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Important Tools for Understanding Cash Flow

Cash flow is an important indicator for any business. For example, an accrual based business can show net income, but due to collection issues it could experience negative cash flows over the same period. Understanding how cash flows impact a business and tools available to monitor historic and on-going cash flows is vitally important.

Statement of Cash Flows

Many business owners are very familiar with the balance sheet and the income statement (sometimes called a profit and loss statement, or P&L). However there is a third statement that can provide valuable insights to business owners: the statement of cash flows. The statement of cash flows is broken down into three components, all helping to account for the total change in a business’ cash over a period of time:

Cash Flow from Operating Activities

Operating cash flows are derived from normal business operations, whether that is selling inventory, providing services, or collecting rents, less the expenses of carrying on those activities.

Cash Flow from Investing Activities

Typically a negative flow (in other words a cash outflow), cash flows from investing activities represent the business turning cash into long-term assets, such as purchasing capital equipment, buildings, and investments into securities. It also includes proceeds from these investments, such as cash received for the sale of fixed assets or sales of securities.

Cash Flow from Financing Activities

Cash flow from financing activities include cash inflows and outflows related to funding a company. Proceeds from debt, repayments of debt, as well as contributions and distributions to shareholders are all included in this category.

Each one of these categories can help tell a different story about your historical cash flow over a period of time. Consistent periods of negative operational cash flows can be highly concerning, as it can indicate that the operations of the company are not supplying enough working capital to sustain the business. Long periods of time without investing outflows may indicate that a Company is overdue for capital expenditures. Long periods of positive cash flow in financing activities may indicate that the business is relying too heavily on debt or owner contributions to continue.

Cash Flow Models/Projections

While preparing and analyzing a statement of cash flows can provide insight into the history of your cash movement, cash flow models and projections are a useful tool to determine future cash positions based on assumptions.

Generally, these models and projections are built off a rolling cash flow projection of between three to twelve months. Methodologies exist to project cash flows beyond this period, but assumptions can cause larger degrees of error the farther out they are projected. Simpler calculations are often useful beyond the twelve-month timeframe.

In developing a cash flow forecast, it’s important to not only factor in operating cash flows, but to also develop assumptions around outside financing cash flows (loan proceeds and paybacks), and the need for future capital expenditures to support your operations.

One of the most important steps in developing a cash flow forecast is to develop your assumptions, including those on the revenue side as well as on the expenditure side. It can be tempting to paint an optimistic picture for revenues, but be sure to realistically consider when customers are likely to pay their invoices. If you hold inventory, you may need to consider cash flows out well in advance to maintain inventory levels. Payroll projections are also useful, especially if labor costs tend to fluctuate over time, whether due to seasonality or overtime requirements for production.

Lastly, it’s important to be sure a cash flow model is flexible and continuously reviewed. A static cash flow model that never changes will often lead to the continuance of bad assumptions. If reality changes in ways you didn’t account for in your model, you should change it to fit new assumptions. It’s also a good practice to compare historical data to your cash flow model to see if your predictions work properly, or if the model is yielding incorrect information.