Cash Flow: What It Is and What It Isn't

If a commemorative coin were commissioned to recognize the contribution of the small business economy, it would surely be embossed with the words: In Cash We Trust.

If you've ever scrambled to make payroll, you know that cash flow is to your livelihood what blood flow is to your life. When it stops, the situation quickly turns critical. Unfortunately, the concept of cash flow is largely misunderstood. So, before you inadvertently bleed to death, let's get to the heart of cash.

Consider, Stick It To Em, Inc., a manufacturer of industrial adhesives. Over the past several months they've hired people, purchased equipment and raw materials, run the machinery to produce their gluey concoction, and paid a sales team to sell it.

The good news is the market loves the product. They're growing like crazy, doubling their volume every month. Production costs are low and profit margins are high. They're working overtime and adding staff to meet the demand. The sales team is continuing its magic.

An entrepreneur's dream, right? Actually, more like a nightmare. Turns out, in spite of expanding revenues and strong profits, Stick It To Em is going, make that growing, broke!

Here's why.

Even if their crackerjack bookkeeper fires the bills out as soon as products are shipped, they best they can hope for is payment in thirty days. More likely, some checks will be "lost in the mail," and won't find their way to a deposit slip for 60 or 90 days. Meanwhile, in anticipation of the next few months' sales, they double their raw material purchases. Here's where the tourniquet starts to tighten. They'll suddenly have more cash going out than they'll have coming in, and that's before all that extra payroll, rent, etc.

On one level, cash flow is a very simple concept. Your business has to generate more cash than it uses. It almost sounds too obvious, yet many business owners don't understand that you can't spend profit.

You'd think, given how important it is, that you could turn to your financial statements for a read on how your cash is flowing. Unfortunately, that's not the case. Take a look at our sticky subject's Income Statement.

Stick It To Em Income Statement



Cost of Goods


Operating Expense






Net Income


Looks great, right? But as we now know, the company didn't collect that $1.8 million in sales. They're still waiting for some customers to pay. And those "cost of goods" numbers only include inventory that was used during the period, not what the company had to shell out for raw materials to support future sales. The interest expense is only half the cash picture. You darn well better have paid the principal portion of the loan payment too, but that doesn't show up here; it's reflected as a reduction in debt on the balance sheet. One bit of good news: depreciation isn't cash. It's just an accounting convention for spreading the cost of an asset over its useful life. Don't forget though, a bunch of cash was spent on that equipment — it just doesn't show up here.

A Balance Sheet is even less helpful than an Income Statement when it comes to understanding cash. True, there's an entry on the Balance Sheet called "Cash," but it's simply a snapshot of what you had on hand at a point in time. That was then, this is now.

Then there's Working Capital — Current Assets minus Current Liabilities. Basically, Working Capital is the difference between what's likely to become cash in the near term and what's going to require cash over the same period. A handy way to gauge your Working Capital is by tracking your Current Ratio (Current Assets / Current Liabilities). The right level varies by industry (our previous article on Financial Benchmarking: How to Find Competitive Information will help you find yours), but 2 to 1 is considered a minimum for a healthy business.

Keep in mind that while Working Capital is a leading indicator of future cash flow, it's not a sure thing. It assumes your receivables are collectable, your inventory can and will be converted into salable items, and customers will continue to line up to buy them.

All right, if cash flow is so bloody important and it's obscure on your Income Statement, it's but a memory on your Balance Sheet, and it's a dubious promise in terms of working capital, how the heck do you track it?

Enter the Cash Flow Report. Here's a simplified version:

Cash Flow From Operations:

+ Cash from Sales
+ Cash from A/R
- Cash paid for Inventory
- Cash paid for Operating Expenses
- Other uses of Cash

= Net Cash From Operations

This is the real bottom line for businesses. If you don't generate cash in your day to day business — the cycle of make/buy, sell, collect — you simply won't survive.

In Cash We Trust — live it, breathe it, believe it, or be prepared to kiss your sweet assets goodbye!

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