Lets talk about cash flow & understanding the statement of cash flow.
Revenue, or sales, accounts are the selling value of goods or services billed to the organization’s customers. Revenue, also called “the top line” because of it’s location on the income statement, is the starting point for calculating net income.
Expenses are subtracted from revenues to get net income, which is the starting point for the Statement of Cash Flow. The reason that net income is the starting point is that, in a perfect cash-only world, net income would, in fact, be your cash flow. Even in an imperfect world, net income or loss is the basis for the direction of the cash flow.
After you have the net income, you add the non-cash expenses back into net income to arrive at an “Adjusted Net Income”. This is for items such as depreciation and amortization expenses because the cash was paid out at the point of acquiring the asset and the depreciation and/or amortization is only an administrative entry that has no effect on cash.
Cash from Investing
Buying & selling of investments & fixed assets
The term, “operations”, is used broadly here. It means cash generated from the regular operating of the business, doing what the business normally does in the regular course of business.
Increases in assets such as prepaid expenses and Accounts Receivable are considered a use of cash. In the case of prepaids, cash has already been spent which caused the asset to increase. An increase in Accounts Receivable is considered a use of cash as well, because Accounts Receivable is nothing more than materials, labor, overhead, and profit monetized together in the form of an invoice to the customer which is now receivable. Conversely, a decrease in prepaids would indicate that it has flowed through the Income Statement and is a source of cash. A decrease in Accounts Receivable also implies the receipt of cash, so the decrease in Accounts Receivable is considered a source of cash.
On the other side of the coin are accrued expenses and Accounts Payable. Increases in liabilities, such as Accounts Payable and accrued expenses are a source of cash because we are delaying payment on these items, thus we are able to use that equivalent cash somewhere else in the business.
As an example of this, think about a $150 invoice from an electrician to fix a light switch. The work is performed in March and you have net 30 terms. In the Statement of Cash Flows, the effect of the $150 in March is to reduce net income by $150 and, because you have net 30 terms, it would be a source of cash in Accounts Payable because you didn’t pay for the expense. The effect on cash in March is zero and is shown by a “use” in the reduced net income and a “source” in the increased Accounts Payable. In April, when the bill is paid, Accounts Payable is reduced which becomes a use of cash on the Statement of Cash Flows.
Inventory is an asset so it’s a good thing, right? What about Accounts Receivable, or overall working capital? Yes and no to all of these. “But we have great terms – we get net 60 days!” Great!… but while extended terms for Accounts Payable is a great thing for your cash, too much of a good thing (Accounts Receivable, inventory, etc..) can kill a business.
Many private companies have three months, or more, of raw material inventory on hand, two weeks in work-in-process, six weeks in finished goods, and then they have sixty days of sales outstanding in their Accounts Receivable. In this scenario, you bring material in and it will be seven months before you turn it into cash (3 months + two weeks + six weeks + 60 days). If the firms’ suppliers give net 30 terms, then it’s down to six months. These numbers are very common and in this situation, the company has to have the ability to finance its’ self for the six or seven month period before the company sees the cash for the product that it just brought in last month.
Also mentioned in the episode are the books, The Goal, and The Great Game of Business. Click here for more details.