Cash Flows – Introduction

Insolvency is defined as the inability to pay liabilities as they come due. To meet the demand of creditors cash is required. For most small businesses there are as little as a single source to multiple sources of cash.

Think about these two extreme examples:

* Food Vendor  – an extremely small business with one primary source of cash and that is the sale of product to customers. A secondary source of cash may consist of a credit card in the name of the owner.
* A Lawn Equipment Supply Company sales are the primary source but a good percentage of sales are on account or via third party financing arrangements. Other sources of cash include lines of credit, floor plans, tax credits, deferred arrangements and long-term secured notes.

The goal of management is to have cash inflows greater than cash outflows to slowly build cash in the bank account for the business. In business there are three primary sources (groups) and uses of cash. The most important and by far most complicated is cash flow from operations. This refers to the main function of the business, the selling of products and/or services. A secondary source and use of cash is in the form of investing. I’m not referring to the purchase of stocks or bonds but the investments made and sold related to fixed assets or the price paid or earned to buy or sell another business or line of operations. The third source or use of cash relates to financing. This includes borrowing or paying back loans from financial institutions and of course the financial exchanges with the owners of the company.

The goal of this article is to highlight each of these three primary sources and uses of cash. Future articles will go into greater detail for each one these major groupings of cash flows.

Cash Flow From Operations

The goal of operations is to generate cash inflows directly related to sales that are greater than the cash outflows for direct costs and operating expenses. With the food vendor his typical cash cycle is the purchase of inventory (meats/breads/condiments) in the morning – cash outflows; then cash inflows in the afternoon from sales of his fare. At the end of the day, hopefully, his cash inflow exceeds his outflows thus generating a profit. But business isn’t this simple.

For most young business operations the outflows from operations exceed the inflows. This is quit common and reflects issues such as economy of scale, building up inventory and extending credit to customers. On the flip side of this there are periods of time where the inflow of cash exceeds disbursements of cash. Examples include selling of products to customers that were purchased on credit from suppliers, paying for labor in extended increments (such as every two weeks), collecting sales or meal tax and not disbursing to the government until the following month.

Each of the groups of inflows and outflows are discussed in more detail below:


Without any question the absolute best source of cash inflow is the sale of a product or service for cash. Think of the world’s number one company; their sales are almost entirely in the form of cash (cash, debit or third party credit card charges). Hardly any customer leaves Wal-Mart check-out with paying for their purchase via a Wal-Mart credit account.

Other sources of inflows exist too. Before I continue let me explain the economic equivalent of a purchase from a vendor or supplier.

When the business purchases a product for inventory from an outside party the economic transaction is the exchange of cash for goods. So a payment to a vendor is an outflow of cash. But if the vendor agrees to sell on credit it is no different then the vendor handing the cash back to the company and saying ‘Pay me later’. He has in effect lent the company money worth the product he sold to the company. This is an economic equivalent. So if a business buys on an account payable this is referred to as an economic equivalent positive inflow of cash.

The same principle is applied with the business related to the labor force. Imagine paying employees each day at the end of the day. Now they in turn hand the money back to their employer and say ‘You can pay me in two weeks’. So accrued payroll or for that matter any accrued liability increase is the equivalent of a cash inflow.

So in essence cash flows consist of two forms, physical (actual cash) and an economic equivalent.

Forms of cash inflows from operations include:
A) Customers paying on their accounts to the business
B) The sale of inventory
C) Short-term working capital loans from financial institutions
D) Customers paying deposits for future work (unearned revenue)
A) Use of credit cards to purchase goods
B) Purchasing inventory via vendors/supplier accounts
C) Accrued expenses (payroll, tax obligations, interest on debt)


The number one outflow for operations are disbursements to pay down accounts payable or satisfy the accrued payroll. This is physical in its affect on the cash account.

Also included in cash outflows are the economic equivalents:
* Sales on accounts for customers – increase in receivables
* Reduction of tax obligations for tax credits
* Allowances granted by creditors

Cash flows from operations focus on the income statement profit or loss and is adjusted by the changes in current liabilities. For those readers that are still novices in business the key is generating sales, especially sales in the form of cash payment. If on account, pay strict attention to collecting in a timely manner the amounts owed to the business. By adhering to these two fundamentals management will maximize cash inflows from operations.

Cash Flow From Investing

The second of the three primary sources and uses of cash relates to the investing aspect of business. For small businesses this means the purchase of fixed assets. The purchase of a vehicle or a new computer system are the more common investments.

Other forms of investment include:

* Organization Costs – initial investment into forming a legal entity, research and training
* Research and Development – work on a particular idea including investment in research
* Goodwill – purchase of another business (value in excess of fair market value of physical assets)
* Copyrights and Patents intangible assets for legal rights

When reported, cash flows from investing is most often an outflow (negative). This is preponderantly common with young growing operations. Sometimes though a major asset or right is sold. When this happens cash inflows may exceed outflows.

So how are these major purchases in investing funded?

Cash Flow From Financing

When expensive ticket items are purchased most small businesses arrange financing. Loans from financial institutions are positive cash flows to a business. Financing is the third of the three primary sources and uses of cash. In addition to loans any activity in the equity section (excluding earnings) is reported in this section of a cash flows statement. So capital contributions from owners is an inflow and distributions/dividends  is an outflow.

Other inflows and outflows for financing include:

* Principle payments on loans (outflow)
* Lease Obligation (inflow)
* Treasury Stock (outflow)
* Sale of bonds, convertibles or debentures (inflow)
* Trust disbursements (outflow)

It is almost a given that financing ends up with a positive (inflow) cash flow on a year to year basis. As any business grows financing becomes essential to fund that growth.

Key Business Principle
Key Business Principle




There are three primary sources of cash flows for a business:
* Operations – main source is sales of products and services in the form of cash and includes changes in current assets (cash account excluded) and changes in accounts payable.
* Investing – purchases of fixed and any other long-term tangible and intangible asset. Inflows from investing include the sale of these assets.
* Financing – long-term loans from financial institutions and changes in equity (excluding earnings).

When combining all three sources the goal is to maintain a positive cash flow over extended periods of time or a business will drain its existing cash. When cash is drained and the business is unable to pay it current bills, this is insolvency.   ACT ON KNOWLEDGE

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About David J Hoare 429 Articles

I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns