The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
In the cash flow statement, cash Is King
When we look at the cash flow statement there are three main activities, which generate cash: operating, financing and investing.
To appreciate why a cash flow statement is useful and why it’s different from am income statement and balance sheet, let me tell you a story.
Let’s call this person “James”. He used to run a successful restaurant. Indeed, he had been in business for over ten years now. Every night he had hundreds of customers and everyone knew him in town. He was named restaurateur of the year.
The future seemed so bright. In fact, he believed that having popular customers made his business grow faster or at least made it more popular. Therefore, half of his clientele was comprised of popular people in town.
Many of them went to his restaurant and after bringing other people along, James allowed them to do so. He allowed to other prestigious customers to open credit accounts called “VIP Accounts.”
Therefore, they could come at any time and pay whenever they were able to. Initially, this seemed to work. More regular customers came in and his profits skyrocketed.
Although, business had never been so good, he was short of cash. Furthermore, salaries for half of the staff were not paid. The staff loved James and they were willing to stay few weeks more without getting paid but they expected him to pay within the month.
Taken aback he went to the bank and asked for a Loan. Once there the director of the bank, a long time friend of him wanted to help but couldn’t. Even though the business looked successful from the outside, it was bleeding from the inside.
Cash was short; nonetheless the restaurant produced $50K in profits, there was a $20K hole due to unpaid balances by customers.
In fact, the account receivables showed over $200K due, 75% of it were over two years old balances. The bank director told James if he wanted to borrow money he had to improve the cash situation.
Therefore, he turned to his managers and asked them to use any methods to collect the money lumped as accounts receivable. The AR skyrocketed in the last two years mainly due to the “VIP accounts”.
Lately though, the restaurant managers were trying to collect the balances from the customers. The VIP accounts holders felt offended.
Therefore, they decided to avoid James’ restaurant and not to pay their balances. Not only James lost the chance to collect the money lumped in the AR, but half of the clientele was gone.
Further, his employees decided to leave. James did not see any other solution that closing the business and declaring bankruptcy. The hole went from $20K to over $200K!
What seemed to be a profitable venture and what seemed to be a small cash issue, turned out to be bankrupt. This was mainly due to poor cash management.
The Three Main Sources Of Cash
What are the main sources of cash for a business?
Let’s go back to James’ story.
Initially, he had a hole of $20K due to the fact that its restaurant operations were not generating enough cash. Therefore, he went to the bank to find cash to finance the business but he was turned down.
Eventually, what killed the business was a total lack of investments in long-term assets, since James spent hundreds of thousands of dollars in marketing, with no focus whatsoever on employees or new equipment.
This is how a cash flow statement (CFS) would look like:
As shown in the picture above, the first section is related to operations, then investing activities, eventually financing activities. Before moving on to the cash flow from operations let me clarify one thing.
Indeed, if you look at the CFS picture, you will notice a small sign “Δ” called Delta. This is the fourth letter of the ancient Greek alphabet. In our particular case Δ means change or incremental value.
In fact, the income statement and the balance sheet are reported in absolute values. For example, if you look at the P&L, the reported revenue will refer to the entire year.
Instead, in the cash flow statement each item is considered from an incremental value standpoint. If you report the accounts receivable, you will take the difference between the current-year, over the previous year.
For example, in Year Two, you have $100 of AR while in Year One you had $50. This implies that your AR grew of $50 from Year One to Year Two.
So the delta is the difference between Year Two and Year One, or $50. But what happened from the cash standpoint? Let me explain in the next paragraph.
Cash Inflow versus Cash Outflow
In order for you to fully understand the cash flow statement you have to change perspective. Indeed, so far we looked at the income statement and the balance sheet through the accrual basis lenses.
It is time now to shift your perspective to the cash basis.
What does it mean?
Well, let’s look again at the example, from the previous paragraph. Our accounts receivable went from $50 in Year One to $100 in Year Two. From the accrual standpoint, it means an increase in asset.
But what if we change perspective and we look at it from the cash standpoint? Well, from the cash standpoint means a cash outflow!
What? Why? The reason is simple.
The purpose of the CFS is to look at cash inflows and outflows for a certain time frame with no regard to profits generated.
In fact, keep in mind that an Asset increase means a cash outflow, while an Asset decrease means a cash inflow.
Instead, a Liability increase means a cash inflow, while a Liability decrease a cash outflow (to understand assets and liabilities read the balance sheet guide).
The Cash Flow matrix below will help you remember this basic assumption:
From the previous example, the increase in asset (AR) from Year-Two to Year-One determined a cash outflow of $50. See below:
To recapitulate we saw that the cash flow statement takes into account the incremental values, called “Δ” (Delta) and that from the cash standpoint an increase in assets determine a cash outflow, and vice-versa, while an increase in liabilities determine a cash inflow, and vice-versa.
Cash Flow From Operations: Are We Efficient?
In this paragraph we will see how to build a cash flow from operations, using the P&L and Balance Sheet.
