.
The short dialog of income and cost bookkeeping in this area is close to dunking our toes in the water.
Profit accounting involves much, much more than this very brief introduction covers.
We go into more details later in this article in and future topics.
Reviewing revenue accounting
When a sale is made for “cash on the barrelhead,” to use an old expression, cash increases and the accountant increases the sales revenue account the same amount.
At the retail level, most sales are for cash, currency and coins are received by the business, or a credit or debit card is accepted that almost immediately increases the cash account of the business.
Interestingly, numerous organizations sell using a credit card, particularly to different organizations.
No money is collected from the customer until a month or so after the sale.
In those cases, the accountant records the sale immediately by increasing an asset account called accounts receivable and increases sales revenue the same amount.
When the customer pays later, cash is increased and the accounts receivable asset is decreased.
Notice the time lag between the two events — point one when the sale is recorded and point two when the cash is received.
Revenue accounting can be much more complicated than recording simple cash and credit sales.
For example, some businesses collect cash from customers before delivering the product or service, such as newspapers that collect subscriptions in advance before delivering the papers, and insurance companies that collect premiums before the insurance period coverage begins.
But in any case, recording revenue is coupled with a corresponding increase in an asset or, in some cases, a decrease in a liability.
Examining expense accounting
A business records many expenses by decreasing cash and increasing an expense account, such as paying the monthly utility bill for gas and electricity.
This transaction is straightforward enough: Cash decreases and an expense account increases the same amount.
But many expenses are more complicated.
Perhaps an expense is recorded before cash is actually paid out, or it may be recorded sometime after cash has been paid out.
Recording an expense is coupled with a corresponding decrease in an asset or an increase in a liability.
For instance, a business gets a bill from its legal advisor for work previously done.
The appropriate expense account (legal fees) is increased, and a liability account called accounts payable is increased.
When the bill is paid later, cash is decreased and the accounts payable liability is decreased.
When a business buys products that it will sell later to its customers, it increases an asset account called inventory. Suppose the purchase is on credit from the vendor.
The inventory asset account is increased, and the accounts payable liability account is increased.
Usually a business pays its vendor before it sells the products to its customers.
However, in some cases a business may sell products to its customers before it pays the supplier of the products.
Another cash-flow example
Here’s another case of a significant cost : Suppose a business purchased a conveyance truck three years back and paid for it at that point.
That portion of the original cost charged to expense in the year is called depreciation expense, and we discuss its cash-flow aspects in the later section “Depreciation expense.”
Contrasting cash- and accrual-basis accounting
For most businesses, profit accounting (recording revenue and expenses).
involves much more than just recording cash inflows and cash outflows.
Recording only cash inflows and outflows is not acceptable for most businesses and, in fact, would be seriously misleading.
That type of accounting, called cash-basis accounting, doesn’t fit how most businesses carry on their profit-making activities or how businesses raise and invest capital.
Under cash-basis accounting, revenue and expenses are recorded when the cash flow happens.
Revenue is recorded when cash is received, and expenses are recorded when cash payments are made — not before and not after.
Some small businesses that tend to operate through straightforward transactions get by with cash-basis accounting.
Federal income-tax law allows cash-basis accounting for businesses that meet certain conditions.
Generally, cash-basis accounting is acceptable only for relatively small businesses that don’t buy or sell on credit and that don’t make investments in operating assets.
Most businesses of any size and complexity buy and/or sell on credit and make sizable investments in long-term operating assets (buildings, machinery, and the like).
For these businesses, cash-basis accounting is woefully inadequate.
Instead, they use accrual-basis accounting.
(How well they use it is another matter.)
Accrual is not a particularly good descriptive term.
In accounting jargon, it doesn’t mean accumulation, accretion, growth, or enlargement.
In the field of accounting, the term accrual refers to recording revenue and expenses (as well as the resultant increases and decreases in assets and liabilities) at the time that economic exchanges and business transactions take place.
The cash flows of many transactions occur before or after the transaction — perhaps a few days, maybe a month, or even years before or after recording revenue and expenses.
Accrual-basis accounting is on one timetable; cash flows are on another timetable.
Seeing Why Profit and Cash Flow Are Different Bottom Lines
You often hear that a business “made money,” meaning that it earned a profit.
But earning a profit does not mean that the business’s cash balance went up the same amount.
In fact, earning profit can sometimes cause the cash balance to decrease.
To keep the business healthy, managers need to differentiate the two numbers and understand the importance of each.
The income statement of a business (a key accounting report also called the P&L report, earnings statement, statement of operations, and other titles) summarizes the revenue and expenses of a business for a period of time.
The last line of the statement is the profit or loss for the period.
The cash increase (or decrease) from making the profit is a different matter.
Many business managers mistakenly assume that profit reported in this statement means the cash balance increases the same amount a potentially dangerous misperception.
In this section, we discuss what information you can glean from the income statement, what info you can’t, and why you need to keep an eye on more than one bottom line.
Considering what the income statement doesn’t say about cash flow
Figure 1-1 presents the most recent annual income statement of your friendly hardware store.
We keep the number of lines in this income statement example to a minimum, to focus attention on fundamentals.
(Following common practice, numbers in parentheses mean a decrease by that amount; numbers not in parentheses mean an increase.)
The business sells a wide variety of products to retail customers who pay cash or use credit and debit cards, which the business converts into cash almost immediately.
The hardware store also sells to other businesses.
Its basic business model is to mark up the costs of products (called “goods”).
it buys to earn enough total gross margin to cover its operating, depreciation, and interest expenses, and to provide profit.
As you see in Figure 1-1, the business earned $600,000 bottom line profit for the year just ended, which equals sales revenue minus all expenses.
As an aside, you may notice that profit equals 5 percent of sales revenue ($600,000 profit/$12,000,000 sales revenue = 5%), which means that expenses are 95 percent of sales revenue.
Income Statement for Year Just Ended
Dollar amounts in thousands
Sales Revenue $12,000
Cost of Goods Sold Expense ($7,500)
Gross Margin $4,500
Operating Expenses ($3,400)
Depreciation Expense ($200)
Operating Earnings $900
Interest Expense ($300)
Net Income $600
Figure 1-1: (Example income statement)
cash flow during the year
The income statement by itself doesn’t report how much of sales revenue was collected in cash during the year.
Consider the $12 million deals income sum, for example.
This accumulation, premise bookkeeping sum might be generally near the real money inflow from deals during the year yet, on the other hand, it may not be.
For this situation, income from deals would be not as much as deals income.
Likewise, the income statement by itself does not report how much of each expense was paid in cash during the year.
You don’t see in the income statement the impact of expenses on the particular assets and liabilities used to record the expenses.
The amount of an expense may be relatively close to the actual cash outflow for the expense.
But maybe not.
One expense in particular is important to understand in this regard because it is a noncash expense : depreciation. Depreciation recorded on the income statement involves
no cash outlay at any point. In contrast, other expenses are intertwined with cash.
(We also explain cash flow for expenses in the next section.)
The actual cash flows of revenue and expenses differ from the accrual-basis amounts reported in the income statement for most businesses.
In this manner, the main concern benefit number doesn’t show the expansion in real money from making benefit.