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How to track (and understand) cash flow

cash flow cash management Mar 01, 2023

Cash flow is one of the most important concepts in business,

yet few business owners understand it.

Today we breakdown the Statement of Cash Flows, one of the most underappreciated tools/statements in finance.

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How to track (and understand) cash flow

Cash flow is a perplexing thing in business.

Here is what tends to happen. For years, a business operates off the Income Statement, because they understand the concept of revenue and expense. They assume “profit” is money coming in the door, meaning cash increases with profit.

But, here in lies the issue: this is true until it’s not.

This is true when all the following are true:

  1. You look at a Cash Basis Financial Statement
  2. You’ve not purchased any new assets
  3. You have no debt
  4. You’ve not contributed or distributed owner's capital

When one of these elements is no longer true, your Income Statement no longer reflects cash.

So, how can we track cash flow?

You need to look at the Statement of Cash Flows.

But first, let’s start with the main components of cash movement in your business:

  • Cash received related to a sale
  • Things purchased and immediately expensed
  • Purchase or sale of an asset
  • Taking on debt or repaying it
  • Owner/Shareholders’ capital contributions or dividend payouts (on Balance Sheet)

This is an oversimplification, but if you can understand what these elements are you can understand the Statement of Cash Flows.

Let’s walk through it.

The Statement of Cash Flows is broken down into 3 sections:

  1. Operating Cash Flow
  2. Investing Cash Flow
  3. Financing Cash Flow

Operating Cash Flow

This section answers the question: am I making money from the operations of the business?

When you look at this section, “Net Earnings” or Net Income is just ONE line of this whole section.

The remainder of the section has 2 main sections:

  1. Non-cash items being adjusted out of the Income Statement
  2. Changes in working capital, short-term assets and/or liabilities

With Accrual Financials, revenue can be counted before the cash is received (reflected in Accounts Receivable) and expenses counted before paid (reflected in Accounts Payable).

Other adjustments include:

  • Depreciation and amortization
  • Deferred expenses, like stock-based compensation
  • Changes in Inventory
  • Other short-term payable/receivables

The goal is to have a POSITIVE operating cash flow because it tells you cash from sales is supporting the business's day-to-day operations.

Investing Cash Flow

This section reflects:

  • The purchase or sale of assets
  • Businesses acquired or sold
  • Other investments, like R&D

By using Operating Cash Flow +/- purchase or sale of assets, you can get to the “holy grail” of financial numbers, Free Cash Flow.

Free Cash Flow is cash flow after required reinvestment for continuing operations. This means that your business is generating enough profit to pay for the “refresh” of equipment needed to keep the business growing.

In a business with high capital expenditures, this is an important hurdle to clear. If you don’t, that means it’s a matter of time before the business can no longer continue, as equipment gets to old to be used and is sold for cash.

Negative cash flow from investing isn’t good or bad. It’s about understanding why it’s that way.

The goal is to make long-term investments.

Financing Cash Flow

This section shows cash movement related to changes in long-term debt and equity.

It can include:

  • Stock sale or repurchases
  • Issuance or repayment of debt
  • Distribution or dividend to owner

Negative cash flow here means one of 3 things:

  • Stock is being repurchased
  • Debt repaid
  • Distributions being made

This is not good or bad in and of itself and can only be understood in the greater picture of the company as a whole.

What it all means

With Operating Cash Flow, I can’t think of a situation where negative is good.

If cash flow is negative cash flow from operations, you have to make up the difference from:

  • Investing Activities
  • Financing Activities
  • Previous cash balances
  • Owner funding the business

With Investing and Financing, it’s the context of the full situation that matters.

With Investing:

  • Negative is good when reinvesting in the long-term health of the business
  • Positive is bad when selling assets to cover operating losses

With Financing:

  • Negative is good when the business owner is taking out money because the business generates more cash than it needs.
  • Positive is bad if you’re taking out debt to cover operating losses.
  • Issuing stock to generate cash can be good (growth) or bad (cover losses).

Overall, the Statement of Cash Flows is one of the more complex and confusing concepts in finance.

But, it’s also one of the most important.

By understanding this statement you’ll have a deeper understanding of your business and how to manage your cash.

What should I write next?

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Something Interesting

  • If you want to dig into this concept deeper, I wrote about the relationship between cash and profit here and about the cash conversion cycle here.
  • Elizabeth Holmes had a 2nd child and is seeking to have her 11-year prison sentence delayed because of it. Scammers gonna scam, eh? I wrote about the red flags of a scammer after the FTX debacle, which you can check out here.
  • My friend Dave wrote a great article identifying the “common culprits” of a bad hire and 6 questions to avoid them in the future. You can read it here and should subscribe to his newsletter while at it.

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