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Many business owners get excited about profits but can overlook a more crucial question: Where’s the cash? Jack Welch, former CEO of General Electric (GE), put it this way:

“If I had to run a company on three measures, those measures would be customer satisfaction, employee satisfaction, and cash flow.”

Cash Flow over Profits?

Jack Welch ran a massive publicly traded company and was judged and rewarded on profitability by his board and the market. So why would he mention cash flow and not profits?

Let’s imagine cash flow as the blood of your business. Like in the body, the “oxygen” keeps the body alive.

So, a cash flow statement is like a blood test; it helps indicate the health of your business. It shows the money flowing in (receipts from sales) and out (expenses) over a period. Unlike a profit & loss statement, it focuses on actual cash, not accounting accruals.

Why is this so important? Because even profitable businesses can run into trouble if they need more cash to cover bills. A healthy cash flow ensures you can:

  • Pay expenses on time: Avoid late fees and maintain good supplier relationships.
  • Seize opportunities: Invest in growth, hire new talent, or take advantage of deals.
  • Weather unexpected storms: Be prepared for downturns or emergencies.

So, why is this often-overlooked gem so valuable?

  • It’s simple: Unlike complex financial reports, cash flow is easy to understand, even for non-finance folks.
  • It’s action-oriented: It tells you where to focus your efforts, like boosting sales or reducing expenses.
  • It’s predictive: By analyzing trends, you can forecast future cash flow and make informed decisions.

There are two ways to develop cash flow statements.

Direct Method

The direct method shows exact cash inflows and outflows for each category by going through every cash outflow and inflow for the business over a fixed period. The values calculated are used to prepare the operating section of the cash flow statement, detailing the net cash flow from operating activities.

The direct method focuses on transactions that directly impact a business’s cash balance and excludes items like accrued expenses or earned revenues.

The direct method is more accurate and provides better insights but can be tedious to build and hard to scale.

Indirect Method

Starts with the net income reported on the income statement and adjusts for non-cash items.

Using the indirect method, you do not go through each transaction to determine its impact on the cash.

Instead, you use the net income from the income statement and the changes in balance sheet items to calculate the operating cash flow.

The indirect method is widely used in business and is easier to build. However,  it can be less insightful and prone to inaccuracies.

Which is better for my business?

The direct method is better for small businesses. However, team preferences and regulations may dictate the use of the indirect method.

The cash flow statement typically has three main sections.

  • Operating Activities: Cash from core business activities (sales, purchases, salaries).
  • Investing Activities: Cash used for buying or selling assets (equipment, property).
  • Financing Activities: Cash from issuing debt or equity or repaying loans.

Five essential items to look for when reading a cash flow statement.

  1. Net Cash Flow: The overall health of your cash flow. Positive is good, negative is a warning sign.
  2. Operating Cash Flow: Shows how well your core business generates cash.
  3. Free Cash Flow: Cash available after all expenses and investments, a key measure of financial flexibility.
  4. Days Sales Outstanding (DSO): Average time it takes to collect customer payments. Lower is better.
  5. Inventory Turnover: How quickly you sell and replace inventory. Higher is better, indicating efficient use of resources.

Use cases for business owners.

Cash flow statements help business owners not only understand the current position of their business but help:

  • Plan for upcoming expenses: Payroll, taxes, and seasonal fluctuations.
  • Make informed borrowing decisions: Ensure you can repay loans.
  • Evaluate potential investments: See if they’ll hurt your cash flow.
  • Set realistic sales goals: Align them with your cash needs.

How are cash flow statements created?

Luckily, most business accounting software packages generate them automatically from your financial data. Look for “Cash Flow Statement” or “Statement of Cash Flows.”

Quotes to inspire you:

“The more a business owner knows about their cash flow, the more empowered they become.” – Nick Chandi, ForwardAI CEO”

“Cash flow is more important than profit in the near term. Cash flow is king.” – Mario Gabelli, Investor

“Cash is the oxygen of business. When your cash runs out, you die.” – Richard Branson, Entrepreneur

“The fact is that one of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality.” – Chris Chocola, American businessman and former politician

Remember, cash flow is king. Don’t let your business be blindsided. We recommend every business owner embrace and use this powerful tool often to ensure the financial health of their business.

Sources:

Investopedia: https://www.investopedia.com/investing/what-is-a-cash-flow-statement/

Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/accounting/statement-of-cash-flows/