cash flow

A balance sheet is a static picture of a business at a point in time. It describes what the business owns and who owns it. A business has assets such as cash, accounts receivable, inventories and equipment (fixed assets). At the same time a business owes money to vendors, banks, taxing authorities etc. Whatever's left over is the owner's stake in the business, called equity. An income statement depicts the revenue and expense activity for the business over a given period of time: monthly, quarterly, annually. It reflects how profitable the company is. These are the two classic financial statements. Neither one gives you a complete snapshot as to where the money came from or where it went. Cash flow statements are a bridge between the balance sheet and the income statement. They explain those changes in cash positions which are so important to the entrepreneur, but which are not emphasized using typical accounting techniques.

If this information is so important, why isn't it readily available? I really can't tell you. A cash flow statement is the third leg of the financial stool, and most of us are trying to sit on a stool having only two legs! Probably they are not presented as a matter of course because so few people, accountants included, understand them. They aren't that hard. They measure changes in your cash position by taking portions of the other two statements and restating them. Let's say that Crafts 'R' Us is grossing $100,000 a year and generating a profit of $25,000 to the owner. Now let's take a look at a couple of balance sheets: the one for last year and the one for the end of this year.

         
Last Year>
 This Year>
 Change>
         
   Cash in bank
  $5,000>
  $7,500>
 $2,500>
   Accounts receivable
 5,000>
 7,500>
 2,500>
   Inventories
 5,000>
 7,500>
 2,500>
   Current assets
 15,000>
 22,500>
 7,500>
   Fixed assets at cost
 25,000>
 30,000>
 5,000>
   Accum. depreciation
 <10,000>
 <15,000>
 <5,000>
   Net fixed assets
 15,000>
 15,000>
 0>
   
 =========
 =========
 =========
   Total Assets
 $30,000>
 $37,500>
 $7,500>
         
   Current liabilities
 $2,500>
 $2,500>
 $0>
   Bank loan
 5,000>
 3,500>
 <1,500>
   Owner's draw
 <20,000>
 <36,000>
 <16,000>
   Retained earnings
 42,500>
 67,500>
 25,000>
   Equity
 22,500>
 31,500>
 9,000>
   
 =========
 =========
 =========
   Total Liabilities & Equity
 $30,000>
 $37,500>
 $7,500>
 

Using just these comparative balance sheets, we can draw a picture as to how much cash the business generated, and where it went that year:

       
  Sources of cash:
    Income from operations
 $25,000
    Depreciation expense
 5,000
     
--------------
    Total sources of cash
 $30,000
       =========
    Uses of cash:
    Fixed asset purchases
$5,000
    Repay bank loan
1,500
    Increase in working capital
7,500
    Owner's draw
16,000
     
 --------------
    Total uses of cash
 $30,000
       =========


Depreciation is a non-cash charge on your books. You don't pay anybody depreciation, it's just an accounting entry to reflect the usage of your equipment, i.e., it records a reduction in the value of your fixed assets due to being used in your productive process. Working capital is the money that you have to keep in your business at any given time to operate. See the related discussion on Working Capital.

Are you surprised that cash flow and income are separate beasties? Don't be. The point to be made here is that they are separate concepts. By understanding this third leg of the financial stool, you may save yourself a bit of grief in future when you go to spend those profits.

 

   
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