The cash flow statement, explained

Why profit is not cash

Most businesses keep their books on the accrual basis: revenue is recorded when the work is done, not when the customer pays, and a cost is recorded when the bill arrives, not when it is paid. That makes the income statement a good picture of whether the business is making money and a poor picture of whether there is money in the bank.

Four things move cash without touching profit: customers paying late, inventory bought and sitting on the shelf, loan principal repaid, and equipment bought outright. Four things touch profit without moving cash: depreciation, a bad-debt write-off, an accrued bonus, and a bill recorded but not yet paid. The cash flow statement reconciles the two.

The three sections

• Operating activities: the cash from running the business. Customer payments in; suppliers, payroll, rent, insurance and taxes out. For a healthy business this is positive, and it is the number to watch.
• Investing activities: cash spent on things that last, such as vehicles, equipment, property and software you build, and cash received from selling them. For a growing business this is usually negative, and that is not a problem by itself.
• Financing activities: cash from and to the people who fund the business. Loans drawn and repaid, a line of credit, owner contributions, and owner draws or distributions.
• The three sections add up to the net change in cash. Opening cash plus the net change equals closing cash, which must match the bank. If it does not, something is misrecorded.

Direct and indirect method

The direct method lists the operating cash receipts and payments themselves: collected from customers, paid to suppliers, paid in wages. It is the easier one to read and the harder one to produce, which is why almost no accounting software defaults to it.

The indirect method starts from net income and adjusts it to cash. Add back the costs that did not use cash, such as depreciation and amortization. Then adjust for working capital: a rise in receivables or inventory used cash, so subtract it; a rise in payables preserved cash, so add it. Your accounting software produces this version, and it is the one your banker and your accountant read.

A worked example

A service business ends the year with net income of $120,000. Depreciation on its trucks and equipment was $15,000, so add it back. Receivables grew by $20,000 because customers paid more slowly, so subtract it. Inventory grew by $5,000, subtract it. Payables grew by $8,000, add it. Operating cash flow is $118,000: $120,000 plus $15,000, minus $20,000, minus $5,000, plus $8,000.

The business bought a truck for $45,000 in cash, so investing activities are minus $45,000. It repaid $24,000 of loan principal and the owner took $30,000 in distributions, so financing activities are minus $54,000. The net change in cash is $118,000 minus $45,000 minus $54,000, which is $19,000. Cash was $41,000 at the start of the year and $60,000 at the end. The statement explains the whole $19,000, and the $120,000 of profit became $19,000 of cash.

How to read it as an owner

• Operating cash flow should be positive and close to net income, or above it. If it runs well below net income for several periods, customers are paying slowly or inventory is building, and the receivables aging report will show which.
• A negative investing section is normal when you are buying vehicles and equipment to grow. A positive one means you sold assets, which is worth a second look.
• Read financing for what it is funding. Borrowing to buy a truck is one thing; borrowing to cover payroll is another, and the operating section will have told you first.
• Look at it monthly, not yearly. The annual statement is a history; the monthly one is a warning.
• Pair it with a 13-week cash forecast. The statement says what happened; the forecast says whether the next payroll, tax payment and loan instalment are covered.

The part Liaison does

Liaison reads your books, your bank and your payment processors together, so the cash position is one number with the transactions behind it. Ask whether you can make payroll Friday and it answers from the balance, the payouts on the way and the payroll run, with pending card payments left out. It tells you the morning receivables start building, or a payout does not land. The statement is a report you read; this is the same information, every morning, before you ask.

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Liaison connects to these and more with access you grant, and reads them together with the rest of your business. Each page shows what it reads and does in that tool.

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