The Cash Flow Statement

At the end of the year we look at the income statement, we see $50,000 of profits, and we’re asking, “Well, hey, where is it?”

Some of this stuff got reinvested in buying new equipment. Some of this subsidizes the growth of this business, and when that happens it means you can’t necessarily see that $50,000 in your cash box or in your bank account. It’s spread out through the business, and the question is, are we managing the cash that we need well? Because profits aren’t something that we can spend if we end up using it to reinvest in other things.

The year

Let’s tell a story of a hypothetical business here. In this given year things have been pretty good.

We’ve gotten sales increases. A lot of it, however, has been on credit, so our receivables are up by $3,000. It’s been a good year, because when we look at our inventory, we sold more than we actually bought, so our inventory levels are down $2,000. To make all this work our suppliers had to support us. What we owed them went up, so our payables are up by $4,000. It gave us a chance to catch up on some bills that we already expensed. We had some accrued expenses and those went down by a thousand.

It was also a good year to get retooled. We have some old equipment that we wanted to get rid of. We sold an old piece of equipment for even more than book value, and we actually got a gain of $6,000. We had proceeds - we sold the equipment for $10,000. That was $6,000 more than we thought it was going to be, since our book value was only $4,000 for that. Then we bought a new piece of equipment that cost us $15,000. The equipment that we had on the books was being depreciated, and we had depreciation on that of $5,000.

And then we’ve got some financing that we did. We borrowed some money, we repaid some debt, and then we also paid out some of the proceeds for the owners.

So this overall felt like a good year. We did more sales, but there are some things that we had. It was time to recover. We had to get a little help from our suppliers, who had to get paid a bit later, and we sold more than we even had, so that was an inventory draw down. It feels like a lot of great activities are going on. It was a year where we could refresh our equipment and sell some stuff. We even sold it at a gain, that feels good, and we got to catch up on the bills. This feels good and the owners are pleased. But the question is, are they doing okay, and how are they managing their cash?

The freezer

Let’s talk about this equipment. Imagine it’s a freezer that they’ve got. They had all this cash go out the door because they bought this $15,000 freezer in year one. Now what’s going to happen is they’re down the cash. They don’t have that on the income statement, because they’ve capitalized this as an asset. Now there’s going to be two more years of depreciation on the income statement, and that’s going to have no cash impact at all.

Every single year they’re going to see an expense of one third of $15,000, which is $5,000 each time. Every single year that’s going to be an expense that they put on the income statement, so lower profits. Remember all of that money went out the door in cash when they bought this. It’s this thing that we put on the income statement as depreciation expense, but we don’t actually see cash leave the door.

So what’s going on here? In the first year cash took a big hit, but we don’t see that in the income statement. Then over the next few years we don’t have additional cash outlay, but on the income statement we’re going to see $5,000 leave every single time.

Starting from a number we know

Let’s do a cash flow statement by the method of the indirect reconciliation. What we do is we’re going to start with a number we know, net income, and then reconcile back all the things that either affected cash that are in the income statement, or didn’t affect cash in the income statement and have to be pulled out.

Let’s do an illustration.

We start with a net income of $50,000. Net income is a number that we pull off the income statement. That was the profit.

Depreciation expense is in that net income. We deducted depreciation expense of $5,000 to get to that net income. Now here’s the thing: while that was an expense that we recognized on the income statement, it didn’t actually have cash leave the door. That was an allocated adjustment to make the profit number correct. If we want to get a cash basis we have to add that back, because it never really happened.

The next thing is the increase in accounts receivable. When we have an increase in accounts receivable, when we look at our net income, we booked that revenue. The thing is accounts receivable went up, which means that over that period customers owed us more than before. If that number goes up, that means we still have a certain amount outstanding. That’s in our income statement because we booked it as revenue, but it’s not in cash. The increase in accounts receivable was $3,000, so you can think about it this way: if we’re starting with net income, we have to subtract that to figure out how much cash we actually have.

Inventory went down. We had inventory, and not only did we sell everything that we bought, we sold a little bit more of that. How do we do that? It’s because we had some inventory standing when we started the year. We sold everything that we bought and then we even dipped down into that. When you do that, we had some money that was tied up in inventory, but we sold all that inventory and some more. What that means is when the inventory decreases, it frees up cash. Inventory went down by $2,000, so that means we should have $2,000 more of cash rolling around someplace.

