Where’s My Cash – Part Two

Cash Flow Statement
This week’s post will explore the Cash Flow Statement. The statement begins with the Net Income reported on the Income Statement for the same period. To the Net Income or Loss, non-cash expenses such as depreciation are added back. The purpose of starting with Net Income or Loss and adding back non-cash expenses is designed to measure the contribution or use of cash from normal day to day activities as reflected by the Income Statement.

There rest of the report is broken down into three sections. These sections are 1) Operating Activities, 2) Investment Activities and 3) Financing Activities. We will explore each section in detail.

Operating Activities deserve special attention. The three major components are Accounts Receivable, Inventory, and Accounts Payable. There can be many others depending on the nature of the business. A common term for these items is Working Capital. The higher the investment in working capital the less profitable the business will be. Why is that?

The return on investments in working capital is always negative. Accounts Receivable is not 100% collectible except in extremely rare circumstances. As a result the return will be negative by the percentage of receivables that become uncollectible. If you collect $0.97 for every dollar of sales your return is (3%)! That does not even factor in the cost of the money used to finance your receivables.

Inventory has many associated costs. The costs include shrinkage, obsolescence, and insurance. It may even include a warehouse with its associated costs. Obviously inventory has a negative return. This needs to be balanced with the costs of running out of inventory which will be discussed in the next post.

Accounts Payable is a liability representing financing provided by your vendors. Timely and consistent payments are a critical component of strengthening the vendor relationship. By being consistent, you may be able to pay some vendors beyond the terms. Just don’t push this too far! Keep in mind that you may need some future assistance from that vendor. Would you provide that assistance or invest in the relationship if the customer payments were erratic and late?

The next section is Investment Activities. This does not mean stocks, bonds, loans, or any other type of financial investment. This section deals with investment in assets for the company. The value of the asset purchased is recorded here regardless of how it was paid for. This section is important because many profitable companies suffered severe setbacks or even failure because of the amount of cash and credit that was used to purchase assets. Conversely, under investment can cause problems like slow growth or higher repair costs and downtime which reduce profits.

The final section is Financing Activities. Repayments of debt of any sort – loans, credit cards, etc. are a use of cash. Increased credit card, loan, or other liability balances is a source of cash. For a public company direct sales or repurchases of stocks or bonds works the same way.

Finally, to prove the statement is accurate, all the sections described above (Net Income/Loss, non-cash add backs, Operating Activities, Investment Activities, and Financing Activities) are summed up. This sum is added to the beginning cash balance and the result must equal the ending cash balance as stated on the Balance Sheet for the same period.

As you can see this statement provides critical information and should be reviewed very carefully to discover areas of the company’s financials and operations which require you to delve into the details. Keep in mind that all financial statements represent both what has already happened, and provide the information to understand where you need to dig deeper.