The Cash Flow Statement—
Do We Have Enough to Pay Payroll?

July 2005

The cash flow statement performs very much like your bank account statement at home. It tells you how much cash you had at the beginning of the month and how much cash you had at the end of the month. It summarizes how much cash you collected and how much cash you paid out.

The Cash Flow Statement
BEGINNING CASH
+ CASH COLLECTED
– CASH PAID
= ENDING CASH

The cash flow statement is often confused with the income statement. Some people figure that the final balance of cash will be the same number as your net income. This is never true when you use the accrual basis of accounting—and you probably do.

Cash vs. Accrual Method of Accounting

The cash method of accounting is used by very few businesses, because it takes such a simple view of transactions. Most of us use the accrual method of accounting.

The cash method of accounting works well if you have a very simple business. Let’s take as an example a hot-dog vendor on a college campus. Every weekday morning, the hot-dog vendor wakes up, hitches his hot-dog cart to the back of his truck, and drives over to Sam’s Warehouse and buys hot dogs, buns, condiments, and sodas. He pays cash. He drives over to campus and sets up shop. He sells his hot dogs and sodas for cash. At the end of the day, he eats the leftovers. The next morning, he starts all over again.

His business is all about cash. He doesn’t owe anyone money and his customers don’t owe him any money. There are no receivables and payables. His business is very simple—unlike most businesses.

Most businesses operate with receivables and payables and keep track of their transactions using the accrual method of accounting. The accrual method records everything that happened in the business, whether or not it impacts cash.

You can make a sale and record it on your books, but not collect payment in cash from your customer for 30-plus days. Using the accrual method, you accrue—or record—the income on your income statement. But nothing has happened over on the cash flow statement. What you have just done is create an account receivable.

You can also incur an expense but not pay it in cash. For instance, when I do a training for a university, they are getting the benefit of my services on the day that I do the training, but they won’t pay me for a few months. (Universities are notoriously slow to pay their vendors.) So they record an expense on the income statement for my fee and record an account payable. Again, there is no immediate impact on cash.

So, because of timing differences, the final net income—or the bottom line—on the income statement will never be the same as the ending cash balance on the cash flow statement. Under the accrual method, you record things before they impact cash.

A Real-Life Example of How Profit and Cash Differ

An engineer friend of mine once started a business with several of his engineer friends. They made global positioning systems and were geniuses in regard to the product. However, none of them knew how to run a business. My friend was given the responsibility for keeping the books and records and negotiating contracts. His title was “Engineer in Charge of Finance.” (Do you smell trouble here?)

After much suffering, he came to me and confessed that his partners were upset with him and that he was worried that the business was going to fail. He said that his partners expected the net income off the income statement to be in the bank account and they were very disturbed that they had to keep reaching into their own pockets to pay for payroll. Indeed, on the income statement they were very profitable, but they didn’t have any cash. They thought that my friend had made a major error in the way he was keeping the books or that he had misplaced huge amounts of cash.

What none of them understood was the accrual method of accounting and the importance of cash flow.

The company was indeed very profitable, because they had landed a juicy contract with the Coast Guard to equip its boats with global positioning systems. So on the income statement, they recorded a $400,000 sale. But does the Coast Guard pay fast? No! And the Coast Guard was paying in little bitty installments. My friend would install a global positioning unit on a boat and eventually bill the Coast Guard. The Coast Guard took several more months to pay. The cash was dripping in, not flowing.

Another mistake my friend made was to allow all of his employees to buy whatever they wanted. He didn’t think it was kind to place restrictions on what employees purchased, so he left it up to their discretion to buy what they needed. They had a lovely company boat—to test the global positioning equipment, of course—and art in the boardroom, fancy test equipment, and way, way too much raw materials inventory. And because he wanted to have good credit with all his vendors, he paid every bill that hit his mailbox immediately. Eww.

So no money was coming and a whole lot was going out. No wonder he was out of cash.

I introduced him to the cash flow statement and instructed him to watch it over the next few months. I asked him to plot out exactly what money was coming in each day and how much money was going out each day. This way he would know, ahead of time, whether he would have enough money to pay payroll. At the moment, all of his partners were tapped; they had no more money to contribute into the company. So he did what anyone would do and went to a bank for a loan. Any guesses what the bank told him? They turned him down because he was too much of a risk. Obviously he knew nothing about running a business or cash flow.

Instead the bank offered to factor his accounts receivable. Factoring, as explained in Chapter 2, is selling receivables to the bank or a factoring agent for cash. They pay much less than the receivables are worth, but then they are the ones waiting for payment.

My friend walked away with 87 cents on the dollar for his Coast Guard receivable, in cash, and was happy to have it. The interest rate was steep, but he had the money they needed to stay in business.

Unfortunately, as part of the factoring arrangement, the bank notified the Coast Guard to make future payments on the contract to the bank, not to my friend. This raised a concern with the Coast Guard, who knew that factoring was a high-cost, last-ditch effort to raise capital. They threatened to never do business with my friend again and to rescind their current contract. They didn’t want to do business with someone who would not be able to support the product years down the line.

Fortunately, after much negotiating and pleading, my friend was able to save his contract and relationship with the Coast Guard. He watched cash flow like a hawk and eventually sold his business to a competitor for millions of dollars. He is now happily retired and living on the Texas coast fishing.

The moral of this story is that profit and cash are different because of timing. The accrual method of accounting causes transactions to affect profit that won’t affect cash for months to come.