Cash is what keeps your business functioning. You obviously need profit, but equally as critical is your cash flow.
It's important to know the financial health of your business, which is why you need to understand the purposes of your different financial statements. Your traditional financial statements include a balance sheet, profit and loss statement, and cash flow statement. What does the cash flow statement tell you that the others don't?
There's a difference between profitability and cash flow. You may be profitable and still have a negative cash flow, which is a difficult concept to understand for most business owners. Why? There are things that take cash out of the business that don't classify as expenses and therefore don't appear on your profit and loss statement. These include:
- Payment of loan principal
- Payment of credit card principal
- Owner's draws
These transactions take cash out of the business and therefore show up on your cash flow statement, but not on your profit and loss statement. When you borrow money from a lender or credit card vendor, you don't count it as income. Therefore, when you pay it back, you don't count it as an expense. The interest or finance charges you incur on borrowing that money are an expense and will appear as an expense and use of cash. Similarly, when you invest money in your own business as an owner's investment, it's not counted as income. So when you take money out as an owner's draw, it doesn't count as an expense. Owner's transactions affect your equity, not your revenue or expense accounts.
Click here for a sample cash flow statement.
When looking at a cash flow statement, you have three main breakdowns that show where cash is coming from and going to:
Operating activities include your day-to-day operations. Increases and decreases in receivables and payables are accounted for on your cash flow statement, as are other activities from operating your business and selling your products and services. The operating section is where your main cash flow should be generated. Long-term business health comes from having a good net profit and positive cash flow from your operating activities.
Investing activities include the purchase and sale of your long-term fixed assets, such as property, plant and equipment.
Financing activities include the borrowing and repayment of long-term liabilities.
Understanding what your cash flow statement is telling you about your business is critical. All three of your main financial statements--balance sheet, profit and loss statement, and cash flow statement--relay a different view of your business, and each is critical to the overall health of your business.