1) Cash Flow from Operations
2) Cash Flow from Investing
3) Cash Flow from Financing
Of the three, cash flow from operations is the most prominent. It identifies if the company is making money from its regular ongoing purpose. In a pure cash only operation, the profit as reported on the income statement would also be cash flow from operations. But modern-day business is not pure in how it is conducted. Companies agree to pay suppliers at a later time, payroll is weekly or monthly, benefits that are paid in the future are offered to employees, credit is extended to customers; the list can go on and on.
Because of this complexity, the formula to determine cash flow from ongoing operations is also rather complex. This article breaks it down into three basic steps so the reader has an introduction to the basic formula. To successfully grasp the understanding of how cash flow works, this article explains two of the steps from their cash perspectives. One is from the perspective of current assets and the other is current liabilities. From there, all three steps are combined to determine cash flow from operations. The three steps consist of the following:
Step 1 – Adjust the profit for income statement items
Step 2 – Adjust for current asset changes
Step 3 – Adjust for current liability changes.
Finally, an in-depth example is illustrated for the reader.
The next article in this series will provide insight into understanding cash flow from operations so the reader moves beyond novice comprehension. The goal is to provide knowledge and understanding of why cash flows is so important.
General Introduction To Operational Cash Flow
Of all forms of information in business, no other piece of data is as valuable as understanding how much cash a business generates from its day-to-day operations. Earning cash increases working capital, minimizes insolvency, increases flexibility and makes managing a company a lot less stressful. The formula ties both the income statement (profit and loss statement) to the balance sheet and as one overall financial report. It is also the most mind-boggling business concept to master as even most Certified Public Accountants have difficulty understanding the nuances of the formula. The goal of this article is to keep it simple.
In a pure cash operation like a food cart at the fair or the corner hot dog stand, there are no temporary accounts (inventory, accounts receivable, accounts payable etc.) as pretty much all the inventory purchased in the morning with cash is sold at lunch for cash. So at the beginning of the day the business started with cash and a stand. At the end of the day, its ends with cash and a stand. Hopefully a lot more cash (profit) then what he started out with that day.
The idea for cash from operations is evaluating the position of cash flow at any point in the day. As an example, using the food cart, let’s assume the food vendor starts with $1,000 of cash in his account at 7:00 AM. At 8:00 AM he spends $350 for food. At 8:00 AM his cash flow from operations for ‘That Time to Date’ is a negative $350. This is because the cash account decreased $350 to $650 and all the cash was spent on operational items, food instead of any fixed assets or paying off long-term debt.
By noon, he has sold $170 of the inventory for $400 for a profit of $230. At this very moment in time he deposits his cash into his bank account. The bank account has a balance of $1,050 ($650 carry forward balance plus $400 of cash sales to this point in the day). So at this point his cash flow from operations is $50. Here is the formula:
Both changes in cash should match.
Note ‘A’ – Inventory is a temporary account, that is it will fluctuate greatly over short periods of time. He purchased $350 of inventory at 8:00 AM, sold $170 by noon and therefore has a remaining balance of $180 which equals cash out (negative), i.e. he spent cash to purchase that inventory.
So let’s continue this business operation and evaluate cash flow at 3:00 PM when he is done for the day.
At 3:00 PM the last customer buys food and the vendor is done. He has $5.00 of inventory left (a twelve pack of sodas). Total sales were $1,030. Total inventory used $345 ($350 less $5 remaining balance). So the profit is $685 ($1,030 – $345). The cash in the bank account is now $1,680 ($1,000 starting balance – $350 for inventory + $1,030 from sales). So let’s take a look at cash flow for the day:
Both match for reconciliation purposes.
So a couple of insights to the above. Notice that with the 3 PM analysis the starting point was 7:00 AM and not noon? An accountant could calculate the change in cash since noon and it will look like this:
Both match for reconciliation purposes.
Total profit of $685 – $230 for morning sales = profit since noon.
There is something different with this calculation than the prior two formulas. The temporary balance is not the remaining inventory value but the CHANGE in value since noon. The inventory balance was $180 at noon and now it is $5 (the twelve pack of sodas) at 3 PM. Inventory decreased $175. So this raises an important key in cash flow analysis.
CASH FLOW MEASURES CHANGE IN CASH OVER A PERIOD OF TIME.
So why is it mathematically added to the profit?
The best way to think of this is that the food vendor exchanged the food for cash, whereas the profit is how much he made over the time period of sales. The change reflects additional cash received or given up to address temporary accounts. In this case it was beneficial. The inventory decreased during this time period which provided additional cash.
This fundamental principle thought process is the key to understanding cash flows. It relates to the time period involved (in this case, noon to 3 PM) and the changes in temporary accounts during this period of time.
