Jun 212017

How To Understand The Basics Of The Cash Flow Statement

I have good news for you – it is not too difficult to understand the basics of the Cash Flow Statement – even if you don’t consider yourself a “numbers person”!

Although many entrepreneurs cringe and may even feel a bit of trepidation when they hear the words financial statements, in reality, once you understand a couple of basic concepts, they are quite straightforward.

Here we will focus on understanding the basics of the Cash Flow Statement.

First, let’s review the basics of financial statements in general.

There are three main financial statements with which you need to be concerned as a startup or small company entrepreneur. Those financial statements are:

The Income Statement (a/k/a “Profit And Loss Statement,” or simply “P&L”)

The Income Statement gives you a picture of your Revenues and Expenses over a period of time, most frequently monthly, quarterly or annually, but it can be over any period of time. When you subtract your Expenses from your Revenues, you get your Profit (or “Income,” “Operating Income,” or “Net Income,” depending which expenses you include in the calculation).

The Balance Sheet

The Balance Sheet gives you a snapshot at a point in time (not over a period of time) of your Assets, Liabilities, and Equity. Assets minus Liabilities equal Equity (or “Net Worth”).

The Cash Flow Statement (a/k/a “Statement Of Cash Flows”)

The Cash Flow Statement, as calculated in this article, pulls information from both the Income Statement and the Balance Sheet, to give you a picture of changes in your cash position over a period of time.

The Cash Flow Statement begins with the cash balance at the beginning of the period you are looking at, and ends with the cash balance at the end of the period you are looking at.

Three Parts Of The Cash Flow Statement

The Cash Flow Statement has three parts that you must consider in order to calculate the change in cash balance during the period in question. Those parts are:

Cash Flow From Operations (CFO)

This part starts with the Net Income (from the Income Statement) generated by your business, then adjusts that Net Income up or down for the non-cash effects of operating income. We’ll touch on this in more detail in the example below.

Cash Flow From Investing Activities (CFI)

This part makes adjustments to the cash balance based on cash generated or used by investing activities. Such activities could include the sale of long-term assets, capital expenditures on equipment, and the sale or purchase of other assets, among other investing activities.

Cash Flow From Financing (CFF)

This final part of the cash flow statement accounts for changes in the cash balance that result from financing activities, such as taking out or paying off loans, selling stock, and paying dividends.

Here is a very basic example to illustrate the three sections of the Cash Flow Statement and walk you through some of the calculations you will have to consider in creating your own Statement of Cash Flows.

This sample Cash Flow Statement of John’s Retail Store showing cash flows for the period January 1, 2016 to December 31, 2016 will allow us to talk through some of the concepts described above.

The Cash Flow Statement starts with Cash Flow From Operations (CFO), with the first element of CFO being Net Income.

The Net Income figure would be taken from John’s Retail Store’s Income Statement for the same period of time.

The Net Income is then adjusted for non-cash items that occurred during the same period. The basic concept here is that whatever is shown on the Income Statement as Net Income results from subtracting Expenses from Revenues for the period. Usually though, not all the Revenues are received in cash, and not all the Expenses are paid in cash.

So, in order to understand the cash impact of these Revenue and Expense transactions during the period, you need to look at the change in relevant Balance Sheet accounts during the same period. For example, you’ll see in the illustration above that there was a change in Accounts Receivable (A/R) during the period that had a net positive effect on cash of $5,000. In the world of accrual accounting, this would mean that A/R (on the Balance Sheet) went down $5,000 during the period.

I realize that this may be a bit confusing. Think about the opposite example, which may help to clarify it in your mind. That is, if A/R went up $5,000 during the period, that would have a net negative effect on Cash Flow of $5,000 during the same period. Why is that? Remember the adjustment here is to Net Income. If $5,000 of Revenues came in, but were not collected, that would be a $5,000 increase in A/R relative to the Net Income that was reported during the same period. In other words, $5,000 that is part of the Net Income is not part of cash during that same period, so it would need to be netted out (subtracted) in the CFO section on the Cash Flow Statement.

Let’s take another example in the Cash Flow From Operations section on John’s Retail Store’s sample Cash Flow Statement. You can see that the change in Accounts Payable (A/P) had a negative $8,000 effect on cash flows. What would this mean? Similar to above, but actually opposite, since it’s A/P instead of A/R, if A/P went up on the Balance Sheet, it would have a positive effect on cash flow for the period. If, on the other hand, as occurred in the case of the John’s Retail example above, A/P went down, it would be a use of cash during the period. In this case, A/P on John’s balance sheet was paid down, using cash, by $8,000 during the period.

I won’t go into details here on the Depreciation and Prepaid Expenses entries in the sample Cash Flow Statement above, but if you have questions, don’t hesitate to ask.

Let’s move on to Cash Flow From Investing Activities.

This section is quite straightforward, as it doesn’t involve adjustments to the Net Income. Rather, Cash Flow From Investing Activities describes changes in cash during the period that result from, you guessed it, “investing activities”. In the case of the Cash Flow Statement, these investing activities include such things as buying and selling assets and investments, including capital expenditures on equipment needed to run the business. In the John’s Retail example above, investing activities has a net positive effect on cash of $85,000 during the period.

