When you are reviewing your activity and evaluating the performance of your business, the Balance Sheet and Profit and Loss Statements are the reports you probably generate internally to reference operating results, historical activity, aid in future decision making and tax planning purposes. There is another statement that, although it is required for financial statements prepared in accordance with generally accepted accounting principles (GAAP) that your accountant would prepare at year end, it is not prepared internally during the year. That’s your Cash Flow Statement.
A Cash Flow Statement simply, is a report that shows your cash inflows and outflows and how the business used its cash for a certain period. Cash to pay their vendors, their employees, taxes, and loan activity to name a few examples. In order to have a positive cash flow, not only sales must be generated but also cash collected from these sales from services and/or products.
The Cash Flow Statement differs from the Balance Sheet and Profit and Loss Statements. The Balance Sheet reports the cash balance at a point in time and the P & L shows all expenses, those paid in cash plus those that have been accrued (future cash outlay) if reporting is on the accrual basis of accounting. Even if your reporting is on the cash basis, an expense like Depreciation, is not a cash outflow. Also, payments for new equipment or bank debt do not even appear on the Profit and Loss Statement but does have an effect on your cash flow.
Using the indirect method of cash flow reporting, it begins with Net Income and computes the changes of various accounts like Accounts Receivable, Accounts Payable, Loans with taking into considering non-cash items like Depreciation. It has the following three sections that organizes the statement.
From Operating Activities:
This is the most common type of items reported on a cash flow statement. It includes all those disbursements that result from the activities of operating your business. It is the net inflow/outflows that includes your customers, vendors, employees, etc. It shows how much the company is generating from its main activity.
From Investment Activities:
This reporting are items most commonly are related to the purchase or sale of fixed assets. It does also include other types of investments. Investment activities are considered more of a long-term transaction, does not happen on a daily or regular basis.
From Financing Activities:
The reporting are items that are related to financing arrangements for loans received or payments made. This may include third party arrangements along with owners and investors.
Have you ever experienced in your business or heard others get perplexed as to why they don’t have enough cash to pay their bills timely? They operate a successful business, meet their sales targets, monitor their expenses to their budget but still have difficultly generating enough cash to make payroll or to purchase equipment. A cash flow statement will pinpoint in one report what your starting cash was, what is was spent on and what remains. These fluctuations month to month if the cash flow is prepared and monitored can provide a wealth of information that the Balance Sheet and Profit and Loss Statement cannot provide.
Review these two examples of very simplified computations. Both are on the accrual basis of accounting and let’s say it is the first month of operations where all account balances including cash is at zero with no owner investment to start.
EXAMPLE 1 EXAMPLE 2
Revenue = $ 200,000 Revenue = $ 200,000
Expenses = $ 50,000 Expenses = $ 50,000
Net Income = $ 150,000 Net Income = $ 150,000
Accounts Receivable $ 150,000 Accounts Receivable $ 50,000
Accounts Payable = $0 Account Payable $ 20,000
Answer: Cash Balance $ 0 Answer: Cash Balance $ 120,000
Although this article is not intended to display what a cash flow statement would look like or provide instructions to prepare one, it is meant to provide reasoning why a cash flow statement can reveal information.
Without preparing a Cash Flow Statement, one could easily believe that with a positive net profit, both companies are doing well. However, cash collections are suffering in the first example and continuing to remit payments to vendors as they have been doing will become difficult and will result in a delay or the need for funding. The second example with the same net income has much different results considering better cash collections and timing of payments to vendors.
A Cash Flow Statement will show you how well you manage your cash and what items among operating, investing and financing you are utilizing the cash for and its timing. This will aid you in the current and future stability of the company. It is another useful tool for budgeting, future cash flows and to prepare for any seasonal considerations in your business. So, the next time you are reviewing your Balance Sheet and Profit and Loss, consider adding a Cash Flow Statement to your list of management reports. Since everyone can relate to cash, it will be a wonderful addition to you and your management team with providing relevant information that cannot easily be gathered by the other reports. If you have questions about the reports you need for your business, our Outsourced Management Accounting team is here to help. Contact us today.