Cash flow management is a common challenge for many business owners. You need cash to deliver a product or service to your customers, and to fund business investments. No company can operate without sufficient cash inflows, and you need tools to understand your cash position.
The statement of cash flows reports your firm’s cash receipts and outflows for a specific time period, usually a month or year. If you review the statement of cash flows each month, you can make better decisions and manage your cash more effectively. The cash flow statement is connected to the balance sheet and the income statement.
How the financial reports are connected
A balance sheet is a snapshot of a company’s financial position as of a specific date. The balance sheet lists a firm’s assets, liabilities, and owner’s equity balances for a month or year.
The two other financial statements are connected to the balance sheet. An income statement reports revenue, expenses, and net income for a specific period of time. The net income balance in the income statement increases the owner’s equity balance in the balance sheet.
A cash flow statement lists the cash inflows and outflow of cash for a period of time, and the ending cash balance is the same dollar amount reported in the balance sheet. If you create a June cash flow statement, for example, the June 30th cash balance in the cash flow statement equals the cash balance in the June 30th balance sheet.
The statement of cash flows helps a business owner understand the differences between net income and the activity in the cash account. These differences occur when a company uses the accrual method of accounting.
Accrual method vs. the cash method of accounting
All businesses should use the accrual basis of accounting, so that revenue is posted when it is earned, and expenses are posted when they are incurred. Using this method matches revenue earned with the expenses incurred to generate the revenue, and the system presents a more accurate view of your profitability.
The cash basis of accounting, on the other hand, distorts your true level of profit, and does not conform to Generally Accepted Accounting Principles (GAAP). The cash basis of accounting records revenue when cash is received, and posts expenses only when they are paid. The example below presents a detailed statement of cash flows, and how the statement is connected to the balance sheet and the income statement.
Statement of cash flows: an example
Julie owns Centerfield Sporting Goods, a firm that manufactures sporting goods products and sells them to retailers. Here is Centerfield’s income statement and balance sheet as of 12/31/19:
The income statement reports $40,000 in net income for the year, and net income increases retained earnings in the equity section of the balance sheet. Next is the statement of cash flows.
Cash flow report separates cash inflows and outflows into three categories. To create a cash flow statement, review each cash transaction in the checkbook, and assign the dollar amount to one of these categories:
- Cash flow from operating activities: Operations refer to the day-to-day activities of managing a business. Centerfield has cash inflows for customer payments, and cash outflows to purchase materials, and to fund payroll.
- Cash flow from investing activities: If a business purchases or sells an asset for cash, the impact is posted here. In 2019, Centerfield purchased $40,000 in equipment for cash.
- Cash flow from financing activities: When a company raises money from investors, borrows funds, or pays down a loan, the cash transactions are classified as financing activities. Julie’s firm made $60,000 in loan payments during 2019.
The vast majority of your cash should be generated from operating cash flows. Buying materials, managing payroll, and collecting customer payments are all operating activities. Your company’s financial health depends on your ability to generate future cash flows from operations.
The $160,000 ending balance in the cash flow statement equals the 12/31/19 cash balance in the balance sheet. If you scan the income statement, some line items are similar to (but not identical to) the cash inflows and outflows in the cash flow statement.
Centerfield’s sales totaled $2,080,000 during 2019, and the firm collected $2,000,000 in customer payments. Because the firm uses accrual accounting, annual sales may not equal the cash collected during the year.
Cash flows from operations can be completed using the direct or the indirect method. The direct method refers to assigning cash inflows and outflows to the operations section by reviewing the firm’s cash account. The indirect method is more complex.
Indirect cash flow method — operations
The indirect method for cash flow from operations begins with net income. The report then makes adjustments to reconcile from net income to net cash flow from operations.
The Financial Accounting Standards Board (FASB) creates accounting standards. FASB’s Summary of Statement #95 recommends that firms use the direct method for cash flow from operations. If the direct method is used, the company must provide a reconciliation from net income to net cash flow for operations in a separate schedule.
Business owners should comply with accounting standards, so that the firm’s financial statements are comparable with other companies. If you’re looking for investors, or considering a business sale, you need financial statements that comply with accounting standards. Here’s an example using the indirect method.
Indirect cash flow method: an example
Acme Manufacturing decides to use the indirect method for cash flow from operations. The statement begins with $100,000 in net income. Next, the schedule makes adjustments for current assets and current liabilities.
Current assets include cash, and assets that will be converted into cash within 12 months. Accounts receivable is a current asset account, because you expect to collect all customer payments within 12 months. Inventory is also a current asset account. You expect to sell inventory on hand and convert it to cash within a year.