Finally, let’s talk about the third section of the Cash Flow Statement, which is Cash Flow From Financing Activities. As with the other sections, these flows can be positive or negative, depending on whether you are receiving the proceeds of financing activities, or paying off financing during the period. As you can see above financing activities in this context include such things as debt (loans), stock issuance, and payment of dividends. In the case of John’s Retail during the period, investing activities had a net positive effect on cash of $25,000.

The final step on the Cash Flow Statement involves adding to, or subtracting from, as the case may be, the net result of the above three sections, the beginning cash balance for the period, to arrive at the ending cash balance for the period.

It’s pretty straightforward:

Beginning Cash Balance

Plus: Net Effect of CFO, CFI, and CFF during the period

Equals Ending Cash Balance.

As you can see from the above example, although the calculations are slightly nuanced, given the peculiarities of Accrual Accounting (i.e. not all transactions are on a cash basis, so adjustments need to be made to the Net Income), the overall idea of the Cash Flow Statement is not too complicated.

As with the other two main financial statements, the Income Statement and Balance Sheet, it’s important that you understand the basics of the Cash Flow Statement, as it will help you run your business better and it will help you more confidently manage financial conversations with important constituencies, such as employees, accountants, lenders, and other potential sources of financing or liquidity.

And, as the saying goes, “cash is king”!

I look forward to your questions and comments.


Paul Morin




Aug 162011

3 Common Small Business Killers

Small businesses, even those that appear promising at the start, have an unnerving failure rate.  Here I’ll discuss three common small business killers, and what to do about them.  In my extensive time in entrepreneurship, I’ve experienced and seen them all, in my own businesses and those of my clients.  The good news is that if you are aware of these issues and keep vigilant watch, you can spot them early and often prevent them from killing your business.

Common Small Business Killer #1:  Insufficient Funding

I guess this one should come as no surprise.  Most businesses are started on a “shoestring budget” and tend to stay that way through most of their lives.  While this may be unavoidable for some who are starting a business, for others, it is simply an issue of not understanding the likely capital requirements of the business and planning accordingly.

Solution:  Perform a break-even analysis before you start your business, so you can get a basic understanding of the sales volume you will need to break even.  This will, of course, involve making many assumptions and it will never be perfect, however it will at least give you a target and a basis for understanding where you need to take the business.  It will also help guide you as you put together your pro-forma financials, including a cash flow projection, which will help you understand when the business is expected to start generating, rather than burning cash.  Realize that if you make your projections too “rosy,” you are likely to miss them and run into cash flow problems.  Project conservatively and leave yourself a buffer for projection error.  Finally, make sure you understand the potential sources of capital available and stay ahead of your capital requirements, so you’re not in a compromised position, trying to raise cash in an emergency.

Common Small Business Killer #2:  Weak Profit Margins

Some businesses have inherently weak profit margins, due to a variety of factors, but usually because of intense competition and the pricing power of key suppliers.  If you know from the get-go that you are entering a business with weak margins and little hope of improvement in that area, you’re either crazy, don’t realize this issue, or have some other ulterior motive.

Solution:  Before you enter any business, make sure you have a very good understanding of the profit margins of the business.  In particular, you should look for gross margins of sixty percent or better.  I will agree with you that such businesses are not easy to find, but as one of my first mentors told me, when you have gross margins of sixty percent or better, you can make a lot of mistakes in the remainder of your business and still survive to fight another day.  Make sure that as you are putting together the pro-forma financials for your venture, you are very realistic regarding the direct costs you will have in producing your products and/or delivering your services.  Any unrealistic assumptions regarding these costs will give you an inaccurate picture of the likely gross margins you will enjoy in your business and make your pro-forma financial projections misleading and dangerous.  Likewise, be very realistic about how you will be able to price your offering, as this will be the other determinant of the gross margins you will be looking at.  Finally, be realistic about how these direct costs and pricing power are likely to change over time, given the competitive forces and other market trends you see at work in your industry.

Common Small Business Killer #3:  Unskilled Management

The unskilled (or under-skilled) management issue occurs quite a bit.  Two scenarios where this issue is particularly common are: 1.) a person comes out of a larger corporate environment with a very specific skillset and decides to become an entrepreneur; and 2.) a family business employs its family members in key management and leadership positions, regardless of the fact that they don’t have the experience or the skills to do the job well.  There are many other situations where entrepreneurs do not have the proper skills to run the business they have chosen, but these are two of the most common.

Solution:  When you are starting a business, or even if you already have it up and running, take a close look at the types of skills that will be necessary to run and grow the business effectively.  If you are not sure what it takes to be great at your endeavor, take a look around at those who are already succeeding in the same or similar businesses.  Take a close look at the core skills and knowledge they employ to allow them to do well in that business.  In some businesses, the most important competency is financial acumen, in others it’s operational knowledge, in most all, it’s marketing and sales capabilities.  Make an honest assessment.  Where you see gaps in your knowledge and capabilities, partner with or hire others to fill those gaps.  Remember when you’re doing this assessment that, regardless of how talented you may be, it will be very hard for you to have the time, energy and capabilities to do all tasks well.  Be sure you have the most critical ones covered and seek assistance everywhere else.

It’s important to understand that these are just three of many potential “small business killers,” but start with making sure you have these three under control and we’ll cover some others in the future.

I look forward to your thoughts, comments and questions.  Leave a comment below!

Paul Morin