16
How Cash Connects with Everything Else
Once you’ve learned to read the cash flow statement, you can inspect it for what it tells you about your company’s cash situation, and you can then figure out how to improve your cash position. We’ll spell out some of these opportunities in the following chapter.
But if you’re the type of person who enjoys a puzzle—who likes to understand the logic of what you’re looking at—then stick with us through this chapter. We will show you an interesting fact: you can calculate a cash flow statement just by looking at the income statement and two balance sheets. Now, this may not be what you thought you would be doing when you started your business, but hang in here. The information you’ll learn by going through this exercise can be invaluable. It will certainly contribute to your understanding of how to get to what Gary Erickson, coleader of Clif Bar, calls your sweet spot. Among other things, that is when you are cash flow positive.
The calculations in this chapter aren’t hard; they all require no more than adding and subtracting. But it’s easy to get lost in the process. The reason is that accountants don’t only have a special language and a special set of tools and techniques; they also have a certain way of thinking. They understand that profit as reported on the income statement is just the result of certain rules, assumptions, estimates, and calculations. They understand that assets as reported on the balance sheet aren’t really worth what the balance sheet says, again because of the rules, assumptions, and estimates that go into valuing them. But accountants also understand that the art of finance, as we have called it, doesn’t exist in the abstract. Ultimately, all those rules, assumptions, and estimates have to provide us with useful information about the real world. And since in finance the real world is represented by cash, the balance sheet and the income statement must have some logical relationship to the cash flow statement.
You can see the connections in common transactions. For example, remember that a credit sale worth $100 shows up both as an increase of $100 in accounts receivable on the balance sheet and as an increase of $100 in sales on the income statement. When the customer pays the bill, accounts receivable decreases by $100 and cash increases by $100 on the balance sheet. And because cash is involved, that same transaction affects the cash flow statement as well.
Remember, too, that when the company buys $100 worth of inventory, the balance sheet records two changes: accounts payable, or A/P, rises by $100 and inventory rises by $100. When the company pays the bill, A/P decreases by $100 and cash decreases by $100—again, both on the balance sheet. When that inventory is sold (either intact by a retailer or incorporated into a product by a manufacturer), $100 worth of cost of goods sold will be recorded on the income statement. Again, the cash part of the transaction will show up on the cash flow statement.
So all these transactions ultimately have an effect on the income statement, the balance sheet, and the cash flow statement. In fact, most transactions eventually find their way onto all three. To show you more of the specific connections, let us walk you through how accountants use the income statement and the balance sheet to calculate cash flow.
RECONCILING PROFIT AND CASH
The first exercise in this process is to reconcile profit to cash. The question you’re trying to answer here is pretty simple: given that we have $X in net profit, what effect does that have on our cash flow?
We start with net profit for this reason: if every transaction were done in cash, and if there were no noncash expenses such as depreciation, net profit and operating cash flow would be identical. But since everything isn’t a cash transaction, we need to determine which line items on the income statement and the balance sheet had the effect of increasing or decreasing cash—in other words, making operating cash flow different from net profit. As accountants put it, we need to find “adjustments” to net profit that, when added up, let us arrive at the changes in cash flow.
One such adjustment is in accounts receivable. We know that in any given time period, we’re going to be taking in some cash from receivables, which will have the effect of decreasing the A/R line. We will also be making more credit sales, which will add to the A/R line. We can “net out” the cash figure from these two kinds of transactions by looking at the change in receivables from one balance sheet to the next. (Remember, the balance sheet is for a specific day, so changes can be seen when you compare two balance sheets.) Imagine, for example, we start with $100 in receivables on the balance sheet at the start of the month. We take in $75 in cash during the month, and we make $100 worth of credit sales. The new A/R line at the end of the month will be ($100 – $75 + $100) or $125. The change in receivables from the beginning of the period to the end is $25 ($100 – $125). It is also equal to new sales ($100) minus cash received ($75). Or to put it differently, cash received is equal to new sales minus the change in receivables.