An increase in current assets is subtracted, and a decrease is added to the schedule. The $20,000 decrease in accounts receivable is added, and the $30,000 increase in inventory is subtracted.
Current liabilities are bills and other debts that must be paid within 12 months, including accounts payable. An increase in current liabilities is added, and a decrease is subtracted. Acme adds the accounts payable increase and subtracts the decrease in accrued expenses. The result is a $92,000 balance in cash flow from operations.
The statement of cash flows is the primary financial tool for managing cash flows. Some companies also use free cash flow to assess business performance.
Free cash flow
Free cash flow takes into account cash flow from operations, and the cash required to pay for capital expenditures (CAPEX). The formula is (cash flow from operations) less (capital expenditures to support current operations).
Well-managed companies plan for capital expenditures, which may include investments in machinery, equipment, and other long-term assets. A chain of restaurants, for example, must eventually replace ovens, refrigerators, and furniture. The cost of replacement should be included in the restaurant chain’s annual budget.
If the restaurant can generate more cash from operations than is needed to pay for capital expenditures, the company has some options. The extra cash might be used to pay a dividend to investors, or retained in the business to expand operations.
A successful business must manage liquidity and solvency. Liquidity refers to your firm’s ability to generate enough current assets to pay current liabilities. Solvency has a long-term focus. If your company can produce cash inflows over the long-term, you can pay for capital expenditures in future years, and repay loan balances.
The statement of cash flows, and the free cash flow calculation are tools you can use to manage your business. Once you start using these tools, you need to make changes to improve cash inflows.
How to increase cash collections
Improving cash collections can make a huge difference in your business. You can avoid borrowing funds, and the related interest expense. When you have the opportunity to add a business location or start a new product line, you’ll have cash to expand your business. Consider these strategies to increase cash inflows.
Create a formal collection policy
Firms that do not closely monitor accounts receivable and enforce a formal collection policy may not generate sufficient cash inflows to operate. Your accounting software should provide an aging schedule for accounts receivable, which groups your receivables based on when each invoice was issued.
You should monitor the aging report and implement a collections process to email and possibly call clients to ask for payment. Some firms email the customer when an invoice is over 30 days old, and call if an invoice is outstanding for 60 days or longer.
Manage cash used to purchase inventory
Many businesses do not carefully plan for inventory purchases, and these firms risk the loss of a sale if inventory levels are too low. However, if you purchase excess inventory, you’re using too much of your firm’s cash. To maximize sales and conserve cash, plan for an ending balance in inventory at month end.
An ending inventory balance allows your company to fill customer orders in the first few days of the next month. The formula for ending inventory is:
Beginning Inventory + Purchases – Sales = Ending Inventory
Ending inventory is often based on a percentage of monthly sales.
Assume, for example, that a hardware store’s beginning inventory balance of lawn mowers is 50 units, and that the company forecasts 300 mower sales for the month. If the business wants 30 mowers (10% of expected sales) in ending inventory, the number of mowers purchased should be:
300 Projected Sales + 30 Ending Inventory – 50 Beginning Inventory = 280 Purchased
Use the ending inventory formula to ensure that you maintain a sufficient amount of inventory. The formula will also help you conserve your cash for other purposes.
Automate the invoicing process
Automation reduces the amount of time a firm spends on the invoicing process. Companies make fewer errors, and recurring invoices can be processed in far less time.
Emailing invoices — and providing an online payment option — encourages customers to pay immediately, which speeds up the cash collections. Best of all, invoice automation makes the buying process easier, and improves the customer’s experience with your company.
Ask for deposits, offer discounts
Don’t hesitate to ask a customer for a deposit, particularly for large orders. Customers are in the habit of making deposits when they order products and services. Clients know that businesses must cover costs to deliver a product. If you can make deposits a company policy, you’ll increase cash inflows immediately.
Offer customers a discount, if they pay within ten days. You’ll earn less cash on the sale, but you’ll collect money faster. If you increase cash inflows by offering a discount, you can avoid paying interest costs on a loan.
Take charge of cash flow management
Analyze the statement of cash flows to understand cash inflows and outflows, and to forecast future cash needs. Each section of the cash flow statement reveals different information about your business. When you generate a cash flow report, think about the type of cash in each section.
If cash flow from investing has declined, you may be overspending on asset purchases. A big increase in financing cash inflows may relate to issuing stock to investors, or borrowing money.
Growing cash flows from operations, however, is the key to a successful business. If you can run your day-to-day operations and collect more cash over time, you’re generating higher profits and controlling spending.
Fortunately, you can purchase industry-specific accounting software that will generate a number of useful cash flow reports. Prepare a statement of cash flows each month, and manage your business with confidence.
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