Edge Retail Academy Blog

The Importance of Understanding Cash Flow

by Phyllis Casey

Many business owners use their Income Statement to judge the health of their business. While the Income Statement shows a company’s profitability, it does not tell us about liquidity. Many companies go out of business due to lack of cash and cash flow, despite a history of net profits.

A simple cash flow analysis would include adding back to net profits and any non-cash expenses such as depreciation, to net profits. Non-cash expenses include depreciation and amortization. The cash expense is incurred when a piece of equipment is purchased. Depreciation serves to distribute the expense over the life of the equipment. Other non-cash expenses could be asset write-downs – such as bad debt write-offs or inventory adjustments. Goodwill can be tested for value, resulting in impairment charges which are non-cash.

Banks and investors look at EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, as a measurement of how much cash a company generates that can be used to repay debts.

A more thorough valuation of cash flow, starts with net profits, adds back non-cash items then adds and subtracts balance sheet changes. Increases in assets represent uses of cash, such as new equipment. Decreases in assets represent sources of cash, such as collection of Accounts Receivable or the sale of Inventory. Increases in liabilities and equity represent sources of cash, such as new financing. Decreases in liabilities and equity are uses of cash, such as retirement of a bank debt.  

Growing companies often run out of cash, as inventories and accounts receivable are growing, so watching these Balance Sheet changes is vital for independent business owners who may have limited resources.

For a company with net profits of $50,000, depreciation of $5,000, inventory growth of $100,000, and new Line of Credit financing of $10,000 cash flow – differs greatly from profitability. True cash flow, after sources and uses of cash, would be $50,000 + $5,000 – $100,000 + $10,000 = ($35,000) – very different from the $50,000 net profit that the Income Statement implies.

Another drain on cash flow is owner distributions, or dividends. If an owner wants to build equity, then distributions should be limited to less than net profits. When distributions exceed profits, the company becomes more reliant on liabilities to finance its assets. If the above company decided to distribute out all of its profits, $50,000, then the net cash flow would be ($85,000).

For the independent business owner, it’s important to keep your financial statements up to date and look at both your Income Statement and Balance Sheet to evaluate your cash flow. And remember:

Income Statements Measure Profitability while Cash Flow Statements Measure Liquidity.

For help understanding your Financial Statements contact Becka Johnson Kibby at 714-925-2456. 

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