Another adjustment is depreciation. Depreciation is deducted from operating profit on the way to calculating net profit. But depreciation is a noncash expense, as we have learned; it has no effect on cash flow. So you have to add it back in.
A START-UP COMPANY
Clear? Probably not. So let’s imagine a simple start-up company, with sales of $100 in the first month. The cost of goods sold is $50, other expenses are $15, and depreciation is $10. You know that the income statement for the month will look like this:
Reconciliation
In a financial context, reconciliation means getting the cash line on a company’s balance sheet to match the actual cash the company has in the bank—sort of like balancing your checkbook, but on a larger scale.
Income Statement
| Sales | $100 |
| COGS | 50 |
| Gross profit | 50 |
| Expenses | 15 |
| Depreciation | 10 |
| Net profit | $ 25 |
Let’s assume that the sales are all receivables—no cash has come in yet—and COGS is all in payables. Using this information, we can construct two partial balance sheets:
Now we can take the first step in constructing a cash flow statement. The key rule here is that if an asset increases, cash decreases—so we subtract the increase from net income. With a liability, the opposite is true. If liabilities increase, cash increases, too—so we add the increase to net income.
Here are the calculations:
| Start with net profit | $ 25 |
| Subtract increase in A/R | (100) |
| Add increase in A/P | 50 |
| Add in depreciation | 10 |
| Equals: net change in cash | ($15) |
You can see that this is true because the only cash expense the company had during the period was $15 in expenses. With a real business, however, you can’t confirm your results just by eyeballing them, so you need to calculate the cash flow statement according to the same rules.
A REALISTIC COMPANY
Let’s try it with a more complex example. Here (for easy reference) are the income statement and balance sheets for the imaginary company whose financials appear in appendix A:
Income Statement (in thousands)
| Year ended Dec. 31, 2007 | ||
|---|---|---|
| Sales | $8,689 | |
| Cost of goods sold | 6,756 | |
| Gross profit | $1,933 | |
| Selling, general, and admin. (SG&A) | 1,061 | |
| Depreciation | 239 | |
| Other income | 19 | |
| EBIT | $ 652 | |
| Interest expense | 191 | |
| Taxes | 213 | |
| Net profit | $ 248 | |
Balance Sheet (in thousands)
| Dec. 31, 2007 | Dec. 31, 2006 | ||
|---|---|---|---|
| Assets | |||
| Cash and cash equivalents | $ 83 | $ 72 | |
| Accounts receivable | 1,312 | 1,204 | |
| Inventory | 1,270 | 1,514 | |
| Other current assets and accrualS | 85 | 67 | |
| Total current assets | 2,750 | 2,857 | |
| Property, plant, and equipment | 2,230 | 2,264 | |
| Other long-term assets | 213 | 233 | |
| Total assets | $5,193 | $5,354 | |
| Liabilities | |||
| Accounts payable | $1,022 | $1,129 | |
| Credit line | 100 | 150 | |
| Current portion of long-term debt | 52 | 51 | |
| Total current liabilities | 1,174 | 1,330 | |
| Long-term debt | 1,037 | 1,158 | |
| Other long-term liabilities | 525 | 491 | |
| Total liabilities | $2,736 | $2,979 | |
| Shareholders’ equity | |||
| Common stock, $1 par value | |||
| (100,000 authorized, | |||
| 74,000 outstanding in | |||
| 2007 and 2006) | $ 74 | $ 74 | |
| Additional paid-in capital | 1,110 | 1,110 | |
| Retained earnings | 1,273 | 1,191 | |
| Total shareholders’ equity | $2,457 | $2,375 | |
| Total liabilities and shareholders’ equity | $5,193 | $5,354 | |
| 2007 footnotes: | |||
| Depreciation | $239 | ||
| Number of common shares (thousands) | 74 | ||
| Earnings per share | $3.35 | ||
| Dividend per share | $2.24 | ||
The same logic applies as in the simple example we gave earlier:
- Look at every change from one balance sheet to the next.
