Statement of Cash Flows

Posted by PITHOCRATES - December 18th, 2012

Economics 101

No Business will be able to Repay any Loan unless their Business Operations can Generate Cash

In business cash is king.  As it is in life.  We need cash to buy food to survive.  Just as a business needs cash to pay its bills to survive.  Cash is so important to a business that there is a special financial statement to summarize cash flows in a business.  It looks something like this.

The above are made up numbers that could be similar to any statement of cash flows.  It shows the three sources of cash for a business.  Operating activities.  Investing activities.  And financing activities.  Every last dollar a business has came from one of these three sources.  And we can determine the health of the business just by seeing where its cash came from.

Not all business owners use a statement of cash flows.  Most small business owners probably don’t.  Having some other method to see where their cash is coming from.  And going to.  But if they plan on borrowing money from a bank they’re going to need one.  As bankers want to see a business’ ability to generate cash from their business operations.  For no business will be able to repay any loan unless their business operations can generate cash.

An Increase in Accounts Receivable indicates a Business’ Customers are Paying them Slower

A business generates cash from operating activities.  Which comes from sales.  Of course business have to spend a lot of money to create those sales.  So the net cash generated is basically net income with a few adjustments.  In accrual accounting we expense a portion of what we spent on an asset as a depreciation expense each accounting period.  Because although we pay for an asset in one year we may use that asset for the next 5 years.  Or more.   So we expense a portion of that asset each accounting period.  But we don’t have to write a check to pay for depreciation.  It is a non-cash transaction.  So to adjust net income to show net cash generated we have to add back this depreciation expense.

An increase in accounts payable indicates a business is paying their bills slower.  And when you pay your bills slower you free up cash for other things.  Becoming a source of cash.  With each payroll a business has to withhold taxes from their employees’ paychecks.    Social Security, Medicare, unemployment insurance, the employee’s federal and state withholding taxes.  With each payroll these liabilities accrue and are payable to the various government agencies.  You  can free up some cash by paying these taxes late.  But it is not recommended.  For the penalties for doing so can be severe.

An increase in accounts receivable indicates their customers are paying them slower.  An increase in inventory indicates they’re buying more into inventory than they’re selling from inventory.  Prepayments will conserve cash in the future by paying for things now.  But they will leave you with less cash now.  A decrease in accrued liabilities indicates they’re catching up on paying some of their accrued expenses.  Like those payroll taxes.  (In the ideal world if you add up the increase and decrease in accrued liabilities they should net out. Indicating you’re paying your accrued expenses on time.  In this example the business has a balance of $3,000 they’re paying late.)  Increases in all of these items consume cash, leaving the business with less cash for other things.

When the Owner has to put in More of their Own Cash into the Business Things are not going Well

Cash flows from investing activities can include financial investments a business buys and sells with the excess cash they have.  In this example the only investment activities is the buying and selling of some plant assets.  Perhaps selling some old equipment that is costly to maintain and replacing it with new equipment.  Even replacing a vital piece of production equipment that breaks down.  Putting a business out of business.  Thus requiring a cash purchase to replace it as quickly as possible.  Short-term borrowing may be advances on their credit line while the settlement on short-term debt may be the repaying of some of those advances.  Proceeds from long-term debt may be a new bank loan.  While payments to settle long-term debt may be repaying a previous loan.  Finally, paid-in capital is money from the business owner.  Such as cashing in a 401(k) or getting a second mortgage on their house so they can put it into their business to make up for a cash shortage.

So what does all of this mean?  Is this business doing well?  Or are they having problems?  Well, the good news is that they are meeting their cash needs.  The bad news is that it’s not because of their operating activities.  They’re meeting their cash needs by paying their vendors slower.  In fact, if they didn’t they may have had a net loss of cash for the year.  Which means had they not paid their bills late they may have gone bankrupt.  And their cash problems are evident elsewhere.   For not only are they paying their vendors slower their customers are paying them slower.  Making them wait longer to get the cash from their sales.  And with more money going into inventory than coming out of inventory it indicates that sales are down.  Leaving them with less revenue to convert into cash.  And what’s particularly troubling is that increase in accrued liabilities.  Which could mean they’re paying their payroll taxes slower.  Accessing their credit line also indicates a cash problem.  Also, having to borrow $50,000 to help repay a $100,000 loan coming due is another sign of cash problems.  Finally, when the owner has to put in more of their own cash into the business things are not going well.

These are things a business owner has to deal with.  And things a loan officer will note when reviewing the statement of cash flows.  Some people may think a net increase in cash of $18,000 is a good thing.  But it’s not that good.  Considering they had to get that cash by paying their vendors slower, paying the government slower, borrowing money as well as investing more of their personal savings into the business.  Worse, despite having all of these cash problems the government is taxing away of lot of their cash.  Because their net income passing through to their personal income tax return is $235,000.  Putting them in the top 5% of income earners.  And into the crosshairs of those looking to raise tax rates on those who can afford to pay a little more.  To make sure they pay their ‘fair’ share.

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