Increase in payables. When we have an increase in payables, it means that was expensed. We incur this expense, but instead of spending cash we owe our suppliers. Those expenses are in our income statement, but we haven’t paid it yet, because we have an increase in payables - more stuff that we owe them. We can add that back to our net income if we want to get to a basis of how much cash we have, because while we took the hit in net income we haven’t quite paid it yet. We add back that $4,000.

Now the gain from the sale of equipment. Why do we have this gain? Because we’ve depreciated it. We say that the book value of this equipment is actually lower compared to what we sold it for, but that depreciation isn’t really cash. We’ll talk about the impact of the cash coming in and out for the sale of the old stuff, and for the purchase of the new stuff. That gain is a book gain, but it’s not real when it comes to cash.

Finally, when it comes to accrued expenses, we paid off some expenses. We paid off $1,000 worth of expenses. That means we had to do that with something, and it’s cash. While those expenses were already acknowledged before, the fact that we’re paying out the cash now is a decrease in cash.

Why 50 and 51 landed so close, and when they will not

So we start with all these adjustments, starting with $50,000, and we take all these net differences. The net cash from operating activities is $51,000.

This was almost the same as net income, so it landed pretty close. It turns out that all these different effects almost net out for each other. This is not something that is normally the case. It doesn’t have to be the case, because as we make all these adjustments we could actually have a net cash flow derived indirectly from that income be wildly different. If there’s a lot more booked sales and the receivables went up because we haven’t collected them, it could differ quite a bit. At the same time, if things shift cash more compared to what actually leaves the door versus the accrual picture, these numbers can differ quite a bit.

So let’s talk about if it differs quite a bit, in both directions.

What happens if operating cash flow is well below net income? Why would the cash picture differ from the accrual picture?

One of them could be that we’re booking sales where the money hasn’t come in yet and that is unusual. That’s generally a smoking gun, because perhaps we’re over-optimistic in what we’re actually going to collect and we have to look at the quality of the collections coming in. Or it could be something that’s normal, because we fully know that the customers are good for paying us. They just haven’t paid us yet.

Another reason why cash flow could be far below net income is that we are doing a lot of prepaying. Perhaps we’re prepaying for expenses that have not yet been utilized, have not yet hit. Though we’re out the cash, we know that because we prepaid we’re not going to have to pay money out for those expenses later on.

It could be that we’ve had a lot of money that we owed our suppliers. They were helping us and basically extended very generous credit terms. In one year we finally paid them all back. That was all credit in the sales for prior periods, but we’re finally truing things up, so we’re going to see more cash come out. Those sales were not from this year. They were booked from the years before and we were just chewing up on that. That could be another reason why our cash flow runs well below net income.

So you see sometimes the reason to be concerned, and sometimes a very logical explanation for it.

What about the other way? What if we have a lot more cash than net income would suggest?

Perhaps it is the year where we finally got all of our customers to pay and we did a lot of collections. It could be that we are leaning on our suppliers, that we are buying a lot of things from them but we’re not paying them until much later and our payables are growing. Perhaps this is the year where we sold a lot of things and we had certain inventory levels but we dipped well into our safety supply stocks. What happens is our inventory went down versus the beginning balances. What that means is now, let’s say the warehouse is almost completely empty. We’re able to turn all that inventory into cash, so we get more cash, so the cash flow is higher versus where it was last time.

The thing to worry about with all this is: is this kind of stuff sustainable? If we have a lot of cash, very often it’s because we’re leaning on our suppliers or we’re selling down more of our inventory. You have to ask yourself: why do we have inventory levels so high? If that’s the normal safety level we have to have in order to not stock out, then we’re dipping below our safety areas and we’re going to have to replenish more of that inventory in the next period. That’s going to have the opposite effect on cash flow. If we always were bloated on inventory and this was a way to get closer to where we ought to be, then perhaps it’s sustainable, and that impact that we have on cash flow is something that’s not going to reverse.

The rule underneath all of it

So what’s the net thing here? When assets go up, it uses up cash, and when liabilities go up, we’re freeing up cash, because instead of spending it we’re owing people.

That sounds a little backwards, but we need to understand where we got to with the income statement and then back out all the things that actually happened when it came to cash, in order to get this reconciliation. That’s why we call this the indirect method.

Investing: what actually happened to the equipment

Now that we’ve talked about the cash flow from operating activities, let’s get into a couple of other things that are happening in the business.

We have two other sections. The cash flow from investing activities: we got $10,000 for selling the stuff. Those were the proceeds of selling the old equipment. Now we had to buy some new equipment and that cost us $15,000. $10,000 came in because we sold something, and $15,000 went out because we bought something that has to do with investing in new equipment. That is a net impact of negative $5,000.