- Determine whether the change resulted in an increase or a decrease in cash.
- Then add or subtract the amount to or from net income.
Here are the steps:
| Observation | Action |
|---|---|
| Start with net profit, $248 | |
| Depreciation was $239 | Add that noncash expense to net profit |
| Accounts receivable increased by $108 | Subtract that increase from net profit |
| Inventory declined by $244 | Add that decrease to net profit |
| Other current assets rose by $18 | Subtract that increase from net profit |
| PPE rose by $205 (after adjusting for depreciation of $239—see note 1) | Subtract that increase from net profit |
| Other long-term assets decreased by $20 | Add that decrease to net profit |
| Accounts payable decreased by $107 | Subtract that decrease from net profit |
| Credit line decreased by $50 | Subtract that decrease from net profit |
| Current portion of long-term debt rose by $1 | Add that increase to net profit |
| Long-term debt decreased by $121 | Subtract that decrease from net profit |
| Other long-term liabilities increased by $34 | Add that increase to net profit |
| Dividends paid—$166 (see note 2) | Subtract that payment from net profit |
Note 1: Why do we need to adjust for depreciation when looking at the change in PPE? Remember that every year PPE on the balance sheet is lowered by the amount of depreciation charged to the assets in the account. So if you had a fleet of trucks that were acquired for $100,000, the balance sheet immediately after the acquisition would include $100,000 for trucks on the PPE line. If depreciation on the trucks was $10,000 for the year, then at the end of twelve months, the line in PPE for trucks would be $90,000. But depreciation is a noncash expense, and since we’re trying to arrive at a cash number, we have to “factor out” depreciation by adding it back in.
Note 2: Notice the dividends footnoted on the balance sheet? Multiply the dividend by the number of shares outstanding, and you get roughly $166,000 (which we’re representing as just $166). Net income of $248 minus the dividend of $166 equals $82—the precise amount by which shareholders’ equity increased. This is the amount of profit that stayed in the company as retained earnings. If there is no dividend paid out or no new stock sold, then the cash provided or used by equity financing would be zero. Equity would simply increase or decrease by the amount of profit or loss in the period.
Now we can construct a cash flow statement based on all these steps (see following page). Of course, with a full balance sheet like this one, you have to put the change in cash in the right categories as well. The words in the right-hand column show where each number comes from. The “cash at end,” of course, equals the cash balance on the ending balance sheet.
This is a complicated exercise! But you can see that there’s a good deal of beauty and subtlety in all the connections (maybe only if you are an accountant). Go beneath the surface a little—or, to mix metaphors, read between the lines—and you can see how all the numbers relate to one another. Your financial intelligence is on the way up, as is your appreciation of the art of finance.
Cash Flow Statement (in thousands)
Year ended Dec. 31, 2007
| Cash from operating activities | |||
| Net profit | $248 | net profit on income statement | |
| Depreciation | 239 | depreciation from income statement | |
| Accounts receivable | (108) | change in A/R from 2006 to 2007 | |
| Inventory | 244 | change in inventory | |
| Other current assets | (18) | change in other current assets | |
| Accounts payable | (107) | change in A/P | |
| Cash from operations | $498 | ||
| Cash from investing activities | |||
| Property, plant, and equi pment | ($205) | PPE change adjusted for depreciation | |
| Other long-term assets | 20 | change from balance sheet | |
| Cash from investing | ($185) | ||
| Cash from financing activities | |||
| Credit line | ($50) | change in short-term credit | |
| Current portion of long-term debt | 1 | change in current long-term debt | |
| Long-term debt | (121) | change from balance sheet | |
| Other long-term liabilities | 34 | change from balance sheet | |
| Dividends paid | (166) | dividends paid to shareholders | |
| Cash from financing | ($302) | ||
| Change in cash | 11 | add the three sections together | |
| Cash at beginning | 72 | from 2006 balance sheet | |
| Cash at end | $ 83 | change in cash + beginning cash | |