Cash Flow Statement Can Diagnose the Well-Being of Your Firm

What is cash flow, and why is it of special importance to the small or mid-sized business? How do you manage cash flow, and what good comes of doing so?

As outlined in this space last week, cash flow is the lifeblood of your business--and the healthier the lifeblood, the healthier the business.

But cash flow is not profit, although many business owners confuse the two. It is akin to profit, and it can help you prosper if you understand it. It will surely put you in the poorhouse if you don’t.

Cash flow is what you have left after you pay your cash expenses at the end of a given period--usually one month. A cash flow statement shows you what you started with, what you paid out, and what you ended up with. As an accountant would say, it illustrates the change in your cash position from last month to this.

Profit, on the other hand, is the surplus of revenue over expenses, including taxes and such noncash items as depreciation, at a given point in time--at the end of the month, the quarter, six months, the year.

If that sounds like a distinction without a difference, it isn’t. Your profit and loss statement is a photograph of the condition of your business at a given point in time. Your cash flow statement is a movie showing the health of your business over time.

In an important way, cash flow comes before profit. Indeed, cash flow keeps you alive long enough to enjoy your profit. Without it, you can be profitable on paper and broke in fact--because your P&L; statement doesn’t diagnose the well-being of your company. Only a cash flow statement can do that.

“If I make a sale today and I also draw up my P&L; statement today,” says Alan Lewis, assistant dean of the A. Gary Anderson Graduate School of Management at UC Riverside, “the sale shows up on the P&L; statement even though I may not collect cash for another 30 days.

“In other words, the P&L; statement doesn’t show whether my customer gave me cash for the sale or bought my goods on terms. And if I still owe my suppliers for what I sold today, that won’t show up, either.”

A cash flow statement, on the other hand, would show when the merchant in Lewis’ example might expect money from the customer and when it must go out to suppliers.

Put another way, it would show the movement of cash in and out of the business over time--and that is the practical value of the cash flow statement, Lewis says. Just as a statement for the last month measures the health of your business over that time, so the projection for the next tells you whether you will survive it--by showing whether you can pay your bills on time.

Similarly, it tells you what to do if things get iffy.

Lewis gives the example of the merchant who sells a television for $500. Assuming a wholesale cost of $300, the merchant’s P&L; statement shows a profit of $200.

But if the merchant sells the TV on 30-day terms, he or she sees no cash from the sale for that period of time--and can’t satisfy the wholesaler’s invoice for $300 in the meantime. The merchant has a negative cash flow for the period, Lewis says, and if it gets bad enough, it could force the merchant into bankruptcy.

The solution? The merchant has several options:

* Negotiate a line of credit from a bank;

* Negotiate longer terms from the wholesaler, so that money needn’t go out before it comes in;

* Discount the price of the TV in exchange for full, immediate payment; or

* Offer the customer longer terms in exchange for a higher price.

Each option carries a price tag, Lewis adds:

* Banks want interest on their loans.

* The wholesaler might want a higher price for the TV.

* Any discount to the customer would hit the merchant’s revenue.

* Any increase in the price of the TV might drive the customer to a competitor.

The task for the merchant is to weigh the costs of each option--or even some combination of all four options. Whatever the strategy, the key is the merchant’s cash flow, Lewis says.

“Cash flow is what you have in the bank when you open in the morning, plus whatever comes in during the day, less whatever goes out,” he says. “If you do a cash flow statement today and again tomorrow, the difference between today’s statement and tomorrow’s is your flow of cash for the two days.

“If the statements show cash piling up over time, you’re probably going to be profitable. If not, you’re in trouble--and you need to learn how to manage your cash flow better.”

Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.