Something I want to close the loop with: it was a little bit confusing that we had the $6,000 gain on the sale of equipment come out of the operating side, and then we see the $10,000 that we got, the proceeds from selling this equipment, show up in investment.

Here’s what’s going on. When you sell a piece of equipment at an accounting book gain, you see that in net income. That is a gain that you’re going to realize, because the proceeds that came in are more than the cost that you have on your balance sheet. But that stuff is made up, because the balance sheet is an accrual number of this depreciation stuff that did not really have cash impact. That’s why we have to subtract that out of the operating stuff.

What really did happen? It’s very clear when we look at the cash flows from investing. We sold something, so $10,000 came in. We bought some other replacement equipment, so $15,000 went out, which means the net cash flow from investing activities around buying productive assets is negative $5,000. That makes it really clear.

One thing you’ll notice is that, from a timing standpoint, financial impact is really jarring here, because things show up all at once when you buy equipment. It’s all $15,000 at once, all out the door, a big negative hit. It’s a little bit more gentle and smooth on the income statement, because we capitalize that as an asset but the expenses leak out over three years, $5,000 at a time, through depreciation. Depreciation as a way of smoothing things out, because we’re matching the use of these assets over the time period instead of having these big punctuated hits. Either selling equipment or buying equipment - same transaction, it’s captured in two different ways.

Financing: money in from lenders and owners, and money back out

Now imagine when we talk about financing activities, which is like borrowing money, or getting money from investors, or paying back investors or owners.

We’ll say we borrow some money from a bank, about $20,000. We repay some of some other older bank loans, and say that’s $8,000. That means $20,000 came in, that’s positive cash flow, but $8,000 flowed out as negative cash flows.

For dividends paid, that’s when we take money that’s in the company and pay it out to our owners. We pay a dividend of $5,000, so that’s another $5,000 out the door. When you net this out, we have a net cash from financing activities of positive $7,000.

Here’s the thing on financing activities. This stuff doesn’t really touch the income statement, because when we pay off a loan it comes off of our balance sheet and cash has come out, but it’s not hitting the income statement anywhere. That’s important, because we’re restructuring not whether or not the business makes money - we’re restructuring how the business is funded and financed, not whether or not it’s performing better or worse.

Now in the last chapter we talked about dividends. We either pay out dividends from retained earnings or reinvest in the company. If we pay out dividends it shows up as cash leaving the door, and now we’ve finally connected this. Cash leaves the door. It goes to investors. From a business standpoint we’re going to see that as a financing activity where cash leaves.

It’s the negative of when investors come, and usually when investors come they put cash in, they put an infusion in. We see paid-in capital go up and cash go up. But at some point investors need to get paid back. When cash comes out of the business, when they withdraw that, we see that in the form of a dividend. Cash goes down and that gets paid out as a dividend. That’s almost the undoing of the financing. We always think about financing as them putting in money and then the business runs because it has cash. This is the reverse of that.

Putting it together

So let’s sum up the impact. The operating cash flow was $51,000, and then we have to subtract $5,000 from investing activities, plus $7,000 from financing activities, which is $53,000.

We started with cash of $25,000 and in the end we had $78,000. We should find that the difference between these two is exactly what we can measure on this cash flow.

It turns out that $78,000, which is what we ended up with, minus $25,000 - well, how do we get there? We can see it in these numbers from the cash flow statement. The net effect is $53,000. We had a cash inflow from operating activities of $51,000, then from investing activities a negative impact on cash of $5,000, and then financing activities was a positive impact of $7,000. That’s a net of $53,000, and that’s exactly what reconciles the opening cash balance of $25,000 with the closing cash balance of $78,000.

Now we have a full reconciliation between where cash started and where cash ended, based on the operating, investing, and financing activities of this year.

Where all of this comes from

We finally get the balance sheet. The beginning and end of year should be the same thing as the end of two consecutive periods.

We see on this that cash has gone up by $53,000. That is what we need to reconcile. How do we get from 25 to 78?

You can go through the rest of the pieces. Some of this has to do with changes in balance. The accounts receivable went from $20,000 to $23,000. I want you to tie this out to Table A, where we have this indirect reconciliation of all of those moves. In fact let’s do that. When we look at this balance sheet, the accounts receivable went from 20 to 23. That is an increase of $3,000, and if you tie back to Table A, it is an increase in accounts receivable of $3,000.

