A Practical Perspective on Cash Flow

February 2007

Most of you know my view of how to manage cash flow. The Four Principles of Happy Cash Flow book contains tips for how to maximize your cash through managing your working capital. Here is another perspective written by Brian Hamilton, the owner of Sageworks, a company that designs financial analysis software.

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If You Manage Nothing Else...

By Brian Hamilton, CEO, ProfitCents

People say that businesses fail because they run out of cash. This is like saying that someone is dead because he does not have a pulse—not an especially useful diagnosis. Businesses fail because they get sick and can't recover. Eventually, they run out of cash. All businesses get sick at one time or another, so entrepreneurs have to be ready to meet their tangible cash needs.

Know How To Read A Cash Flow Statement

"Making money" is one thing, but generating cash is quite another. Certainly you'd like to boast more revenues than expenses in a given period. Yet for a host of accounting reasons, you can show positive earnings on your income statement but be draining cash at the same time. (Remember Enron?) There is plenty of debate about
the relative value of the three main financial statements: income statement, balance sheet and cash flow statement. Certainly all are important for different reasons, but for small companies, the cash flow statement may be the most critical.

First, a quick refresher. The cash flow statement is a marriage of the two other financial statements: It combines operating activities (shown in the income statement) with changes in balance sheet accounts to paint a picture of how the cold cash is "flowing." All sections of the cash flow statement are important, but the section labeled "cash flow from operations" is definitely the most important because it represents how much cash a company is generating from its core operations. The cash flow statement accounts for profits and losses, as well as any "working capital" changes—fluctuations in current assets and current liabilities, such as accounts receivable and accounts payable.

Let's take an example. Say your business has revenues of $100 for a given month, but all the merchandise was sold on credit (meaning that you didn't actually receive the cash in that period). Now say total cash outlays were $75 for the period. In this case, your income statement would report a "profit" of $25 ($100 in total revenues less $75 in expenses). Fair enough. Meanwhile, however, "cash flow from operations" dropped by $75. That's because the business had to pay $75 in cash expenses but did not collect any offsetting cash from customers. (An increase of $100 to accounts receivable balances the books.)

Now consider the flip side. Say your company pulls in $200 in cash revenues but shelled out $400 in expenses—only $100 of which was paid in cash during the period, with the rest being "financed" via accounts payable. In this case, the income statement shows a loss of $200—that's $200 in sales less $400 in expenses—yet the company generated $100 in positive cash flow from operations. How? Remember, you received $200 in cash but paid out only $100 in expenses, leaving $100 in cash left over.

This drama plays out in the cash flow statement, which would show $200 in losses offset by a $300 increase in accounts payable.

Managing Your Cash Flow

The lesson here is clear: Managers must manage their working capital accounts to maximize cash flow. One way to do that is to offer different credit terms to different customers. (Most small businesses don't think to do this.) Generally speaking, reports on "aging" accounts—receivables, inventory, payables, etc.—need to be reviewed regularly.

Here are some other things to keep in mind when managing cash flow:

• Get access to short-term credit. Small businesses often don't have predictable cash flows. Having access to short-term credit—such as credit cards, home equity lines and credit lines from a bank—can make all the difference when weathering sudden shortfalls in ready cash.
• Prepare realistic monthly forecasts. Entrepreneurs are inherently optimistic—an admirable quality, and all the more reason they should create clear-eyed forecasts for the coming months. There are plenty of easy-to-use software tools available, including ProfitCents (developed by my company, Sageworks), Intuit's (nasdaq: INTU - news - people ) QuickBooks or just a plain old Microsoft Excel spreadsheet.
• Make a personal budget. Entrepreneurs need not only mind the shop's cash drawer; they also have to keep their households financially sound. Put another way, the business has to throw off at least as much cash as the entrepreneur needs to live. This might sound like an obvious point, but it's one that often gets lost in the excitement and mayhem of running a small company.

Cash is a company's lifeblood. Managing it is something that all entrepreneurs can do effectively—that is, if they want to stay in business.

About the Author

Brian Hamilton is the chief executive officer and leader of the management team for Sageworks, Inc., which develops ProfitCents (www.profitcents.com), an application that aids accountants in communicating with clients. Brian can be reached at brian.hamilton@sageworksinc.com or 919.851.7474 (x501).