Cashing In

Profits are great, but they don’t always equal cash in the bank. This issue will explain why that is, and how the cash flow statement makes this clear.

Introduction to the Cash Flow Statement

So why aren’t profits going straight to the bank?

Before I answer that question, let’s first review the previous financial statements thus far:

• The balance sheet tells you who owns what. It calculates the business’s “net worth”.

• The income statement tells you how much money you’re making. It’s like your business’s salary (this is why mortgage brokers want to see income statements to pre-approve business owners in place of W-2s).

And now for the third of the “big three” financial statements.

The cash flow statement tells you how all the activities from these statements impact the cash in your bank.

Why is this necessary?

Shouldn’t this already be obvious?

How is this different from the income statement?

These are good questions. They introduce a very important principle of accounting. And that is…

This becomes apparent when we compare income statement for a given period to the balance sheets from the start and end of that same period. Each of those balance sheets will have a line item for cash in the assets section.

The difference between these two numbers will be how much cash changed from the start to the end of the period. But this difference will not be the same as the net profit on the income statement.

The cash flow statement will explain why this is. It helps businesses reconcile the difference in cash between the two balance sheets.

Let’s dive back in to our coffee cart example to see how.

Cash Flow from Operations

The first section of the cash flow statement reports cash flow from operations. This section shows how the operations of the business impacts the cash in the business.

We start with the net income from the income statement. These are the net profits for the quarter. The line items below will then show what happens to all that profit.

There are some new terms here that I’d like to define:

• Depreciation - this is a “non-cash” operating expense that you may see on an income statement. If a business buys an asset like a car, it needs to account for that asset decreasing or increasing in value. This is recorded in the depreciation line item.
  

• Amortization - This usually applies to recording expenses for “intangible goods”. I didn’t cover these in the balance sheet issue, but you would find them here in the assets section.
  
  Intangible goods are non-physical assets like patents or licenses that carry non-physical value. Accountants will amortize payments for these intangible goods over the lifetime of the asset. There’s a reason for this that is outside the scope of this issue.
  

• Accounts Receivable - Not all bills are paid on time. The business needs to know about this. Accounts receivable is the amount in revenue that the business has yet to receive. If this is too high, your customers might not be paying their invoices.
  

• Accounts Payable - This is the reverse of accounts receivable. This is all outstanding bills owed toward suppliers and vendors.

Cash Flow from Investments

You have to spend money to make money, so they say. This section of the cash flow statement records cash that went toward investment activities to grow the business.

Say the owner of the coffee cart business in our example recognizes that their cart is getting old. Perhaps it needs a new engine. These limitations are a risk for the business. For this reason the owner decides to invest in a new cart.

When a business needs to buy new equipment to facilitate their operations, they will record this transaction in this section of the cash flow statement. Although not the case in this example, you might see this purchase labeled as a capital expenditure.

Cash Flow from Financing

For most businesses there is a cost for how their business is financed. Financing is the process of supplying capital to businesses, so that they can make investments and fund operations.

This financing can come in the form of debt (e.g. a loan) and/or equity (e.g. stocks/shares). The cash flow statement will show how financing impacts the cash in the business.

Putting it all together

The bottom of the cash flow statement will sum up all the activity from each section. The last line will provide the ending cash balance as of the last day of the reported period (March 31 in our example).

One final thing to mention here…the number for total cash generated must always match the difference between the cash on the balance sheet at the start of the period, and the cash on the balance sheet at the end of the period.

P.S. If you want to dive deeper into accounting, I highly recommend this course from growthcurve.io . Much of what I’m sharing in this newsletter I learned from this course.