To drive the point home, let’s modify what happens between noon and 3 PM. The food vendor notices a long line at 12:30 and is worried he’ll run out of food. So he calls his wife and asks her to purchase more food. She goes out and buys $200 of more food and brings it to her husband at 1:30. He is relieved. But it starts raining, and at 3 PM he serves his last customer.
At this point there is $205 of food left ($200 of food his wife purchased plus that $5 twelve pack of sodas). What is the cash flow since noon? First off, the profit hasn’t changed. It is still $455 as stated earlier.
Both match for reconciliation purposes.
Note ‘A‘ – Inventory increases from $180 to $205 or $25. When the inventory went up, cash was used therefore an increase in an asset based temporary account uses cash; which is symbolized as a negative. Another way to look at this is he started with $180 of inventory at noon, used $175 and bought $200 ending with $205. The net effect to the balance sheet for inventory is a consumption of cash of $25.
Note ‘B’ – Here is the ledger for the bank account:
This makes sense; before it was $1,680 and the wife spent $200.
Notice a couple of extremely important rules related to calculating cash flows.
Rule Number One – It is always stated as covering a time period. Stated correctly – ‘Cash Flow from Operations for the Month of ABC’, not ‘Cash Flow from Operations is $ZZZ’.
Rule Number Two – It evaluates the effect operations had on the cash accounts (bank accounts, petty cash, escrow cash, etc.). This is why both the change in cash and cash from operations is compared, to determine if they reconcile.
Rule Number Three – It incorporates both the income statement and the balance sheet.
To illustrate how accountants calculate cash flows, let’s walk through their process for the same food vendor.
CASH FLOW TODAY’S OPERATIONS – FOOD VENDOR
Step 1- Get the before and after balance sheets.
Comparative Balance Sheets
. 7:00 AM 3:00 PM
Cash $1,000 $1,480
Food Inventory -0- 205
Cart 10,000 10,000
Total Assets $11,000 $11,685
Common, Stock $11,000 $11,000
Current Earnings -0- 685
Total Equity $11,000 $11,685
Step II – Get the income statement for the period.
For the Period Ending 3 PM Today
Cost of Food 345
Gross Profit $685
Profit $685 * Matches Current Earnings
Step III – Calculate the change in cash.
The change in cash increased $480 from 7 AM to 3 PM.
Step IV – Calculate cash flow from operations for the day.
Using the formula:
Profit Earned Today $685
Less any Increase in Temporary Assets (205)
Change in Cash $480
There is a match between actual change in cash as calculated in Step III and the amount derived in Step IV.
Up to this point, temporary assets have been mentioned several times. So it is prudent to define temporary assets. Temporary assets are all gross (current assets) except for cash. Basically they are all gross working capital accounts with the exception of cash. They include:
* Accounts Receivable
* Prepaid Expenses
* Tax Refunds
* Escrow Amounts
The term temporary is used because these assets change frequently, for most businesses, daily. Fixed assets and other assets change in value less often.
For cash flow purposes, whenever these assets increase in value, it is the equivalent of consuming cash. It makes sense. To increase inventory like our food vendor did, cash is used. In economics it is referred to as a financial equivalent.
Take for example accounts receivable, whereby the customer is invoiced for the sale. Suppose the sale is for $200. What if the customer handed you $200 in cash instead as payment; then you turn around and hand it back saying “You owe me $200”? That handing back of $200 decreases the cash. The accounts receivable balance went up and the effect on cash is nill. $200 in for the sale and $200 out for the receivable. The increase in a temporary asset has a negative effect on the profit. Here the sale is $200, no cost of sales with a profit of $200. It looks like this:
This matches exactly what happened to the cash account.
So Step 2 of cash flow from operations is to calculate to total change in all current assets except cash. Remember you need both a beginning and ending balance sheet for the period in question. So let’s calculate the net change in current assets without cash for a more complicated balance sheet. Look at the following:
Remember if total temporary assets increase, it decreases cash flow from operations; not cash flow from the perspective of the cash account. If temporary assets decrease then these changes generate positive cash flow. Think of the customer paying his invoice of $200, cash account goes up $200 and receivables (temporary asset) goes down $200.
This same concept is also used with temporary liabilities except it is in reverse.
There are two groups of liabilities, short and long-term. Short-term liabilities are identified as current liabilities and these are the temporary liabilities for cash flow from operations as used in Step 3 of the formula. A liability is the economic equivalent of borrowing cash. That is, as the liability increases, cash flow increases.
