How To Understand Your Business’s Cash Flow
Money is coming in, but where’s it going? You’ve been expecting to see your accounts flush with a lot of revenue, but why isn’t that the case?
You may be hitting the ground running with new revenue opportunities and increased sales, but are scratching your head when you review the financials and trying to understand where all that money went. To figure out just what is happening with that revenue, you’ll need to take a good look at your cash flows.
This guide will go over how to undertake a cash flow analysis, understand why your balance sheet is important, where your operating activities might be creating long- or short-term cash flow issues, and how to fix such problems to maximize your company’s financial performance.
What Does Cash Flow Mean?
Cash flows demonstrate when money is coming in and when it is going out. If you were able to conduct your entire business with actual cash, this would be a breeze, but the truth is that few businesses have much cash on hand these days.
Toss in credit purchases, loans, investments, and extensions of credit to your customer, though, and you will see how quickly the concept of cash flows becomes quite complicated.
8 Most Common Cash Flow Models
Each of the following models serve specific purposes and can be adapted to the unique needs and circumstances of a business. The choice of model and its complexity will depend on the business’s size, industry, and strategic financial management objectives. Click here for cash flow Excel/Google Sheet templates.
1. Direct Cash Flow Model
Explanation: The direct cash flow model calculates cash flows by listing all cash business activities, including cash receipts from customers and cash payments to suppliers and employees. This model is straightforward and focuses on the actual cash transactions that occur within a specific period.
Real-World Example: A small retail business may use a direct cash flow model to track daily or weekly cash movements. By monitoring cash inflows from sales and outflows from expenses like rent, utilities, and inventory purchases, the business can manage its cash on hand efficiently and make informed decisions about ordering inventory or offering promotions.
Complexity: This model is relatively simple and direct, making it accessible for small businesses or those with straightforward cash transactions. However, it can become more detailed when tracking numerous sources of income and various expense categories.
2. Indirect Cash Flow Model
Explanation: The indirect cash flow model starts with net income from the income statement and adjusts for non-cash transactions, depreciation, changes in working capital, and other operating activities. This model is used to bridge the gap between accrual accounting and cash operations, providing a view of cash flow that complements the income statement and balance sheet.
Real-World Example: A manufacturing company with complex operations and significant investments in equipment might use the indirect cash flow model. By adjusting its net income for depreciation, changes in inventory levels, receivables, and payables, the company can understand how its operations impact cash flow, separate from its accounting profits.
Complexity: The indirect cash flow model can become quite complex, especially for larger organizations with many non-cash transactions and significant changes in working capital components. It requires a thorough understanding of accounting principles and financial statements.
3. Free Cash Flow (FCF) Model
Explanation: The free cash flow model calculates the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s an important measure for investors, indicating the cash available for expansion, debt repayment, dividends, and stock buybacks.
Real-World Example: A tech company looking to evaluate its growth prospects and investment attractiveness might use the FCF model. By calculating free cash flow, it can demonstrate its ability to fund new projects, acquire other companies, or return value to shareholders without needing external financing.
Complexity: While the concept of free cash flow is straightforward, calculating it accurately can get complex, especially for businesses with significant capital expenditures or irregular investment activities. It requires careful analysis of operational cash flow and investments.
4. Projected Cash Flow Model
Explanation: This model forecasts future cash inflows and outflows based on historical data, expected sales growth, and planned expenditures. It’s crucial for strategic planning, budgeting, and ensuring liquidity over the short and long term.
Real-World Example: A construction company planning for upcoming projects might use a projected cash flow model. By estimating future cash receipts from projects and the timing of expenses for materials, labor, and equipment, the company can plan its cash flow to ensure it has enough liquidity to cover costs and take on new projects without financial strain.
Complexity: Projected cash flow models can range from moderately complex to highly detailed, depending on the length of the projection period, the variability in the business cycle, and the precision of the assumptions used. They require a deep understanding of the business, market trends, and potential financial impacts of strategic decisions.
