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Lesson 5: The Cash Flow Statement

A Couple Things Before We Start

Before we get into the cash flow statement, I need to explain what accountants mean when they say cash. We talked about this in lesson 2: assets, but it’s super important so let’s review. Cash is more than just the $20 bill in your wallet or the change you found in your couch. It’s also the money in your bank accounts because it’s easily accessible and can be turned into physical cash very quickly (i.e. you can withdraw cash from your bank account).

One other thing to keep in mind when we’re talking about cash flow statements, is net income is not cash. Net income is revenue minus expenses. If we think about it in terms of regular operations, you could make a sale (i.e. generate revenue) in one month and not get paid until the next month. You would have revenue in the month of the sale, but you wouldn’t have cash until the next month when you were actually paid.

The difference between cash and net income is important because as you fulfil the sales contract, you’ll likely have expenses to do so. Simply speaking, you would need to pay cash out for those expenses before you’ve received cash for the sale. An income statement doesn’t reflect the timing differences of cash in versus cash out.

Cash Flow Intro

The cash flow statement is the bridge between your income statement and your balance sheet. It describes the change in cash from one period to the next using net income and the change in certain balance sheet accounts. In other words, it’s an explanation of where you spent cash and how you generated cash. Don’t worry if that didn’t make much sense, we’re going to break it down so it does.

The cash flow statement is divided into three types of activities, operating, financing and investing. Each of these three represent a different intention for the cash that’s moved through the company. Let’s start with operating activities because it’s the first activity on the statement and arguably the most important for small business owners.

Operating Activities

Operating activities are the day-to-day transactions of a business – it’s the cash required to operate the company. It starts with net income at the top and adds/subtracts different items to get to the cash generated or used during regular operations.

The first items you add back to net income are non-cash expenses. Most expenses require cash to be paid or at least a short-term IOU be signed (accounts payable from lesson 3), but some expenses are “accounting” expenses. The most common non-cash expense is depreciation expense. (We talked a little bit about depreciation in lesson 2 when we talked about capital assets.) When we’re looking to isolate the cash movement (cash flow statement) we need to remove these non-cash items.

You might be saying, “but I did pay money for the capital asset we’re depreciating”. That’s true, but that payment doesn’t belong in the operating activities section because you don’t make those purchases as a regular course of business. Those purchases go into the investing activities section, which we’ll talk about later.

The Bridge Part

Some balance sheet accounts are directly related to cash and are part of the day-to-day operations of the business, All current assets (lesson 2) and current liabilities (lesson 3) are examples of balance sheet accounts that are directly related to cash and need to be included in the operating activities section.

Full disclosure: this next part gets a bit technical, because I’m explaining why you would add or subtract the change in some balance sheet accounts to net income to get to cash generated or used from operations. If you’re really not interested, skip down a little bit to the Get to the Point heading.

Let’s look at accounts receivable to illustrate. Accounts receivable represents the amount a company is owed by it’s customers. If most sales are on account (i.e. you rarely receive payment at the time of purchase), accounts receivable will go up and down as sales fluctuate.

If you sold more this year than you did last year, accounts receivable would likely be higher (you have more outstanding invoices because you sold more). If accounts receivable is higher, you haven’t been paid for those additional sales. To get to cash generated or used from operating activities, we need to reduce net income by the amount we haven’t received cash for – this year’s accounts receivable number minus last year’s. We subtract because the additional sales will be recorded in the net income number, but we don’t want them recorded in the cash received number.

Therefore an increase in accounts receivable must be subtracted from net income to get to cash received for sales. If you just remember that last line, it’ll be enough to understand the rest. (I totally get that this is tough to understand, it’s definitely the hardest statement to figure out.)

This same concept can be applied to each piece of the current assets and current liabilities section of the balance sheet. Remember that liabilities are the opposite of assets, they’re an amount owed by the company. When you think about an increase in accounts payable, it’s the opposite of accounts receivable. An increase in accounts payable (expenses on the income statement you haven’t paid cash for yet) needs to be added to net earnings to calculate cash generated or used for operating activities.

Get to the Point

There was a lot in that last section, but it’s the way we bridge the gap between the income statement (net earnings) and the balance sheet (the change in assets, liabilities and equity). It explains why you could have $50k in net income and still have a negative bank account balance. Maybe you’ve generated lot’s of sales, but your customers aren’t paying you on-time, or maybe you paid a bunch of outstanding bills from last year. Neither of those would be reflected in your income statement, but they’re super important to know when you’re managing your business and your money.

Another important thing to take from your cash flow from operating activities is the cash generated (positive number) or used (negative number) tells you if your operations are paying for themselves. If you have a negative operating cash flow, you’re business is in trouble. It means the company requires more cash to operate than it’s generating. That’s not sustainable and a correction needs to be made quickly.

Investing Activities

This section is a lot more straight-forward than the operating section, This is where cash you’ve spent on big purchases (capital assets, lesson 2) or on investments goes. It’s also where you would list any asset sales you made. Maybe you sold the truck you were driving because you bought a new one. That sale would go here. You can look at this listing and have a good idea of where big chunks of you’re money went/came from. If you didn’t make any large purchases or sell any assets, this section would have nothing in it. The investing section literally shows you how you’ve invested in your company.

Financing Activities

Financing activities are related to the financing of the company, so things like selling the shares of the company or issuing a long-term debt. Payment of dividends also falls into this category. Usually a small business will have dividend payments and that’s about it in this section. Like the investing section, the financing section literally shows how the company is financing it’s long-term goals and objectives.

What Does It All Mean?

When you look at a cash flow statement you’re looking at how the business has managed it’s cash. If you divide cash generated from operating activities by sales, it gives you the amount of cash generated for every dollar of sales. This number will vary depending on the company and industry, but you can compare the current year to past years and to industry benchmarks to see how your company is doing.

Free cash flow is another metric to measure how well cash is being managed in your company. Free cash flow is determined by subtracting the cash spent on capital assets from the cash generated by operating activities. Free cash flow is a measure of how much cash could be distributed to shareholders as dividends or could be re-invested in the company for future growth. A negative free cash flow number suggests a company may be struggling. As with all metrics, it’s important to compare them to prior periods and industry benchmarks. One number by itself doesn’t give you much information.

Cash Conclusion

The cash flow statement is perhaps the most important statement for small business management, but it’s also the most complicated. If you have one take away from today’s lesson, it should be to start looking at your cash flow statement regularly and make sure you’re comparing multiple periods (at least two). The information in your cash flow statement can have a direct impact on how much you can (or should) pay yourself at the end of the day. It shows you where the cash is coming from and going to, which will tell you why there’s not as much in the bank as you’d like. Use this statement to find out how to get more money in your bank account and ultimately in your pocket.

If you’re curious what your cash flow statement is telling you, then let’s chat! Ask me anything!

Kaitlin Kirk CPA

Kaitlin Kirk, CPA
Number Ninja

Kaitlin Kirk is a Chartered Professional Accountant who helps small business owners learn about their financial situation, work less, and get paid more. She used to do financial process improvement for a $5 billion company and now brings those big business skills and insights to small business owners. She spends a lot of time on the volleyball court and on-stage doing improv comedy when she’s not teaching small business owners how to decode their financial statements.