The main purpose of this statement is to take off from the net income the non-cash items included in it and all the cash inflows and outflows that happened in a certain period.
Let’s look at the image below:
The net income is the starting point. Why do we start from the Net Income?
The Net Income is given by Revenue – Expense.
When revenues or expenses are generated, it does not mean cash was generated. By going back to James’ restaurant example, a profit of $50K for the year generated a hole of $20K.
Why? Well, in the specific case, most of the income reported as revenue was comprised of receivables, which were not collected for over two years.
Therefore, the purpose of the cash flow is to clean the net income from all these non-cash items and non-cash expenditure comprised in it. Let me show you now the three simple steps to build your cash flow from operations:
Step 1: find the non-cash items
Find the non-cash items. In fact, they did not contribute any cash inflow or outflow. Therefore, before we clean the net income from these items, let’s find them:
- Depreciation & Amortization expense: The former is the recorded decline in value of assets. The latter is the distribution of cost for intangible assets. On one hand, they were reported as expenses in the P&L and they affected negatively the NI. Indeed, the Depreciation expense allows businesses to reduce their Profit Before Tax and by doing so, reducing their taxable income. On the other hand, the depreciation expense did not determine any cash outflow. Thereby D&A need to be added back to the NI.
- Impairment: When an asset loses value significantly and abruptly, we have an impairment. It happens when the carrying amount exceeds the recoverable amount. Although, it affects the Net Income negatively, since it will be reported as expense, under the P&L, it does not imply any cash outflow. Therefore, it needs to be added back to the NI.
- Profit/Loss on sale of non-current assets: When a non-current asset is sold, the profit/loss generated is recognized under the P&L and it will affect the net income. However, at this stage is too early to recognize the sale of the non-current asset, since this will be taken into account in the cash flow from investments. Therefore, to avoid any double counting this item will be subtracted in the OCF and added back in the Cash flow from investing.
- Increase/Decrease in inventory, receivable and payables: These three items taken into account altogether form the “working capital”. Defined as the resources an organization has at its disposal used to sustain the operations in the short-term; the formula for the Working capital is given by: Current Assets – Current Liabilities. In the cash flow statement though we take into account the Δ in working capital or change in working capital. This means the incremental value reported as result of the Incremental Inventory + Incremental Receivable + Incremental Payable.
Step 2: Take the Net Income and add back all non-cash items
How these items affect the cash? Let me give you an example on each item. Imagine, your restaurant business reported a net income at the end of Year-Two for $300,000, let us see how to adjust the net income to get the cash flow from operations:
- Depreciation effect on cash. At the beginning of Year-One you bought the kitchen equipment. The whole cost was $100,000 and it will have a useful life of ten years and a residual value of $5,000. The depreciation expense in Year-Two is $9,500 or ($100,000 – $5,000)/10. Therefore, at the end of Year-Two an expense for $9,500 will be included as Depreciation expense in the P&L. We have to add it back for two main reasons: First the depreciation expense implies no cash outflow. Second, we will take into account the change in non-current assets through the cash flow from investments. In conclusion, we take the $300,000 earnings for Year-Two and add back $9,500 of depreciation expense (non-cash expense) = $309,500.
- Profit/loss on sale of non-current assets’ effect on cash. In Year-One you bought a machine to produce fresh pasta. You paid $3,000 for the machine and the estimated useful life is three years with no residual value at the end. The depreciation rate is $1,000 or $3,000/3. In Year-Two the machine is reported as worth $2,000 on your BS, since you depreciated it by 1/3 or $1,000. You eventually sell it for $2,500. It means a profit of $500 ($2,500, selling price – $2,000 asset value per BS). The profit from the sale, $500 is included already in the NI in Year-Two. We have to take them out for two reasons. First, although there is a profit of $500, this is just a “paper profit” (In the real world the machine was bought for $3,000 and sold for $2,500). Second, the Profit/Loss coming from the sale of non-current assets will be taken into account in the Cash flow from investment. Therefore, to avoid any double counting it is crucial to take it out from the OCF. Going back to the example, recall in the previous bullet point we added back the depreciation expense from the NI and we had $309,500. Furthermore, Let’s take off the “paper profit” generated by the machine sales. Therefore, $309,500 – $500 = $309,000.
- Net Working Capital effect on cash. As we said in step 1, the net working capital is given by: Incremental AR + Incremental Inventory + Incremental Payable. Let’s assume in Year-One you had $500,000 in AR, $240,000 in Inventory and $300,000 in AP. In Year-Two, instead, you have respectively $550,000, $200,000, and $350,000. See below how to translate the net working capital from the balance sheet to the OCF:
Notice, the increase in AR from Year-One to Year-Two determined a decrease in cash. A decrease in Inventory determined an increase in cash and an increase in AP determined an increase in cash. Therefore, the Net working capital is $40,000, that adds up to $309,000. Eventually, we get $349,000.
Although, the NI for Year-Two was $300,000 the Net OCF was $349,000.
