Some Basic Concepts Relating to Cashflow

 In Cash Flow

In Chapter 2 of the cashflow drivers ebook I touch on some of the basics surrounding the financials. I am not an accountant by any means so I have put Chapter 2 into terms a non-accountant can understand (that non-accountant being me). I encourage any feedback or comments.

One needs to be familiar with the basics of accounting and the structure of financial statements, ratio analysis and construction of a cash flow statement as it will be easier to understand the nuances of cash flow. While some transactions within the organization affect cash flow, others do not. We can consider the accounting system as more or less the language that helps us interpret and assess entries made in the balance sheet and income statement. These two are critical statements. Let us take a brief look at these and how the cash flow statement differs.

The Balance Sheet

The balance sheet describes the assets of the business, the business’s net worth and owner equity and the business’s liabilities. A business that is not aware of cash flow dynamics is committing suicide. In fact, more companies go bankrupt because of cash flow dynamics ignorance than because of fraud, disaster, competition etc. I was at a Westpac function last week and out of all the companies that go into liquidation as much as 40% of them are profitable businesses. If you look at the HIH disaster their accounts were showing a profit before they went under.

The Income Statement

The income statement shows the details of cash flow, but does not show the source of cash or how it was utilized. It only shows income and expense which relate to value flow, rather than cash flow.

The Cash Flow Statement

The cash flow statement, on the other hand, combines the balance sheet and income statement information, showing the true picture about cash flow. You can prepare the cash flow statement using a beginning balance sheet, an ending balance sheet and an income statement for the period in between. The balance sheet and income statement bring the time dimension into the cash flow statement. The balance sheet shows cost of inventory and accounts receivable, allowing you to get an idea of cash flow in the near future. As your business converts inventory into sales and accounts receivables and thereafter, back to cash, the inventory and accounts receivables help to predict cash flow from these sources.

With the balance sheet and income statement, you can match revenue to the time period in which the activity generating revenue occurs.  While the balance sheet and income statement are not concerned with actual payment receipt dates, cash flow deals with these realities.

It is a fact that revenue growth shows that the organization is growing. Cash flow keeps tabs on the ability to grow. If there is no inflow of revenue, it means the organization has to change. This is done by most businesses by letting go of staff, merging with another business, selling assets , etc. For a business, it is important to know where the firm is going, why it is going there and the related cash implications of this movement. It is not enough for only the top management to be aware of this information. Other key personnel in the organization must also be tuned to this line of thinking to enable them to set cash driver objectives. These objectives, in turn, should be conveyed to those whose jobs influence the business.  The business must be ready for overall growth and not just sales growth.

Obviously, it is positive cash flow that indicates that a business is sustainable, regardless of its size or industry. The business may get its cash inflow from its own operations or from outside sources, namely, its customers. Ultimately, it is cash flow that decides whether the business will thrive or barely survive.

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