Part 1: “Dude, Where’s My Cash?”

I once engaged in a friendly argument with a colleague, he said, that a business cannot fail if it is consistently profitable.  I argued that such a thing surely could happen; that even a good, profitable business could run out of cash and be forced to close.

Anyone could understand that if you sell a lot of product but never get paid, you will run out of cash and go out of business.  This is theoretical.  In the real world, good businesses have many customers, and if they have a desirable product or service, most of those customers will pay.  This is true, but it does not diminish the importance of understanding and effectively managing your cash flow in business, because the failure to do so can cause trouble with your suppliers, your banker, and the many people who depend on you for their livelihood.  To help my Clients achieve a deeper understanding of cash flow, I like to start by introducing them to their Statement of Cash Flows.

The Statement of Cash Flows is not magic – it can be developed manually with pencil and paper, but any good accounting software, such as QuickBooks, provides a Statement of Cash Flows as a basic report.   An example is shown below.  This format is commonly known as Uniform Cash Analysis (“UCA”).

Note that the shaded boxes show the difference between Net Income and Net Change in Cash (another way of saying “net cash flow”) for the same period: Net Income (Revenues minus Expenses) was $15,000.00, but net cash flow was negative (-$10,000.00).   Why the difference?

To answer that question, let’s begin with Accounts Receivable.  In many businesses, when you make a sale on payment terms, you are going to have Accounts Receivable or “A/R.”   By definition, A/R means that you have made a sale, and someone owes you the money for it.  If Accounts Receivable increases, that means that our amount of new invoiced sales (not yet paid) has exceeded our cash collections for the period (net negative cash flow). If A/R decreases, that means that our collections for the period have exceeded our new invoiced sales (net positive cash flow).

Now remember, when you book a sale to Accounts Receivable, you are recording profit (Revenue minus expenses) prior to cash being received. This is proper accounting, but it creates a timing difference between when you record profit and when you receive your payment.  In the example below, the client has already recorded profits of $15,000.00.   To translate that into cash flow, we must adjust for increases and decreases on the balance sheet. Accounts Receivable have increased by $305,000.  Our profit on those receivables is already incorporated into the Net Income.   To reconcile net income to cash, I must subtract $305,000 from Net Income, because that is the amount of Invoiced Sales for which I’ve received no cash (yet).

Invoiced Sales > Collections = Increase in A/R = Decrease to Cash.

Invoiced Sales < Collections = Decrease in A/R = Increase in Cash.

For a liability account, the same principle works in exactly the reverse.  Accounts Payable are amounts you owe to someone else (a vendor, a subcontractor, etc.).  If you have bought materials on credit, but not yet paid, your expenditure has been counted in your Net Income, but no cash has gone out your door.   Therefore,

Purchases > Vendor Payments = Increase in A/P = Increase to Cash.

Purchases < Vendor Payments = Decrease in A/P = Decrease to Cash.

We can draw out the same principle to encompass all Asset and Liability Accounts on your balance sheet:

Increase in Asset = Decrease in Cash (and vice-versa)

Increase in Liability = Increase in Cash (and vice-versa).

As you look at this example, the numbers start to become clearer: negative numbers mean net cash has gone out the door, relative to Net Income, and positive numbers mean net cash has come in the door, relative to net income.  This client’s cash flow from operations, for the month of October, was negative ($92,000).   The Client also invested in some Vehicles and Equipment (“Investing Activities”), netting to a cash outflow of ($43,000).  Taken together, we have ($135,000) of net cash going out the door in the month of October.  How did the Client finance this outflow?

Well, take a look at the Financing Activities. It looks like the Client took out a loan to finance 100% of the Vehicle purchase of $35,000, so that washes out (they spent $35,000 on the Vehicle, but borrowed all of the money from the bank, so the net cash flow of that transaction is zero). The Client also borrowed $90,000 during the month on its Line of Credit, to help fund that significant increase in Accounts Receivable. That’s all. As a result, the Client’s bank account balance decreased by $10,000, from $66,155.59 to $56,155.59.

So, here is an example of a situation where a Client “made money” in October 2018, but spent more cash than it brought in. Of course, the reverse can also be true, and hopefully in your business, you are experiencing more cash-flow positive months than cash-flow negative months.  Either way, if you need some help getting a better handle on your business profits AND cash flow, reach out to us at CLM Advisors.

In Part II of this series, we will explore in greater depth how businesses use financing (borrowing) to sustain and grow their businesses.  We’ll talk about short-term debt, like credit cards and bank lines of credit, and long-term debt, like equipment loans and mortgages, and reinforce the principles of UCA Cash Flow Analysis.   Stay tuned!