Profits On Purpose | Teaching Financials To Drive Performance: Part 3 The Cash Flow Statement
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Teaching Financials To Drive Performance: Part 3 The Cash Flow Statement

Our two most recent posts, we’ve discussed that there are 4 critical items to understand your financials. 3 come from the balance sheet (asset quality, liquidity and leverage) and the 4th comes from the income statement (profitability).

Today, we’re going to differentiate from bottom line profit and cash flow. I was talking to a potential client today who had $3.2 million in bottom line profit last year, but his cash account only increased $850,000.   So, why didn’t his cash account increase by the total amount of his profit? Today, we’re going to talk about that.

The cash flow statement could be the most confusing piece of your financial statements and possibly the least used by management. Here are the important elements of the cash flow statement. I’ll use this business owner in my example.

Yes, this business owner made $3.2 million in profit, but was the cash flow for the year from the $3.2 million in profit you earned. Cash flow and profit are different.

This company generates cash from sales, but then they have to pay labor and materials for the product they make. They have to pay operating expenses and interest expense on money they borrow. Because they have inventory and fixed assets, they have some short term and long-term debt. They also pay out distributions to shareholders for taxes and other withdrawals. So, even though they made $3.2 million in profit, their cash flow only increased by $1 million.

The controller or CFO of your company will prepare a cash flow statement that tracks the sources (where cash came from) and uses (where cash went) on the cash flow statement. It is broken up in to three sections:

Operating activities: revenue, cost of goods sold and operating expenses with changes in receivables, and accounts payable

Investing activities: changes in fixed assets, interest expenses, and dividends or owners withdrawals

Financing activities: changes in short term or long term debt, paid in capital or common stock

The best way to avoid confusion between cash flow and profit is to think like business owners instead of accountants.

A business owner thinks in cash flow terms not profit terms. They look at revenue when it’s collected and they look at expenses when they have to write the checks. If they run out of money, they borrow from a bank or put the money in themselves.

So, back to our client example: This business collected $50 million from sales (source of cash) but they had to pay for labor and materials for the inventory they sold and operating expenses of $46 million (use of cash). So cash flow from operating activities was $4 million. (50-46=4)

They bought $1 million of fixed assets and used cash to pay down debt and made owners distributions of $1 million each (investing and financing activities). So, cash increased $1 million due to the total of all those activities. (4-1-1-1=1)

The goal of the cash flow statement is to summarize where the business got its cash and what it did with the money. In our example, the cash came from sales and the cash was used to pay cost of goods sold (materials and labor), buy fixed assets and pay down debt.

To get a complete financial picture of the business, a business owner should read all of the financial statements. The balance sheet tells you about your overall financial condition, the profit and loss statement tells you whether you made a profit or not and the cash flow statement shows whether cash flow was positive or negative. A business owner should look at all these reports to get an accurate picture of how the business is doing.

Bill McDermott
bmcdermott@mcdfs.com
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