When your business was just starting out, you may have received only an income statement from your accountant. The question you wanted answered was whether the company was profitable. Then your accountant told you that you needed a balance sheet to help you understand your company’s assets and liabilities. That was fine. But ultimately, to see the full picture of your business, you also need a cash flow statement.
You’d think a cash flow statement would be easy to read. Since cash is real money, there are no assumptions and estimates incorporated in the numbers. Cash coming in is a positive number, cash going out is a negative one, and net cash is simply the sum of the two. In fact, though, we find that nearly every entrepreneur and nonfinancial manager takes a while to understand a cash flow statement. One reason is that it is always divided into categories, and the labels on the categories can be confusing. A second reason is that the positives and the negatives aren’t always clear. For example, a typical line item might say, “(increase)/decrease in accounts receivable,” followed by a positive or a negative number. Well, is it an increase or a decrease? A final reason is that it can be tough to see the relationship between the cash flow statement and the other two financial statements.
We’ll take up the last issue in the following chapter. Right now, let’s just sit down with a cash flow statement and learn the basic vocabulary.
The statement shows the cash moving into a business, called the inflows, and the cash moving out of a business, called the outflows. These are divided into three main categories.
At times you’ll see slight variations to the label, such as “cash provided by or used for operating activities.” Whatever the specifics, it is more accountantspeak: too many accountants can’t say “operations”; they have to say “operating activities.” But whatever the exact language, this category includes all the cash flow, in and out, that is related to the actual operations of the business. It includes the cash customers send in when they pay their bills. It includes the cash the company pays out in salaries, to vendors, and to the landlord, along with all the other cash it must spend to keep the doors open and the business operating.
The second category is called cash from or used in investing activities. Note that investing activities here refers to investments made by the company, not by its owners. The biggest subcategory here is cash spent on capital investments—that is, the purchase of assets. If the company buys a truck or a machine, the cash it pays out shows up on this part of the statement. Conversely, if the company sells a truck or a machine (or any other asset), the cash it receives shows up here.
The final category is called cash from or used in financing activities. Financing refers to borrowing and paying back loans, on the one hand, and to transactions between a company and its shareholders, on the other. So if a company receives a loan, the proceeds show up in this category. If a company gets an equity investment from a shareholder, that too shows up here. Should the company pay off the principal on a loan, buy back its own stock, or pay a dividend to its shareholders, those expenditures of cash also would appear in this category.
You can see right away that there is a lot of useful information in the cash flow statement. The first category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. A company with a consistently healthy operating cash flow is probably profitable, and it is probably doing a good job of turning its profits into cash. A healthy operating cash flow, moreover, means that it can finance more of its growth internally, without either borrowing or bringing in more outside investment.
The second category shows how much cash the company has spent on investments in its future. It reflects the idea that any successful business must make such investments. Printing companies need to buy presses and other equipment. Software development companies need high-powered computers. If the number in that second category is low relative to the size of the company, the owner may be treating the business as a cash cow, milking it for the cash it can generate while not investing in future growth. If the number is high, relatively speaking, it may suggest that the owner has high hopes for the future of the company. Of course, what counts as high or low will depend on the type of company it is. A service company, for instance, typically invests less in assets than a manufacturing company. So the analysis will vary according to the bigger picture of the company.
The third category shows to what extent the company is dependent on outside financing. Your cash flow statements over time will indicate whether your company is a net borrower (borrowing more than it is paying off). They’ll also show whether you have been selling new shares to outside investors or buying back company stock.
Finally, the cash flow statement allows you to calculate Warren Buffett’s famous “owner earnings” metric (see the toolbox at the end of this part).
We noted earlier that Wall Street in recent years has been focusing more and more on public companies’ cash flow statements. As Warren Buffett knows, there is much less room for manipulation of the numbers on this statement than on the others. To be sure, “less room” doesn’t mean “no room.” For example, if a company is trying to show good cash flow in a particular quarter, it may delay paying vendors or employee bonuses until the next quarter. Unless a company delays payments over and over, however—and eventually, vendors who don’t get paid will stop providing goods and services—the effects are significant only in the short term. All this is true for private companies as well; it just doesn’t show up on the public radar screen.
If a public company has extra cash and believes that its stock is trading at a price that is lower than it ought to be, it may buy back some of its shares. The effect is to decrease the number of shares outstanding so that each shareholder now owns a larger piece of the company. Privately held companies can also do stock buybacks—for example, when an owner or investor is bought out of the business. The price in this case would be negotiated by the parties involved, since there is no market-based share price for a private company.
If your accountant hasn’t put together a cash flow statement for you yet, ask him to. A cash flow statement, like the other two statements, is an important management tool for the business owner. So get one from your accountant, and then sit down with him and walk through the numbers together. Our guess is that it will be an eye-opening experience.