This is the second in an installment of articles geared toward understanding the financial data behind your business. Part 1 of the series introduced working capital and the current ratio used to measure it. An excellent measure of your liquidity and ability to continue as an ongoing concern. The concept and details of cash flow and your cash flow statement will be analyzed next. As previously mentioned, in its conceptual form, cash flow is the net amount of cash that an entity receives and disburses during a period of time. A positive level of cash flow must be maintained for an entity to remain in business. Unlike working capital, the value of cash flow is reported on a standardized time period, usually quarterly, and even monthly in the early phases of an operation. The following is a basic example of a cash flow statement:
You will notice that the statement of cash flow is broken down into three categories:
- Operating Activities: Cash flows in and out of the business through line items such as those above. Operating Inflows are cash paid by customers for services or goods provided by your business. Operating outflows are expenditures made as part of the ordinary course of operations, such as payroll, the cost of goods sold, rent, and utilities.
- Investing Activities: Your investing activities, other than perhaps sales of equipment and such, will be rather Spartan as a new business.
- Financing Activities: Depending upon how you capitalized your business, debt or equity, you will list these inflows and outflows under financing activities. An example of cash inflow would be the result of getting a bank loan or obtaining cash through other borrowing means.
The bottom lines of the statement total your net cash flow, and then adds this or subtracts it to the cash balance at a beginning period of measure. Cash flow is not the same as the profit or loss recorded by your business, since accruals for revenues and expenses, as well as for the delayed recognition of cash already received, can cause differences from cash flow. For example, depreciating an item for its useful life is accounted for by subtracting a given amount each reporting period, even though no actual cash flowed out of the business.
Lack of cash is one of the biggest reasons small businesses fail. The Small Business Administration says that “inadequate cash reserves” are a top reason startups don’t succeed. It’s called “running out of money,” and it will shut you down faster than anything else. Let’s summarize by putting cash flow together with your other two financial statements, the balance sheet and the income statement. The final line in the cash flow statement, “cash and cash equivalents at end of period,” is the same as “cash and cash equivalents,” the first line under current assets in the balance sheet. The first number in the cash flow statement, “consolidated net income,” is the same as “income from continuing operations” on the income statement.
Keep a very, very close eye on cash flow and working capital. These are extremely important for a start-up and will give you a very, real-time picture of whether or not you have enough money to keep going. A persistent, ongoing negative cash flow based on operational cash flows should be a cause of serious concern, since it means that the business will require an additional infusion of funds to avoid bankruptcy.