As gasoline is to a car, cash is to a business. Cash is the fuel that makes your business go – without it, the business simply cannot run. As an owner or manager, it’s vital that your understanding of financial statements goes beyond the Income Statement to include the Statement of Cash Flows.
The Income Statement reports revenues and expenses over a period of time, for example, the year Ended December 31, 2009. If revenues exceed expenses, you’ve got a profit. Congratulations! But profits are only part of the story.
In my experience, the Statement of Cash Flows has traditionally been the most troublesome for small business owners, entrepreneurs, and non-financial managers. The Statement of Cash Flows is similar to the Income Statement, in that it reflects a series of transactions over a given period of time, with two major differences:
- The Income Statement reflects accrual-based transactions, while the Statement of Cash Flows includes only cash-based transactions; and
- Certain types of transactions do not appear in the Income Statement, because they are not considered to be revenues or expenses.
#1 – Accrual-Based Transactions vs. Cash Transactions
In general, the Income Statement is prepared using what accountants refer to as the accrual basis – revenues are recorded when earned and expenses are recorded when incurred. Therefore, revenues and expenses reported in the Income Statement do not necessarily reflect cash transactions.
For example, revenue is recorded in the Income Statement the moment a sale takes place, even if the cash from that sale will be received in the future (i.e. accounts receivable). For purposes of the Statement of Cash Flows, the same transaction is recorded during the period the cash is received from the customer.
Similarly, an invoice for cleaning services is recorded as an expense in the Income Statement at the time those services are rendered. The same transaction is reported in the Statement of Cash Flows when the actual payment is made to the vendor.
#2 – Other Transactions
The Statement of Cash Flows also includes certain transactions (both cash inflows and outflows) that do not appear in the Income Statement.
For example, your company borrows $100,000 from the bank. This transaction, which does not appear in the Income Statement because it is not considered revenue, will appear in the Statement of Cash Flows as a cash inflow. Similarly, repayments of that loan are reported only in the Statement of Cash Flows as cash outflows. If you think about it, this makes sense – when we think of revenues, we think of income from customers in exchange for goods and services we provide. Intuitively, we know that a $100,000 loan from the bank doesn’t meet the definition of earned revenue, and therefore probably shouldn’t be included in measuring the results of our operations.
Similarly, purchases of long-lived assets are not presented in the Income Statement, but rather in the Statement of Cash Flows. If your business purchased a piece of equipment for $150,000, it wouldn’t make sense to report it as an expense in the year it was purchased, because it would distort operating results for that year. Instead, accountants have figured out a way to systematically allocate a portion of the total cost of the equipment to the Income Statement over a period of years in the form of depreciation expense. Although depreciation is considered an expense, it does not consume cash, so it is reported as an adjustment to net income in the Statement of Cash Flows.
Keep an eye on profits, but keep a closer eye on cash flows. Profits are great, but cash still pays the bills.
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