Inc.com | How Do You Define Cash Flow?

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In my last column, I gave you an important question to answer.

If you increased your sales by 25% to 50% over the next six months, what would happen to your cash balance?

My experience is nine out of 10 business owners can't answer this question. That's why so many businesses succeed in growing their business only to end up with an uncomfortable and embarrassing cash flow crisis on their hands.

How Do You Define "Cash Flow"?

Knowing what makes up your cash flow is the first step to avoiding a cash crisis. Most business owners believe their cash flow is defined as the revenues they generate less the expenses they have to pay.

Not true.

The answer lies in the fact that the accounting rules that govern the creation of financial statements are not about tracking the actual flow of cash through your business. They are focused on measuring profit or loss -- not cash flow.

The "bottom line" of the P&L is net income. And net income does not tell you what happened to your cash balance during the period. It merely defines net income based on the accounting rules used to create the income statement.

It's an important measurement, but it is only one component of understanding and managing your cash flow.

Certain cash flow items never show up in an income statement while other cash flow items will show up there but in different periods and in different amounts. So what you will find is that your income statement will not show you what happened to your cash flow. Why? Because your cash flow is made up of more than just profit and loss. It also is affected by:

  • Accounts receivable
  • Inventory
  • Accounts payable
  • Capital expenditures
  • Borrowings and debt service
  • Other "timing" differences

That's why you can't look at your income statement and see what happened to your cash during the month. Profit and loss is only one component of your cash flow. You have to have a clear picture of how each of the other areas affected your cash flow each month in order to understand, and take control of, your cash flow.

Here's an example to illustrate the point.

I Made Money, But What Happened to the Cash?

I worked with a client recently who could not understand why his income statement said he made money last year but he didn't have enough cash to pay all his bills.

In this case, the difference between his net income and his cash flow was primarily a result of the purchase of a truck for cash, sales made during the period that were not collected (accounts receivable), estimated tax payments made in an amount different than tax expense for the period, increased inventory levels in preparation for the coming selling season, distributions to the owner, and principal payments on a bank loan.

The rules of accounting determine when transactions are recorded in your financials and how they are recorded. The reality of business determines when you receive, or let go of, your cash.

It's All About the Cash

On top of having a P&L that governs your accounting life, it's important to keep a schedule that governs your monthly cash flow. Imagine having a schedule in front of you every month that showed you exactly what was going on with your cash flow. A schedule that made it simple and easy to know exactly what was going on with the lifeblood of your business -- your CASH.

That's the secret to taking control of your cash flow.

You need an easy-to-understand view of each component of your business that affects your cash flow. Your cash flow schedule needs to show you what's going on with each of the components of cash flow mentioned above.

If you're ready to take control of your cash flow, check out my December column, which provides you a template and step-by-step instructions for formatting easy-to-understand cash flow projections.

Focus on understanding and managing your cash flow each month and you will make it dramatically easier to grow your business without creating a cash flow crisis in the process.

Last updated: Jun 1, 2005




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