Understanding the Key
Components Of Cash Flow
We hear over and over in the business news about an airline or car company losing millions of dollars yet they still continue to operate and we wonder how they do it.
On a smaller scale, some of my clients have accumulated seven figure losses, yet all the while increasing revenues and expanding markets. On the other hand, other companies have had to liquidate after compiling relatively small losses.
What makes the difference? Why are some companies forced into bankruptcy or liquidation after accumulating only small losses while other companies with large losses continue to grow and expand?
The answer is simple. Companies go out of business because they cannot pay their bills, not because they have accumulated losses. That is the difference between cash flow and earnings. Earnings are an accounting concept defined by the accounting profession. Cash flow, on the other hand, is based on the timing of receipts and disbursements of cash. The following are some examples of how an income statement approach is different from cash flow.
Depreciation. Depreciation is an accounting term for allocating the cost of an asset over its useful life. This can range in time from 3 years to 40 years. Although the cost of the asset is allocated over a number of years, it is normally paid for at the time it is installed with an outflow of cash or combination of cash and a loan, neither of which show up on the income statement.
Amortization. This, too, is an accounting term that allocates costs over an arbitrary time period. Although the money to purchase the asset is spent prior to using the asset, the cost of the asset, from an income statement perspective, is spread over its useful life, not when the cash is spent to purchase it.
Prepaid Items. These are cash payments made in one period that reduce earnings in future periods, not in the period that the payment was made.
Sales/Accounts Receivable. Income statement, accrual based accounting, allows non-cash sales to be recorded when title passes. Cash flow, however, is affect only when the receivable is paid.
Inventory. The income statement, accrual method, requires that the cost of the product is expensed when the sale takes place. However, most inventory is paid for long before its related sale is made.
Property, Plant and Equipment. Cash is reduced by both the initial down payment and all subsequent installment payments. Earnings, on the other hand, is affected only by depreciation.
Why is cash flow important?
Cash flow is the lifeblood of a company and is fundamental to its very existence. It determines whether or not a company can pay its bills. A company can be profitable and have limited cash flow or inversely it can be operating at a loss and have excess cash flow. Since cash flow is critical to the livelihood of the business, and cash flow is never a steady stream of receipts and disbursements, but fluctuates from day to day, month to month, season to season; cash flow forecasting becomes a necessary tool for successful management..
How to get control of your business’ cash flow.
Establishing a good and effective cash flow forecasting program takes the involvement of all people. It cannot be developed by someone in the accounting department that has no contact with anybody else in the company. It is an all out effort between sales, operations, financing, marketing, and distribution with coordination of top management. Depending on the type of the company and the amount of cash it has in reserve, it is an on-going, monthly process. It takes work, but the companies that have implemented a systematic cash flow forecasting system, never have to worry if there is going to be enough cash to operate their business. They are free to focus on their business and they become much more effective and productive.
By Dan Lacy
Anderson, Indiana
