Key components of the financial and operational planning process for small businesses - Part 5 The Cash Flow Statement

Nov 20, 2019
Key components of the financial and operational planning process for small businesses - Part 5 The Cash Flow Statement

This article is part of a series of articles that will explain the key components of the financial and operational planning process for small businesses. This is the fifth article in the series and will explain the next element of the financial plan: the cash flow statement.

Click here to read Part 1 Basics of Budgeting

Click here to read Part 2 Sales Forecast

Click here to read Part 3 Proft and Loss Statement

Click here to read Part 4 The Balance Sheet

Cash flow statement

A cash flow statement (or “statement of cash flows”) presents the change in cash for a period of time in terms of your business’ operating, investing and financing activities. Basically, it shows how much cash your business brought in, how much cash it paid out, and what its ending cash balance was, typically per-month.

That might sound like sales, expenses, and profits, but it’s not.

When you think about cash flow, you need to consider that certain activities don’t have an immediate impact on cash, such as: What happens when you send out an invoice to a client, but they don’t pay it by the due date? What happens when you pay your own bills late, or early? These kinds of things aren’t reflected in your profit and loss statement, but they are explained in your cash flow statement.

Your cash flow statement is just as important as your profit and loss statement. Businesses run on cash—and you need to understand your cashflow.

Without a thorough understanding of how much cash you have, where your cash is coming from, where it’s going, and on what schedule, you will have a hard time running a healthy business. And without the cash flow statement, which lays that information out neatly for lenders and investors, you’re not going to be able to raise funds. No financial plan is complete without a cash flow plan.

The cash flow statement classifies the various cash inflows and out flows into three categories—operating, investing, and financing—and relates these categories to the beginning and ending cash balances.

  • Cash flows from operating activities are the cash effects of revenue and expense transactions that are included in the income statement.
  • Cash flows from investing activities are the cash effects of purchasing and selling assets.
  • Cash flows from financing activities are the cash effects of the owners investing in the business and the creditors loaning money to the business and the repayment of either or both.

The cash flow statement helps you understand the difference between what your profit and loss statement reports as income—your profit—and what your actual cash position is.

It is possible to be extremely profitable and still not have enough cash to pay your expenses and keep your business running, and it is also possible to be unprofitable but still have enough cash on hand to keep the doors open for several months and buy yourself time to turn things around—that’s why this financial statement is so important to understand.

How accrual versus cash accounting affects the cash flow statement

There are two methods of accounting—the accrual method and the cash method.

The policy of recognizing revenue in the accounting records when it is earned and recognizing expenses when the related goods and services are used is called the accrual basis of accounting. The purpose of accrual accounting is to measure the profitability of the economic activities conducted during the accounting period. For example, if you received a big preorder for a new product, you’d wait to record the preorder sales revenue until you actually started manufacturing and delivering the product.

The most important concept involved in accrual accounting is the matching principle. Revenue is offset with all of the expenses incurred in generating that revenue, thus providing a measure of the overall profitability of the economic activity. Under the accrual basis of accounting, cash receipts or disbursements may occur prior to or after revenue is earned or an expense is incurred.

An alternative to accrual basis is called cash basis accounting. Under cash basis accounting, revenue is recognized when cash is collected from the customer, rather than when the company sells goods or services. Expenses are recognized when payment is made, rather than when the related goods or services are used in business operations. The cash basis of accounting measures the amounts of cash received and paid out during the period, but it does not provide a good measure of the profitability of activities undertaken during the period.

When you use the cash method of accounting in your business, your cash flow statement isn’t going to be very different from what you see in your profit and loss statement. That might seem like it makes things simpler, but I actually advise against it. The accrual method of accounting gives you the best sense of how your business operates, and you should consider switching to it if you aren’t using it already.

Here’s why: Let’s say you operate a facility that hosts events, like weddings. You might receive payment from a customer in January, several months before the event actually starts in June—using the accrual method, you wouldn’t recognize the revenue until you’ve provided the service, so both the revenue and the expenses for the event would be accounted for in the month of June.

With the cash method, you would have recognized the revenue in January, but all of the related expenses in June, which would have made it look like you were profitable in all of the months leading up to the event, but unprofitable during the month that event actually took place.

Cash accounting can be difficult to use when it comes time to evaluate how profitable an event or product was and can make it harder to really understand the details of your business operations. For the best insights to how your business works, and a more accurate measure the profitability of the economic activities conducted during the period, accrual accounting is the way to go.

If you’d like help creating your comprehensive financial plan and understanding the related financial statements … we can help. We specialize in helping businesses create comprehensive financial plans, monitor their financial activity and understand their financial statements. So, if you don’t have the expertise or resources, click here to contact us!

For more on small business financial plans, check out Part 6 for an explanation of the relationships among financial statements.


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