Cash Flow From Investing: Are We Killing The Goose?
In this section are shown the cash inflows/outflows related to non-current assets, such as property, plant and equipment. The non-current assets are the ones that generate future benefits for the organization.
Therefore, they are considered as investments.
Here the key difference to understand is between CAPEX and OPEX.
Indeed, all the money spent on acquiring things that will have a useful life over one year at least, worth more than $2,500 and that will bring future benefits to the organization can be defined as CAPEX. The rest, we’ll call it OPEX.
In this category are included all non-current assets under the balance sheet, such as: property, plant and equipment. In the previous paragraph, we saw that to avoid double counting, items such as depreciation & amortization, sales of non-current assets are added back to the net income to get the operating cash slow. Some examples of cash flows generated from investing activities are:
- Disposal or Purchase of fixed assets
- Disposal or Purchase to buy shares or interest in other joint ventures
If we go back of the example from the previous paragraph, so far the cash generated by operating activities is $349,000. Furthermore, we want to see the cash flows generated by the investing activities.
For example, imagine, at the beginning of Year-Two you decide to renovate the building owned by the restaurant business. The building is worth $300,000 on your balance sheet.
The renovation costs you $50,000 and it lasts few months. The money spent in renovating the building is not operating expenses.
Therefore, they can be defined as capital expenditure since they increase the value of the building on the balance sheet.
From the cash standpoint this means a cash outflow of $50,000. The cash flow will look like the following:
As you can see from the image above, the $50,000 spent to improve the building will determine a cash outflow for the same amount. Therefore, CAPEX will be (50,000), that will reduce the cash generated in Year-Two.
Cash Flow From Financing: The Cash Paradox
This is the cash generated through activities focused on raising money for the long-term growth of the business.
For any business, it is important to find the resources to grow the income in the long run. Yet, too much debt can be lethal.
On the other hand, in theory, a business not able to issue debt through banks or other creditors may be a bad signal as well (I want to stress that this is true only in theory, many small businesses – to run – do not need to optimize their debt ratios. The key principle there is avoid debt!).
In fact, when a business is lacking the credibility or trust of the markets, no one will lend money to it. For such reason, although raising debt translates to long-term liabilities and higher risk for the business, finding the optimal capital structure is crucial for any organization.
There is no magic rule for it.
And it really depends on the kind of business you are operating. Of course, if you own a manufacturing company, it will need much more resources to run the operations, since it is much more capital intensive.
Therefore, this implies a higher debt equity ratio, without making the business necessarily riskier, given its more stable income streams.
On the other hand, if you own a service or IT organization, you don’t need much capital to run the operations and given the highly competitive industry, you will report unstable income streams.
This makes the business more risky in its own right. Therefore, it is better to have a lower debt to equity ratio. Not by chance, companies such as Apple and Microsoft keep high cash reserves.
Indeed, a manufacturing company in a traditional industry has more chances to survive for decades.
An IT organization has less chance to pass two decades of life. To go back to our previous example, remember that you bought the kitchen equipment for $100,000, in Year-One.
You found the resources to buy them through one of your partners who loaned the money to the restaurant business to be repaid in three years.
At the end of Year-One you don’t make any payment, but at the end of Year-Two you decide the pay half of the debt. This means you will report a cash outflow of $50,000.
When liabilities decrease, they determine a cash outflow, since the debit is getting repaid and you are using cash to pay it back. Eventually, our cash flow will look like the following:
At the end of Year-Two, although a NI of $300,000, the net cash for the period was $249,000, while the cash from operations was $349,000.
Due to an increase in net working capital, given by decreased inventory, that means the company sold more goods that it has purchased.
This had a beneficial effect on cash that generated a cash inflow for $40,000. Further, an increase in AP determines a cash inflow as well.
This is due to new credit condition given by suppliers. They allowed you to have more time to pay for the purchased goods or raw materials.
When a business is able to play on the time difference between accounts receivable and accounts payable, creates liquidity to run the business (Amazon cash conversion cycle is a good example).
Let me explain trough an example. Imagine, you own a business and you sell canned tomatoes. You do not produce them, since the product is bought from other tomato factories.
Therefore, after getting the canned tomato from the manufacturer, you label it and sell it to final customers. Thereby, the tomato factory is your supplier, while the retailers are your customers.
Thanks to the long-term friendship with the manufacturers you are able to secure payments every sixty days. On the other hand, your customers pay you every thirty days.
Imagine, you place the first order of canned tomatoes for $100 and you will repay them in sixty days. In the same day, the canned tomatoes are labeled and sold to customers.
They pay you $2 per piece and buy 100 pieces. At the end of the first month you generated $200 in revenue and one additional month to pay your suppliers.
Therefore, in one month you generated $100 of additional profits financed by your customers. Companies which are able to tight the AR while stretching the AP can generate additional liquidity for the organization, with no additional cost.
Above another example of how Amazon unlocked liquidity over the years by playing on the difference between receivables, payables and inventory turnovers.
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