What Do Most Business Leaders Do?
Many business owners use their bank as their primary way of identifying whether they have good or bad cashflow. And this obviously has its uses, otherwise countless business owners wouldn’t refer to it to make decisions. But what generally happens is the business leader looks at their bank balance, then in their head they add any expected sales and/or subtract any known payments due to suppliers or for tax. This then leaves them with a rough balance in their head as to whether they have the cash in the bank to survive. This is sometimes taken further with a business leader understanding the cash trends in their business intuitively and doing a sort of mini-forecast in their head.
But clearly, unless the business is extremely simple with very few transactions, this approach has its limits. This is where the Cash Flow Statement comes in; a report that looks backwards to see the movement of cash and identifies the true ‘available’ cash at the end of a period (usually a month).
Report Summary
To quickly understand The Cash Flow Statement, you can look at the bottom to see the total movement of cash in or out of the business in a given period. It will be labelled something like Net Change In Cash For Period or Net Cash Increase For Period, but this term may differ slightly depending on the method or software used to create the report. Sometimes this report will also show the cash at the beginning of the period and the cash at the end of the period separately so you can see a snapshot for the period.
In the next few sections we’ll break the Cash Flow Statement down in detail.
Three Components
There are three main sections to the Cash Flow Statement; Operating Activities, Financing Activities and Investing Activities. The report will show any relevant movements of money and/or anything owed to or by the business. These three sections are then split out into sub-categories. These subcategories can vary depending on what you’d like to see and different accounting tools will display it in different ways.
Operating Activities
Operating Activities are the day to day transactions that relate to the businesses main operations such as receiving income from customers or making payments to suppliers. Here’s some of the items included in this section:
● Receipts From Customers - Sometimes grouped with ‘payments to suppliers’ as ‘net income’. Receipts from customers show the payments that a business has received from their customers. This will normally be a positive figure unless you have had to make significant refunds.
● Payments to Suppliers / Employees - Sometimes grouped with ‘receipts from customers’ as ‘net income’. Payments to suppliers will show the payments that you’ve made to suppliers, in addition to any employees (e.g. salaries, wages and benefits). This will be a negative figure unless you have received significant refunds.
● Interest Payments: Cash paid for interest on loans and other forms of debt.
● Tax Payments: Cash paid for income taxes (sometimes referred to as income tax payments in software, although this is for business taxes and not personal)
● Other Operating Receipts: Cash received from other operating activities that do not directly involve customers or suppliers. For example, compensation from a legal settlement.
● Other Operating Payments: Cash paid for other operating activities that are not classified under the categories above. For example, redundancy payments as part of a business restructure.
● Changes in Working Capital: Changes in current assets and liabilities, such as accounts receivable (debtors), accounts payable(creditors), and inventory. An increase in accounts receivable, for example, represents cash that has been earned (invoiced) but not yet received.
● Gain/Loss on Sale of Assets: Cash received or paid related to the sale of assets, excluding inventory, which falls under operating activities. If the company sells a piece of equipment, for instance, the cash received would be included.
Financing Activities
Financing Activities shows any changes that have occurred to either loans or equity (ownership of the company). For example, if you’ve made a loan payment you will see a negative figure which shows that the cash has left your bank to pay for the loan repayment. However, if you take a new loan out, you would see a positive figure here as you have received cash into the business.
Within the equity area it will show any reduction in retained earnings if dividends have been paid, but it may also show a Share Premium account. A Share Premium account is used when the amount the company receives for its shares is greater than the shares face value. So if someone bought 100 shares worth £25 each, but paid £35, they have overpaid the face value by £10 each. You would see 100*£10 which is £1000 represented in the Share Premium account.
Investing Activities
Investing Activities are not always seen on the Cash Flow Statement because it is only relevant if a business makes investments; this relates to both financial investments, such as buying shares and also physical investments, such as cash spent on buying or improving a building.
Here’s a list of some of the items included here:
● Purchase of Property, Plant, and Equipment (PP&E): Cash spent on acquiring or improving physical assets like buildings, machinery, or equipment.
● Sale of Property, Plant, and Equipment: Cash received from the sale of these physical assets.
● Purchase and Sale of Investments: Cash spent on acquiring investments such as shares (stocks), bonds, or other securities, as well as cash received from selling these investments.
● Loans Made to Others: Cash loaned to other entities that are not considered part of the company's normal operations.
● Cash Received from Loans Repaid: Cash received from loans made to other entities.
● Acquisitions and Mergers: Cash used for acquiring other businesses or merging with existing businesses.
● Cash Received from Divestitures: Cash received from selling a portion of the business or a subsidiary.
● Intangible Asset Purchases: Cash spent on acquiring intangible assets such as patents, copyrights, trademarks or license agreements(e.g. franchise license)
● Cash Received from Intangible Asset Sales: Cash received from selling intangible assets.
● Other Investments: Cash transactions related to the realisation of other long-term investments not covered by the above categories. Realisation is the point at which an investment is officially recognised for accounting purposes.
So How Do I Use This Report?
Initially, when looking at the Cash Flow Statement it’s likely you’ll see the report over a one month period, or one quarter period. This can be useful to identify if the business has increased or decreased its cash position over that time. But it can often be more valuable to compare this period with others, such as all periods during the last 12 months, or this year versus last year. These comparisons allow you to spot trends and seasonality, for example, in an ecommerce business that makes the bulk of its sales in the lead up to Christmas and then has a very quiet January it may be that the cash position reduces during January. This might cause concern, but comparing this period with the same period the previous year can give you a good indication of whether the business is in abetter or worse financial position when compared to the year before.
So if you’re prone to looking at your bank account before making business decisions, it might make sense to look at a Cash Flow Statement so you can identify your true Cash Flow position. Similarly, comparing your Cash Flow with a previous period can help you identify anomalies, unusual transactions and potential risks.
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