MBA Mondays From The Archives: Cash Flow
Continuing this month’s practice of pulling an accounting related blog post from the archives, this week we feature the post on Cash Flow. The Income Statement and Balance Sheet get more attention, but there is nothing more important in keeping your business afloat than Cash Flow.
This week on MBA Mondays we are going to talk about cash flow. A few weeks ago, in my post on Accounting, I said there were three major accounting statements. We’ve talked about the Income Statement and the Balance Sheet. The third is the Cash Flow Statement.
I’ve never been that interested in the Cash Flow Statement per se. The standard form of a cash flow statement is a bit hard to comprehend in my opinion and I don’t think it does a very good job of describing the various aspects of cash flow in a business.
That said, let’s start with the concept of cash flow and we’ll come back to the accounting treatment.
Cash flow is the amount of cash your business either produces or consumes in a given period, typically a month, quarter, or year. You might think that is the same as the profit of the business, but that is not correct for a bunch of reasons.
The profit of a business is the difference between revenues and expenses. If revenues are greater than expenses, your business is producing a profit. If expenses are greater than revenues, your business is producing a loss.
But there are many examples of profitable businesses that consume cash. And there are also examples of unprofitable businesses that produce cash, at least for a period of time.
As I explained in the Income Statement post, revenues are recognized as they are earned, not necessarily when they are collected. And expenses are recognized as they are incurred, not necessarily when they are paid for. Also, some things you might think of as expenses of a business, like buying servers, are actually posted to the Balance Sheet as property of the business and then depreciated (ie expensed) over time.
So if you have a business with significant hardware requirements, like a hosting business for example, you might be generating a profit on paper but the cash outlays you are making to buy servers may mean your business is cash flow negative.
Another example in the opposite direction would be a software as a service business where your company gets paid a year in advance for your software subscription revenues. You collect the revenue upfront but recognize it over the course of the year. So in the month you collect the revenue from a big customer, you might be cash flow positive, but your Income Statement would show the business operating at a loss.
Cash flow is really easy to calculate. It’s the difference between your cash balance at the start of whatever period you are measuring and the end of that period. Let’s say you start the year with $1mm in cash and end the year with $2mm in cash. Your cash flow for the year is positive by $1mm. If you start the year with $1mm in cash and end the year with no cash, your cash flow for the year is negative by $1mm.
But as you might imagine the accounting version of the cash flow statement is not that simple. Instead of getting into the standard form, which as I said I don’t really like, let’s talk about a simpler form that gets you to mostly the same place.
Let’s say you want to do a cash flow statement for the past year. You start with your Net Income number from your Income Statement for the year. Let’s say that number is $1mm of positive net income.
Then you look at your Balance Sheet from the prior year and the current year. Look at the Current Assets (less cash) at the start of the year and the Current Assets (less cash) at the end of the year. If they have gone up, let’s say by $500,000, then you subtract that number from your Net Income. The reason you subtract the number is your business used some of your cash to increase its current assets. One typical reason for that is your Accounts Receivable went up because your customers are taking longer to pay you.
Then look at your Non-Current Assets at the start of the year and the end of the year. If they have gone up, let’s say by $500k, then you also subtract that number from your Net Income. The reason is your business used some of your cash to increase its Non-Current Assets, most likely Property, Plant, and Equipment (like servers).
At this point, halfway through this simplified cash flow statement, your business that had a Net Income of $1mm produced no cash because $500k of it went to current assets and $500k of it went to non-current assets.
Liabilities work the other way. If they go up, you add the number to Net Income. Let’s start with Current Liabilities such as Accounts Payable (money you owe your suppliers, etc). If that number goes up by $250k over the course of the year, you are effectively using your suppliers to finance your business. Another reason current liabilities could go up is Deferred Revenue went up. That would mean you are effectively using your customers to finance your business (like that software as a service example earlier on in this post).