Depreciation expense: you’re going to see here accumulated depreciation. Depreciation expense is something that we have to get off the income statement, so we won’t see that.

The decrease in inventory: we look at inventory, which went from $30,000 to $28,000. That’s a decrease in inventory of $2,000, and that’s why you go to Table A. You will see that $2,000 there.

Accounts payable, when we look at this one, went from $15,000 to $19,000, so it went up $4,000. That’s why we see on Table A that increasing accounts payable. We have to add that in there.

Gains on the sale of equipment: you’re not going to see it except on the income statement. For accrued expense it went from $6,000 to $5,000. That’s a decrease of $1,000, which is why on Table A we see a decrease in accrued expense there.

We tie out what we’re going to do for the operating activities. There is some income statement stuff that you have to get off the income statement, and that is the net income of $50,000, as well as the depreciation expense that we have to put back in there, and then the gains on the sale of equipment. The other stuff is differences in balance sheet accounts that we can find on the balance sheet.

This is a table that captures how things have changed on the balance sheet. That stuff is going to feed all the stuff we talked about before in Table A.

Two things worth noticing on those statements

A couple of things you can observe here.

You notice that accumulated depreciation went down from $40,000 to $37,000 in a year where we recorded $5,000 depreciation expense. How is this possible? It’s because we disposed of an asset. When you sell the asset, you take the asset value off the books. You also take the accompanying depreciation off. That’s how that works. It’s not broken. That’s why we can see that in the balance sheets.

One thing you can notice is that if you look at these balance sheets, total assets went from $135,000 to $195,000 and total equity went from $74,000 to $119,000. Assets went up by $60,000 but owner’s equity only went up by $45,000. What’s going on here?

We can ask you now: is this a good year? The important thing to know is this is not just about operating activity. Did this business make more money, and if it did it should have net more assets, which means more assets for the owners. Other things have changed. They’ve done some financing activities. They borrowed some money, which is going to increase assets but it’s also going to increase liabilities. They’ve also repaid some bank loans as well. Remember there was a big dividend payment as well, and that’s going to be a difference between how assets grow and how the business has performed, because it’s a financing activity.

You cannot necessarily look at it right off the bat and say this is a bad sign because equity only went up by a fraction of what total assets have gone up. You have to remember there are other things going on. But the cash flow statement helps you reconcile this:

• How much of this is due to cash having changed, or any total assets might have changed, because the business has thrived and created value?
• How much of this is about moving money around, either through financing or through investment activities?

What this statement is good for, and what it is not

A couple of things on limitations. The thing about the cash flow statement is that it can’t be faked. There’s the beginning cash, the ending cash. You can look in your cash balance and you want to know: how do we get from here to there? It’s a nice reconciliation and it’s easy to count, no assumptions required. That’s the strong thing.

The problem with this is it breaks up all this matching, and you can’t really use how things change from time to time, looking at this and matching it to what’s going on economically. It doesn’t give you a good model of what your business is doing, and therefore be informative about what the levers of improving things are. How do you improve profitability?

Because that tie breaks, this is good for understanding things over a very long term, if you have cash flows over a greater trend. It’s also good to make sure that people stay honest, and it’s a check to make sure there’s nothing funky and weird in the income statement for all those assumptions. It also helps you manage this very important asset that is cash. But it’s not a great statement for running the business, because it’s not a great model of how value gets created and how those economics work.

Red flags

The nice thing about this is it provides some good red flags. Just because your business is profitable doesn’t mean it’s going to survive.

When you’re looking at this, comparing it to the income statement, even if you’ve got a good income statement, you’re looking for some red flags. If we are doing well on income and growing a lot, unless we’ve got some big infusions of cash from investors, we’re going to start getting taxed on this, because growth consumes cash. That’s a big warning sign.

Cash flow is getting tight but growth is high. We’re going to have to find some way to finance this thing and get some outside cash to invest into this business in order to survive. Otherwise, ironically, something that is thriving and is growing and seems to be a commercial success is going to get crushed under its own weight of mismanaging cash.

If you could only keep two

So if someone gave you an income statement, a balance sheet, and a cash flow statement and said, “Hey, you only keep two,” what would you do?

It’s easy: I would keep the income statement and the balance sheets, and here’s why. From that you can back into what the cash flow statement is. No loss. The cash flow is a reconciliation of cash, which you see on balance sheet period one and period two. Use changes in those balances, as well as the income statement, to back into what the cash flow statement is. So you can always build the perspective of a cash flow statement if you have a good balance sheet and income statement.

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