Cash flow is an important indicator of financial health for any business. For example, while an accrual-based business may display net income, they may be experiencing negative cash flows over the same period due to collection issues.
Through careful analysis of cash inflows and outflows, business owners can obtain a more accurate understanding of a business’ activities.
In addition, cash flow models and projections can serve as a useful indicator of future business performance.
Statement of Cash Flows
Many business owners are likely familiar with two of the most common financial statements, the balance sheet, and the income statement—sometimes called a profit and loss statement. However, there is a third statement that can provide valuable insights to business owners: the statement of cash flows.
This financial statement details the cash inflows and outflows during a reporting period and is especially useful when used in conjunction with the income statement, particularly when the amount of profit or loss reported does not reflect the cash flows experienced by the business.
The statement of cash flows is broken down into three components that account for the total change in a business’ cash over a period of time. Each one of these categories can help tell a different story about your historical cash flow.
Cash Flow from Operating Activities
Operating cash flows are derived from normal business operations, such as selling inventory, providing services, or collecting rents, minus the expenses of carrying on those activities. Analyzing a business’s operational cash flows can provide useful insights into the success of core business activities.
For example, consistent periods of negative operating cash flows can be highly concerning, as it can indicate that the business operations are not supplying enough working capital to sustain the business.
Cash Flow from Investing Activities
Cash flow from investing activities includes proceeds from investments, such as cash received for the sale of fixed assets or sales of securities. A negative cash flow, or a cash outflow, from investing activities typically represents the business turning cash into long-term assets.
This may include purchasing capital equipment and buildings or investments into securities. Long periods of time without investment outflows may indicate that a company is overdue for capital expenditures.
Cash Flow from Financing Activities
Cash flow from financing activities includes 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 the category. Long periods of positive cash flow in financing activities may indicate that the business is relying too heavily on debt or owner contributions.
Cash Flow Models/Projections
While preparing and analyzing a statement of cash flows can provide valuable insight into the history of your cash movement, cash flow models and projections are a useful tool for estimating future cash positions. These models are generally built off a rolling cash flow projection of between three to twelve months.
Methodologies exist to project cash flows beyond this period; however, assumptions can cause larger degrees of error the farther out they are projected.
One of the most important steps in creating a cash flow forecast is to develop assumptions around operating cash flows as well as outside financing cash flows, such as loan proceeds and paybacks, and the need for future capital expenditures to support your operations. Ensuring development of assumptions around both future revenue and expenditures is critical to accurately determining future cash positions.
Through careful analysis of cash inflows and outflows, business owners can obtain a more accurate understanding of a business’ activities.
While it can be tempting to paint an optimistic picture for revenues, it is best to realistically consider when customers are likely to pay their invoices.
It also is important to ensure your 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 did not account for in your model, you should change it to fit new assumptions. It also is 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.
Understanding how cash flows impact a business is vitally important to businesses’ long-term success. Through utilizing the tools available to monitor and analyze historic and ongoing cash flows, as well as developing cash flow forecasts, businesses will be better equipped to manage their financial health.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
As a member of our Small Business Advisory practice and the cannabis industry practice, Jay Jerose, principal at The Bonadio Group provides tax, attestation, business valuation and consulting services to businesses and individuals across a variety of industries, including cannabis. Jay has specific focuses in passthrough taxation, sales and use taxes, federal excise taxes, fuel excise taxes, start-up consulting, projections/forecasting, as well as reviews and compilations of financial statements.
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