Step 3 of the cash flow from operations formula is to add or subtract any net aggregate change in current liabilities to the income statement’s adjusted profit. The formula for step 3 is tied to this table:
. Change in Aggregate Current Liabilities Cash Flow Effect
. Increases Positive
. Decreases Negative
This makes perfect sense. Think of accounts payable, when a business owes the supplier for materials or services it is economically the equivalent of borrowing money. Therefore the effect on cash is an increase. Whereas a decrease in accounts payable is related to payments via cash disbursements resulting in cash decreases.
The following are the typical current liability accounts:
* Accounts Payable
* Credit Cards
* Accrued Payroll
* Accrued Expenses
* Taxes Payable
* Lines of Credit
Just like with temporary assets, when evaluating the total change in temporary liabilities the accountant needs both the beginning and ending balances. The following is an illustration of this section of a comparative balance sheet and the corresponding change for each account.
MinBrook Metal Fabricators
Comparative Balance Sheets Limited Scope (Current Liabilities Only)
. 05/31/2016 06/30/2016 Change
Accounts Payable $23,711 $17,402 ($6,309)
Credit Card Accounts 41,632 22,171 (19,461)
Accrued Payroll 11,419 14,607 3,188
Accrued Expenses 6,997 5,733 (1,264)
Taxes Payable 4,061 6,999 2,938
Lines of Credit 24,700 20,200 (4,500)
Total Current Liabilities $112,520 $87,112 ($25,408)
During this one month, overall current liabilities decreased $25,408 which means cash was used to reduce this balance.
Now that both Steps 2 and 3 have been explained it is time to explain the income statement adjustments.
Income Statement Adjustments
The starting point for all cash flow calculations is the net profit reported as current earnings in the equity section of the balance sheet. For an understanding of the relationship between net profit and current earnings read Lesson 9 of the Bookkeeping series on this website.
This profit amount is adjusted for all noncash items related to fixed assets, other assets and long-term liabilities as explained below.
Depreciation is the number one non-cash deduction. Depreciation is a method of allocating fixed asset costs over time. The asset purchased had cash involved at the initial start and thus no actual cash is involved throughout the depreciation period. The typical entry involves a debit to depreciation in the capital costs section of the income statement and a credit to accumulated depreciation in the fixed assets section of the balance sheet.
In some industries like real estate, depreciation can be a significant cash adjustment. Take for example a 100 unit apartment complex with $1,000,000 of rents per year. Depreciation can be as much as $200,000 per year. This greatly reduces the profit for this type of business operation. At the other end of the spectrum are service based operations. Here depreciation is usually an insignificant amount.
Just like depreciation, amortization is an allocation of initial costs for intangible assets. A good example is amortization of financing costs. Very similar to depreciation, amortization’s debit is to an account in the capital costs section of the income statement. The offset is to accumulated amortization in the other assets section of the balance sheet.
Long-term warranties are very similar to amortization. At the time of purchase a large sum was paid for a form of asset protection. This cost is allocated over time to maintenance costs on the income statement. The offsetting credit is to the warranty in other assets reducing its carry forward balance. Warranties are not customarily found on the balance sheet as an asset in small business. It is generally not affordable during an operation’s formative years. It doesn’t mean it is not there, just unlikely.
Long – Term Escrow
This is extremely rare in small business but does exist with dealership operations.
When the dealership sells an inventory item, the lending institution for the financing (customer’s financing) may agree to pay a commission to the dealer contingent on the customer making all their payments. The commission is usually a very small percentage of the interest earned by the lender. In this relationship the dealer gets a monthly statement identifying the amount earned (other revenue). The statement identifies the amount held in escrow which is recorded as a long-term escrow under other assets. This fund has a recourse agreement attached whereby the value of the escrow acts as collateral in case of customer default.
Unlike depreciation and amortization, escrow revenue is not added back to the profit but is subtracted because this revenue increased the profit. Therefore the cash adjustment decreases the profit to the amount it would be without this non-cash revenue.
Discounts on Bonds/Notes
Another rarely used (really nonexistent) amortization expense with small business is bond discounts as additional interest. Typically these discounts are paid when the note or bond is cashed in on the call date. It is an expense on the income statement and if they are included, the accountant must add the value back as an adjustment to profit.
As stated at the beginning of this article, cash flow from operations follows three steps.