5. Scenario-Based Cash Flow Model
Explanation: This model involves creating multiple cash flow forecasts based on different scenarios, including best-case, worst-case, and most likely scenarios. It helps businesses understand the potential impacts of various external factors on their cash flow, such as changes in market conditions, economic downturns, or unexpected expenses.
Real-World Example: A tourism company might use a scenario-based cash flow model to plan for different tourism trends or events, such as a significant increase in visitors during a popular festival or a decrease due to a natural disaster. By preparing for multiple scenarios, the company can devise strategies to manage cash flow effectively under different circumstances.
Complexity: Scenario-based models can become complex as they require detailed assumptions and forecasts for each scenario. They also demand a good understanding of the business environment and the factors that could significantly impact the company’s financials.
6. Cash Flow Budgeting Model
Explanation: This model is a detailed plan that estimates future cash inflows and outflows over a specific period, often aligned with the fiscal year. It’s used for budgeting purposes, helping businesses allocate resources efficiently and plan for financial sustainability.
Real-World Example: A nonprofit organization might use a cash flow budgeting model to plan its expenditures around grant receipts, fundraising events, and operational costs. This ensures that it can fund its programs throughout the year without running into liquidity issues.
Complexity: The complexity of a cash flow budgeting model varies with the size of the business and the detail of the budget. It requires accurate estimation of future cash flows and regular monitoring to adjust for any discrepancies between projected and actual figures.
7. Capital Expenditure (CapEx) Cash Flow Model
Explanation: This model focuses on the cash flow related to a company’s investments in physical assets such as property, plant, and equipment. It’s crucial for businesses that require significant capital investments to grow and maintain operations.
Real-World Example: A manufacturing company planning to expand its production capacity might use a CapEx cash flow model to evaluate the timing and impact of investing in new machinery. This helps ensure that the company maintains sufficient liquidity while investing in growth.
Complexity: The CapEx model can be complex due to the need to forecast investment returns, operational impacts, and financing arrangements. It requires a thorough analysis of investment costs, benefits, and the timing of cash flows.
8. Consolidated Cash Flow Model
Explanation: This model combines the cash flows of different business units or projects into a single, comprehensive overview. It’s used by larger corporations to get a holistic view of the cash flow status across all operations.
Real-World Example: A multinational corporation with operations in multiple countries might use a consolidated cash flow model to aggregate the cash flows from all its subsidiaries. This provides a clear picture of the company’s overall financial health and liquidity position.
Complexity: Consolidated cash flow models are among the most complex due to the need to account for various currencies, inter-company transactions, and the diverse nature of operations across different regions. It requires sophisticated financial modeling and a deep understanding of international finance.
4 Tips to Better Understand Your Cash Flow
There are a few steps you can take to get a better handle on your company’s operating cash flow, accounts receivable, net income, income statement, and other measures or flows of cash going into and out of your accounts.
Understanding the numbers and where they originate (or go) will go a long way in helping you make sure you’re setting your company up for future business success.
1. Create a Cash Flow Statement
The first step to maintaining a clear view of your cash flows is creating a well-structured cash flow statement.
A cash flow statement is similar to your profit and loss (P&L) statement as both represent activity over a period of time. Whether for a short-term time (like a single month) or a long-term one (such as a full year), the cash flow statement shows how individual balances related to how cash inflows and outflows change over the selected period.
Note: What Makes Up A Cash Flow Statement
Your cash flow statement differs from a balance sheet, which exhibits financial balances at a point in time, because it typically starts with the opening balances of your cash accounts at the top of the period.
These balances are then adjusted by cash flows related to operating activities, investment activities, and financing activities. In the end, the statement will reconcile to your period-end cash account balances.
