How to use financial statements to improve cash flow

In business, as in most endeavors, passion is a key ingredient to success. Entrepreneurs who genuinely enjoy sales, operations, and customer service are much more likely to build profitable firms than individuals who are simply “going through the motions” of business in the name of making money. But even the most enthusiastic managers will enjoy much greater success if their passion is governed by sound financial discipline, which stems from an understanding of their financial statements. 

 

There is plenty of debate about the relative value of the three main financial statements: income statement, balance sheet and cash flow statement. Certainly all are important, but for small companies, the cash flow statement may be the most critical. The cash flow statement is a marriage of the two other financial statements: It combines operating activities (shown in the income statement) with changes in balance sheet accounts to show how the company’s cold cash is “flowing.”

 

The section of the cash flow statement labeled “cash flow from operations” is definitely the most important because it represents how much cash a company is generating from its core operations. The cash flow statement accounts for profits and losses, as well as any “working capital” changes–fluctuations in current assets and current liabilities, such as accounts receivable and accounts payable; two important metrics to help determine if your business is healthy.

 

Let’s look at an example. Say your business has revenues of $1,000 for a given month, but all the merchandise was sold on credit (meaning that you didn’t actually receive the cash in that period). Now say total cash outlays were $750 for the period. In this case, your income statement would report a “profit” of $250 ($1,000 in total revenues less $750 in expenses). Fair enough.

 

Meanwhile, however, “cash flow from operations” dropped by $750. That’s because the business had to pay $750 in cash expenses but did not collect any offsetting cash from customers. (An increase of $1,000 to accounts receivable balances the books.)

 

Now consider the flip side. Say your company pulls in $2,000 in cash revenues but shelled out $4,000 in expenses–only $1,000 of which was paid in cash during the period, with the rest being “financed” via accounts payable. In this case, the income statement shows a loss of $2,000–that’s $2,000 in sales less $4,000 in expenses–yet the company generated $1,000 in positive cash flow from operations.

 

How? Remember, you received $2,000 in cash but paid out only $1,000 in expenses, leaving $1,000 in cash left over. This drama plays out in the cash flow statement, which would show $2,000 in losses offset by a $3,000 increase in accounts payable.

 

The lesson here is clear: Managers should manage their working capital accounts to maximize cash flow.