Step 1 – Adjust the Income Statement Profit for Non-Cash Items
The net profit of the income statement is the starting point. This is the same value reported as ‘Current Earnings’ in the equity section of the balance sheet for the period under review. With this value add back the noncash expenses and subtract non-cash revenue as illustrated here:
Cash Flow from Operations
For the Period Ending (Month, Quarter, or Year)
Profit as Reported on the Income Statement $ZZ,ZZZ
Add Back Noncash Expenses:
. – Depreciation $Z,ZZZ
. – Amortization ZZZ
. – Warranty ZZZ
. Subtotal Noncash Expenses Z,ZZZ
Subtract Noncash Revenue:
. – Interest Commissions Held by Bank ($ZZZ)
. – Long-Term Contract Earnings (Z,ZZZ)
. Subtotal Noncash Revenue (Z,ZZZ)
Adjusted Operations Profit Before Balance Sheet Items $ZZ,ZZZ
As with most small businesses it is rare to have noncash revenue items. Please do not confuse this classification with accounts receivable. Although accounts receivable is noncash sales it is handled in Step 2 of the formula – Changes in Temporary Assets.
Step 2 – Changes in Temporary Assets
For cash flow analysis, temporary assets are all current assets except cash. As illustrated above in the temporary assets section the change in temporary assets is based on the same time period as covered by the income statement. If the profit from the income statement covers one month, the two balance sheets used must have a beginning set of values (usually the balance sheet from the last day of the prior month) and an ending balance sheet which is the last day of the month analyzed.
A BALANCE SHEET IS A SNAPSHOT OF A MOMENT IN TIME. USE THE LAST DAY OF THE PRIOR PERIOD FOR COMPARATIVE PURPOSES. IF YOU USE THE FIRST DAY OF THE PERIOD UNDER REVIEW, THE SNAPSHOT IS AT 11:59 PM ON THE FIRST DAY; WHICH MEANS YOU MISSED AN ENTIRE 24 HOURS OF ECONOMIC ACTIVITY WITH THE FORMULA.
With the value ascertained add or subtract the total change in temporary assets per the following schedule.
. Change in Temporary Assets Effect on Cash Flow From Operations
. Increase Decrease
. Decrease Increase
Step 3 – Changes in Temporary Liabilities
The third step in the formula is similar to the second step except the aggregated change is with all current liabilities. Using the same two balance sheets used with Step 2 above to calculate change in temporary assets, determine the change in current liabilities. The result affects the formula per this table:
. Change in Temporary Liabilities Effect on Formula
. Increase Increase
. Decrease Decrease
Notice with liabilities the effect on the formula is exactly the same as the net change in temporary liabilities.
The following is a comparative balance sheet and income statement for Gwyn’s Cleaning Service. What is the cash flow from operations?
Gwyn’s Cleaning Service
Comparative Balance Sheets
February 29, 2016 and March 31, 2016
. 02/29/2016 03/31/2016 Change
Cash $10,205 $13,117 $2,912
Accounts Receivable 14,770 18,920 4,150
Prepaid Expenses 7,200 6,700 (500)
Current Assets $32,175 $38,737 $6,562
Net Fixed Assets 21,400 20,700 (700)
Total Assets $53,575 $59,437 $5,862
Accounts Payable $6,741 $7,040 $299
Accrued Payroll 4,080 5,000 920
Taxes Payable 2,110 1,444 (666)
Current Liabilities $12,931 $13,484 $553
Common Stock 10,000 10,000 -0-
Retained Earnings 28,000 28,000 -0-
– January 1,500 1,500 -0-
– February 1,144 1,444 -0-
– March -0- 5,309 5,309
Total Liabilities & Equity $53,575 $59,437 $5,862
Gwyn’s Cleaning Service
For the Month Ending March 31, 2016
Cost of Services Rendered 27,600
Gross Profit 13,849
Office Operations 2,600
Subtotal Expenses 8,540
Net Profit $5,309
Cash flow from operations for the month of March 2016 equals:
Note ‘A’ – The change in current assets excludes cash ($6,562 – 2,912). Since current assets increased in March, cash was used to fund the increase thus reducing cash flow from operations.
Note ‘B‘ – Current liabilities increased $553 during the month of March. This is an economic equivalent of borrowing cash. Thus the addition of $553 in the formula.
Summary – Cash Flow From Operations
Cash flow from operations is one of the three major sections of the cash flows statement. It is also the most important as it identifies the ability of the company to make money in its normal day-to-day operations.
Cash flow from operations follows a simple three-step formula. Step 1 involves making adjustments to the reported profit for the period under evaluation. Adjustments include depreciation, amortization and other noncash items. This value becomes the adjusted profit for cash flow from operations.
Step 2 and 3 focus on the changes for temporary items of the balance sheet in accordance with the following table:
. Balance Sheet Group Effect on Cash Flow Formula
Temporary Assets Increase Decrease
Temporary Assets Decrease Increase
Temporary Liabilities Increase Increase
Temporary Liabilities Decrease Decrease
The net result is the total change in cash for the company from operations for the period under review. Use this tool to evaluate actual corporate operations performance over time. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.