Then look at Long Term Liabilities. Let’s say they went up by $500k because you borrowed $500k from the bank to purchase the servers that caused your Non-Current Assets to go up by $500k. So add that $500k to Net Income as well.
Now, the simplified cash flow statement is showing $750k of positive cash flow. But we have one more section of the Balance Sheet to deal with, Stockholders Equity. For Stockholders Equity, you need to back out the current year’s net income because we started with that. Once you do that, the main reason Stockholders Equity would go up would be an equity raise. Let’s say you raised $1mm of venture capital during the year and so Stockholder’s Equity went up by $1mm. You’d add that $1mm to Net Income as well.
So, that’s basically it. You start with $1mm of Net Income, subtract $500k of increased current assets, subtract $500k of increased non-current assets, add $250k of increased current liabilities, add $500k of increased long-term liabilities, and add $1mm of increased stockholders equity, and you get positive cash flow of $1.75mm.
Of course, you’ll want to check this against the cash balance at the start of the year and the end of the year to make sure that in fact cash did go up by $1.75mm. If it didn’t, then you have to go back and check your math.
So why would anyone want to do the cash flow statement the long way if you can simply compare cash at the start of the year and the end of the year? The answer is that doing a full-blown cash flow statement tells you a lot about where you are consuming or producing cash. And you can use that information to do something about it.
Let’s say that your cash flow is weak because your accounts receivable are way too high. You can hire a dedicated collections person. You can start cutting off customers who are paying you too late. Or you can do a combination of both. Bringing down accounts receivable is a great way to improve a business’ cash flow.
Let’s say you are spending a boatload on hardware to ramp up your web service’s capacity. And it is bringing your cash flow down. If you are profitable or have good financial backers, you can go to a bank and borrow against those servers. You can match non-current assets to long-term liabilities so that together they don’t impact the cash flow of your business.
Let’s say your current liabilities went down over the past year by $500k. That’s a $500k reduction in your cash flow. Maybe you are paying your bills much more quickly than you did when you started the business and had no cash. You might instruct your accounting team to slow down bill payment a bit and bring it back in line with prior practices. That could help produce better cash flow.
These are but a few examples of the kinds of things you can learn by doing a cash flow statement. It’s simply not enough to look at the Income Statement and the Balance Sheet. You need to understand the third piece of the puzzle to see the business in its entirety.
One last point and I am done with this week’s post. When you are doing projections for future years, I encourage management teams to project the income statement first, then the cash flow statement, and then end up with the balance sheet. You can make assumptions about how the line items in the Income Statement will cause the various Balance Sheet items to change (like Accounts Receivable should be equal to the past three months of revenue) and then lay all that out as a cash flow statement and then take the changes in the various items in the cash flow statement to build the Balance Sheet. I like to do that in monthly form. We’ll talk more about projections next week because I think this is a very important subject for startups and entrepreneurial management teams to wrap their heads around.
The last paragraph ( income stmt, CF stmt & then balance sheet ) is the accounting version of the startup mantra: attract customers, don’t go broke, create value 😉
That is true for any stage of the company. Get more cash, don’t bleed, serve your stack holders :-).
that’s a great way to look at it
“Maybe you are paying your bills much more quickly than you did when you started the business and had no cash.”That is a great piece of advice Fred … especially in manufacturing. Another way to look at it is … “May be you are paying your bills too quickly than your receivables”.
This is a great post. You really break down the process and explain it very well.
Great post, Fred. Thanks.This is a stark reminder just how essential a good banking relationship is for not only for start ups but all companies. That bridge to cash is the ball game in most cases.I hope those banks are out there.
Great post on an important concept.When I work with existing small businesses, I often do the following:Export monthly P&L’s to a spreadsheet.Paste each months cash flow statements under each monthPaste each month balance sheet directly under the cash flow.Then, starting in January, we trace the P&L through to profit. We then look at the cash flow statement and trace it to the cash balance. This is usually an “Ah-ha” moment – where is my cash going?We then look at the changes in the balance sheet, noting where cash is piling up. We end at retained earnings, the cumulative profitability of the company.The same process works for start-ups, though we usually abbreviate the cash flow statement a bit. However, forecasting the balance sheet is just as important as P&L projections.
I had a college professor who used to say, “Cash is king.”In the interest of sharing what has worked for me over 15 years, while my accounting system is accrual, my budgets are cash. At the end of each month in my budget, I change my projected to actual and then make any modifications to future budget months based on the new leanings. This is probably my most important financial tool outside of the accounting system.
you should write a post on that Elia 🙂
Thanks. Maybe I will…
I had a college professor who used to say, “Cash is king.” That was a smart professor!
I really like when you give the “if x is happening you might try y” kinds of practical advice.
entrepreneurs on here today
MBA Mondays posts, as I noted last Monday, attract far fewer comments than posts on any other day of the AVC week or weekend. The hard yards win the game.
Good stuff. Probably most important for startups is to remember to ABS (always be selling). And always hire an accountant so you can forget about such stuff and just sell.
You have to do both. This is actually easy compared to selling.
I have every one of these financial posts bookmarked.They are a lot of work to write. They are most appreciated Fred!
Agreed. Valuable stuff. At the very least a good polish up.
For a different perspective, the public market valueguys will focus intently on free cash flow generation. The conservative way istake the typical free cash flow definition (cash flow from operations – capitalexpenditures), and apply a working capital filter to it.Swings in net working capital (current assets – current liabilities) can skew the free cash flow calculation. If the company ceases paying its bills, cash flow from operations will be overstated. This positive swing in networking capital is obviously not sustainable. A conservative filter is to calculate basic free cash flow, and then also subtract any POSITIVE swings from net working capital. If swings in net working capital decreases cash flow from operations, let it be (to be conservative).For more mature business, this is a great way to analyze the true ability of a company to generate useful free cash that can be reinvested or distributed to shareholders.
22-comments so far and this is 23. The record low comments on AVC in the recent past.MBA mondays are loosing its charm because it is archive post?ORMany AVCers have graduated [email protected] and Mr. gawk.it i really like the ‘recently searched terms on AVC’. One request though … can extend that to last 10-searches? or atleast 5 apart from currently searched term?
both. MBA Mondays is low to begin with. reruns make it worse
Doesn’t matter. There’s still great value in the posts, reruns or not. I’ve sent the links of “reruns” on to others whom I felt it would help and they appreciated it.
MBA Mondays are the main posts I come in for…
I like Peter G hink these are your best posts. That is why I was arguing with William about comments != quality.Mark Suster has the same issue when he talks about sales. They are great posts, few comments.If you are going to run a business the four things you have to know and be able to do are accounting, management, recruiting, and sales. I put them in alphabetical order because if you have a hole in one area it is going to really hurt. Understanding the technical side is also really important, but usually that is so much work you have to split the duties there.
it is rosh hashnah and a repeat post?
Sorry just noticed this now…making note and adding to the ‘to do’ list…most likely I’ll make it part of a customization/setting you can adjust when ‘logged in’…thanks for the idea/suggestion and feedback!
@falicon:disqus I am glad you noticed… what i was thinking is … if you show more of what are the last searches … that will induce searcher to use more of gawk.it… one of the important part of conversation is what are others opinion … what others are talking … and I thought the same holds for searches of conversation.Well ideas are dime a dozen …you can pass a dime if you think this is a good idea :-).
agree…and your check is in the mail 😉
i’m becoming more and more amazed at the things MBAs don’t know these days. Reading some of the comments matches up with some of the conversations i’ve had with graduates and a few investor friends. I didn’t go the MBA route, I started small companies out of high school and sometime after college I decided to try the bank loan – debt route. So I learned on my own from defining accounting terms to financial modeling. I can definitely say that doing so helped out a lot when learning about LBO modeling, etc. Is this the general consensus these days, that one should learn accounting and modeling from starting up rather than the various MBA specializations?