Cash flow is the most important, yet often the most ignored, metric of success for any business. Beyond brand, concept, or team, cash flow stands alone as the most accurate determinator of success.
Defined: cash flow is the figure that indicates the net ins and outs of a company’s cash - a company’s lifeline. As an indicator, cash flow describes the quality of your income. As a pulse on your business, it articulates how likely your company is to become insolvent. Businesses don’t fail because they are unprofitable, they fail because they cannot pay their bills.
Failure is a common reality to small business owners. Put into numbers, one-third of all new ventures fail within the first two years, over half within four years, and 70% within seven years. These failures can be attributed to many factors, sure, but the most common and consistent distinction between those businesses that fail and those that succeed is: companies that succeed have positive cash flow.
With that in mind, I suggest not only measuring your cash flow but developing the processes and deploying the resources necessary to ensure it’s controlled.
What Cash Flow Means To Accounting
The most common small business accounting method is Accrual Accounting. This method recognizes your business’ economic events whether or not a cash transaction has occurred. With Accrual Accounting, there is a bit of, “counting your chickens before they hatch.”
“You cannot control what you cannot measure”
Most businesses use Accrual Accounting because of the way it simplifies complex business transactions. For example, when a widget is bought on credit, Accrual Accounting recognizes that purchase event as income immediately, based on the assumption that the credit transaction will almost certainly clear, resulting in income. Cash Accounting, rather, would defer representing that purchase as income until the cash/credit has cleared.
Both Accrual and Cash-based accounting methods have their strengths, but any way you cut it, you’re going to need your income statement, balance sheet and cash flow statement to accurately assess your financial strength.
How To Measure Your Cash Flow
The product of measuring your cash flow is referred to as a Cash Flow Statement - shocker. This statement is divided into three parts:
Operating Cash Flow: Includes the day-to-day business operating expenses. This is the main driver of cash for any business. This is the cash that is created internally by revenue producing sales and/or services.
Financing Cash Flow: Includes a company’s credit and debt obligations. This is where any dividends for investors would go.
Investing Cash Flow: Includes any acquisitions, long-term investments and securities (might not be applicable)
The information in aggregate is the measure of your cash performance. A good indicator of strength, however, is a single metric referred to as your “net operating cash flow”. Now, since we are calculating CASH flow, emphasis on cash, we’re going to need to adjust some of the information calculated on your income statement and balance sheet so that the figures reflect cash and cash equivalents.
First, reverse the adjustments of your amortization and depreciation present on your balance sheet. In Cash-based Accounting the assets you purchased in cash are seen at “face-value” rather than long-term assets. For assets not in cash form, like inventory or hard investments, go ahead and deduct those from your net income - as they were probably paid for in cash as well. Your cash-flow statement should also include any debt repayments or dividends, if they were present in the period.
Once all of the adjustments are made, the net result of your Investing, Financing and Operating Cash Flows results in your “net operating cash flow”. Let this calculation serve as a good indicator of how healthy your business is in a given period.
Where Cash Accounting Falls Short
The problem with Cash Accounting is that it ignores many of the non-cash variables that make up a business’ profitability story for a given period. It ignores a business’ assets and liabilities as well as entire the entire receivables and payables financials. Your cash flow statement might be a good indicator of solvency, or ability to avoid adjunct failure, but might not give the most insight into how a business is moving in either direction.
If you’re not producing a cash flow statement, do it. It is a tool that displays an undoctored view into your business. Just don’t rely on it as the single source of truth for all things success.
Until next time.