2. Take a Look at Your Operating Activities
Operating activities will make up a majority of your cash flow changes each month. A few quick notes on what to keep in mind during this step:
- Sales receipts, expenses paid, general expenses paid, and employee costs paid would be part of this business activities category and important for any analysis of a company’s cash balance.
- Taking inventory of such expenses related to operations is key to understanding where your money is going each month.
- You might find that there are elements you’re paying for in that balance that you no longer need for the future, for example, thus creating opportunities for savings.
It’s important to remember that sales or purchases made on credit are not included in the cash flow activity, only actual payments made or received. Be sure you’re examining the right aspects of your business operations here so you can get an accurate accounting of your assets, expenses, and operating cash flow.
3. Consider Your Investing Activities
Investing activities are financial moves related to the sale and purchase of investments and any income, such as dividends and interest, received from said investments. A significant event in this area can show you if you are reserving funds for future needs or moving funds from investment accounts to cash accounts.
Negative cash flow for this category indicates you are moving more funds to investments. In contrast, positive cash flow is a sign you are withdrawing invested assets for the business’ other cash needs. Healthy investing activities can be key for company success, especially small business growth, while unhealthy ones could mean you end up with an increase in debt or SG&A expenses that you are not equipped to manage.
4. Examine Cash Flow from Financing Activities.
Financing activities include both cash inflows and outflows related to invested capital, dividends, and long-term debts. These events occur less frequently — often one time per year — for many businesses, so they play a smaller role in regular cash flow management. For others, these financing activities happen in more short-term time frames and thus have more regular impacts on income, expenses, and cash balance.
Either way, keeping an eye on your company’s cash flow from financing activities is important to overall operations because it may make a huge difference in the available amount of money or assets.
Alternative Approaches to Creating Cash Flow Statements
There are alternative approaches to creating a cash flow statement, and the method you use may be dictated by the accounting principles and audit requirements for your business or industry. An accountant can help you with this, but here are a few other cash flow-related items to keep in mind:
- Proper setup and recording of transactions in your accounting software will demonstrate if your business activities are appropriately balanced between incoming and outgoing funds.
- Taking steps for proper setup will ensure your company is viable and profitable as you grow.
- Simply monitoring your success based on your bank balance or income statement is not sufficient in today’s credit-laden environment.
- You need to become invested in understanding how your cash flow impacts your financial statements.
- Regular reviews of cash will show you exactly where the money you bring in goes.
- It will also help you understand where you can make changes in your operations to improve value.
Even if you have a consistently positive cash flow, a periodic review of your cash flow statement will enable you to answer questions such as:
- Should I invest more of my funds for future needs?
- Am I overburdened with servicing debt?
- Can I afford to buy additional supplies or inventory at a bulk rate discount?
- Are there places where I might be inefficient?
- Should I consult a professional for guidance on investing, accounting, or other financial needs?
Keep each of these questions in mind as you look for where your revenue is being used, and always be sure to ask a financial expert or tax advisor if you are concerned about the ways your cash flow might impact your business operations. It’s better to understand your net cash flow and the amount of cash you have on hand so you can make the best plans for the future.
Making Smart Cash Flow Decisions
Monitoring cash flow will be a huge aid in the decision-making necessary to increase profits and grow your business. Remember:
- Information derived from your company cash flow statement will help you determine when it is feasible to expand your business, invest in new technologies, or accept new opportunities that require an upfront expenditure.
- The answer to how this can be done — with current cash available, by taking on additional debt, or by tapping into reserves — will be found in your cash flow.
- Without this information, you, as the decision-maker, may be flying by the seat of your pants and hoping for the best.
- Using the tools included with your own set of financials, you can make informed decisions that consistently increase your company’s value and net income.
Additional Cash Flow Questions?
Do you have questions about your cash flow statement or how the amount or types of cash that enter and leave your business might be impacting your bottom line?
Contact the experts at Silver Tax Group today. Our expert team of tax professionals is happy to help you understand your balance sheet and how best to claim your profits and expenses come tax season.
