Cash flow is the lifeblood of every business. However, most business owners do not regularly measure their cash flow other than to determine whether their cash balance is increasing or decreasing. Cash flow statements are intended to provide cash flow data, but most do not provide enough information and the format is not very user friendly reducing their effectiveness. Tailoring the cash flow statement to focus on the key components of cash flow will make the statement an effective management tool in controlling the company’s cash.
Direct vs. Indirect
Generally Accepted Accounting Principles (GAAP) offer two methods for reporting cash flow. By far, the method most often presented is the indirect method. Cash flow statements prepared using the indirect method start with net income and then lists adjustments to net income to convert it to a cash basis. For example, an increase in accounts receivable would be subtracted from net income because the increase represents revenues reported on the income statement that were not collected in the form of cash. This is where many users get confused. It may seem intuitive that an increase in accounts receivable is a source of cash. It is actually the opposite. It may be converted to cash in the future. But for today, it is a use of cash because someone else is using your cash.
The direct method of reporting cash flow lists the gross amounts of cash inflows and outflows for the key components of the company’s operations. So, instead of reporting a net adjustment to net income for the change in the accounts receivable balance, the direct method would report the total cash received from customers during the period. This information is much more useful when making comparisons to other components of the financial statements, like comparing cash received from customers with revenues for the period. It is more difficult to derive the information necessary for direct method reporting, but the results provide users better information which is easier to understand.
GAAP vs. Management Report
Another issue that makes cash flow statements difficult to understand is they are prepared by accountants for accountants. GAAP statements divide cash flows into three categories: Cash Flow from Operations, Cash Flow from Financing Activities, and Cash Flow from Investing Activities. When preparing cash flow statements for internal reporting, I recommend grouping like items together. For example, an auto dealer finances its inventory using debt which is commonly referred to as a flooring line of credit. Increases or decreases in vehicle inventory (an operating activity) result in offsetting increases or decreases in the flooring line (a financing activity). These transactions have little impact on cash flow. To match these items on the cash flow statement, I would create a category called Cash Flow from Flooring Activities. The transactions reported in this category should net to zero, but timing differences between when a vehicle is sold and when the flooring payment is made would result in a net source or use of cash. A large difference could indicate an issue that should be investigated.
Level of Detail
The point is to present a periodic cash flow statement that is an effective management tool to make better decisions. When gathering information for an internal cash flow statement, the preparer should not only be identifying relationships between components as described above, but also determining how much detail to provide. I was recently preparing a cash flow statement for a client and noticed that many vendor purchases were paid with a company debit card. The business obtained a debit card as a startup to pay for purchases at a time when it had no credit. I reported the amount paid with a debit card separately from cash paid to other vendors. Management was surprised by the amount and determined that credit terms could be established with many of the vendors. In addition, the company switched to a credit card that paid 2% cash back on purchases for other vendors. This made a huge impact on their cash flow.
Developing a meaningful cash flow statement and reviewing it regularly is just as important, if not more so, as reviewing your income statement and balance sheet. It should be reviewed at least monthly and key elements, such as accounts receivable activity, should be reviewed at least weekly. Understanding cash flow and managing it is critical to the success in any business. Effective cash flow statements are an integral part of this process.