Cash flow in your business is like the waves of an ocean, with revenue washing in and payments for expenses flowing out. A picture of cash flow is not easy to capture because the ebb and flow of money in your business is constantly changing. Still, you need a handle on your cash flow to understand trends in your cash management and keep your company solvent.
It might sound like an accurate cash flow statement is impossible due to all this ebbing and flowing. Fortunately, it’s not only possible, it’s pretty straightforward. Let’s take a look at why cash flow statements matter, then we’ll dive into the statement process.
Importance of the cash flow statement
A company may have revenue and appear profitable, but slow collections of invoiced sales can impede its ability to meet its current financial obligations. Delinquencies in payments to employees, vendors, and other creditors can grow to the point of putting the company out of business.
Imagine this scenario: Your business is selling numerous products each month, but most of these products are on credit. Not only this, many of your customers aren’t paying on time or wait until the last minute to pay each month. While you sold a lot of products, your funds are all tied up in delinquent payments and credit accounts.
Even if you have enough money to cover your operating expenses, poor cash flow can leave you one disaster away from not having the working capital to cover your business. Positive cash flow is the difference between having enough cash to cover a disaster or event now, versus later (when it may be too late).
To get a picture of your cash flow over a specified period of time, you’ll need to create a cash flow statement. This is a look back over a specific period of time (typically a quarter), which enables you to look forward to the next period to ensure you have the funds on hand to pay your bills.
You can then use your knowledge of your current cash flow, to predict future cash flows. This will give you a more accurate picture of your company’s financial health, both in the present and down the road.
What makes up your cash flow?
The cash flow statement shows changes in your cash on hand (including funds in your bank account and short-term investments that you can easily convert to cash). The cash flow statement reflects the following business activities:
Cash inflow from operating activities includes revenue from selling products or services, interest and dividends that the business receives, and other cash receipts. Cash outflow from operating activities includes payroll costs (i.e., wages, benefits, and employment taxes), payments to suppliers and vendors, overhead costs (i.e., rent, utilities, insurance, etc.), income taxes, other taxes, and other operations-related cash payments.
Inflow from investment activities includes sales of business assets other than inventory, payments received from loans that the business made, and other sales that are not in the normal course of business. Outflow includes purchases of capital equipment and loans that the company makes.
Inflow reflects money that’s borrowed and the proceeds from the sale of the company’s securities. Outflow shows debt service and dividend payments.
Before you create a cash flow statement
There’s more than one way to make a cash flow statement. In fact, there are two ways:
- Direct method: This tracks cash inflows and outflows from operating activities only, without taking into account additional sources of income such as investments. Essentially, this method merely subtracts money spent from money received to give you an idea of the actual cash coming into your business.
- Indirect method: This method is more complicated. It starts with net income and factors in depreciation, cash flow from operations, cash flow from investing activities, and current liabilities.
The method you choose depends on the information you hope to gain from your cash flow statement. The direct method is simpler and gives you a picture of how much money you’ve received. The indirect method factors in investments, credit, money generated by operating activities, and more to give you a holistic, albeit more complex, look at your cash flow and finances.
Because you’re a small business owner, we’re going to focus on the direct statement of cash flows, as the indirect method is largely intended for corporations with investors looking to gauge current and future liability.
As a small business, you’re largely concerned with your day-to-day operations and your cash flow. Investments aren’t as common for small businesses, so it’s unlikely these make up any portion of your cash flow.
The direct method ignores investments and gives you a clear picture of your cash flow, which is what’s keeping your business afloat. Having the clearest view of your cash flow will allow you to make decisions that impact your business.
Creating your cash flow statement
To create a direct cash flow statement manually, there are several steps to complete.
- Review your income and expenses in each of the three categories discussed above: operating activities, investing activities, and financing activities.
- Use a self-created spreadsheet in Excel or another program, or use a template to organise your data into a cash flow statement. Your entries will show cash in and cash paid out each month for the reporting period of your cash flow statement.
- Include areas on your spreadsheet for the following types of cash transactions: any payment of dividends or interest you received, cash collected from sales, employee wages, supplier expenses paid, interest and income taxes paid.
- Don’t include gross sales. Only include the money received from customers, as you’re wanting an accurate picture of the money on hand, not tied up in credit.
- Total up your money coming in and your money going out. You’ll be left with an accurate view of your company’s cash flow for the period you’ve set.
To make things even easier, you can create a cash flow statement based on a sound accounting system. Having recorded your income and expenses on a regular basis, your accounting software has the information needed to automatically generate a cash flow statement without the need to input each item of income or expense from your business activities. With most accounting software, you can even set a custom time period to quickly generate cash flow statements for different quarters, months, or even weeks.
Reviewing and projecting cash flow
Looking back over the quarter is helpful in knowing where your money went and seeing trends in your business activities. Just as important is looking ahead to make sure you’ll have the funds on hand to meet upcoming obligations.
What are your upcoming expenses? What do you project your future revenue to be? Again, look ahead for a specific period, such as the next quarter or the next year, and use the information in your books to generate your projections.
You’ll follow a process very similar to the one outlined for cash flow statements, but again, you’ll be using hypothetical data. If your business is more than a year old, you can reference last year’s data for the months that correspond with your projection period. This can give you a more accurate cash flow forecast that’s grounded in data, even if it is slightly dated.
If your business is brand new, projecting cash flow can be difficult. Ideally you need to have at least a few months of data, as this will allow you to make rough projections. A month or two of data won’t allow you to account for seasonal factors, but it can at least give you enough to work with. If your business is new and has absolutely no sales data, you’ll be left with speculations. If there’s data available for similar companies in your industry, you can use it to make an educated guess.
Do your best to make accurate projections, as these will help you decide what actions to take. You might decide to cut expenses if too much money is going out compared to revenue coming in, or you might seek a short-term loan if cash on hand isn’t enough to pay your upcoming bills. Once again, it’s up to you to monitor your projections and review your business activities so you can make adjustments accordingly.
Projecting an accurate future
Cash is essential for keeping your company afloat. Make sure you have a good understanding of where your money comes from and when, as well as where your money is spent so you can meet your financial obligations.
Use a cash flow statement as well as cash flow projections to clarify your company’s position on cash. If you have any concerns about creating or understanding your cash flow statement and projections, work with a CPA or other knowledgeable financial specialist.
You can also download a free cash flow statement template to get started. Also, be sure to read up on financial reporting to learn more about essential financial statements, including the balance sheet and income statement. With all of this homework done, you’ll be ready to accurately track your cash flow, and more importantly, predict a cash-filled future for your business.
Cash is essential for keeping your company afloat. Make sure you have a good understanding of where your money comes from and when, as well as where your money is spent so you can meet your financial obligations. Use a cash flow statement as well as cash flow projections to clarify your company’s position on cash. If you have any concerns about creating or understanding your cash flow statement and projections, work with a CPA or other knowledgeable financial specialist.
Download a free cash flow statement template to get started. Or check out our guide to financial reporting to learn more about essential financial statements, including the balance sheet and income statement.