Understanding Your Business’s Cash Balance and Cash Flow

People often ignore the subject of cash balance and cash flow until they have to deal with it. There are just too many things to deal with and decisions you need to make. However, every decision you make will eventually affect your cash. Many people have enough problems understanding their own personal cash situation; when you add in the complexity of a business, many people just want to ignore the subject.

There’s the assumption they just need to do more of what they’re good at, and the cash will take care of itself. The entrepreneur who makes a living making big sales figures another big sale or two will take care of the cash problem.

Dealing with a problem indirectly is not the best way to solve a problem. Once you understand the importance of cash, what it tells you, and what can help you control it, you’ll feel more empowered to deal with it.

How Your Decisions Can Affect Your Business’s Cash

the importance of cash balanceWe’ve all stood on the scale and tried to rationalize the number staring back at us. Our weight is a reflection of our past decisions. Yes, other factors can affect our weight, but at the end of the day, the calories we take in, and the energy we expend are the biggest factors in determining our weight.

Just as people choose to eat unhealthy food that results in a little added fat on the body, businesses also make decisions that have consequences. Some cash decisions are explicit, such as building a new store, hiring people, raising prices, and borrowing money. Other decisions are made by abdication such as not raising prices, not closing a facility that is losing money, and not reducing overhead costs.

What Is Cash?

Cash is an asset that allows a company to pay or satisfy its liabilities as they come. Cash is often used interchangeably with cash balance to describe the amount the company has at the bank after all transactions clear.

A company can borrow to increase its cash; however, those borrowings come with restrictions and security agreements to give the lender comfort they will be repaid. Borrowed money has strings attached.

Lines of credit can skew a company’s cash situation and give management the sense they have a more unrestricted cash balance than reality. The section below shows the same net situation depending on how much the company draws on its line of credit.

A line of credit is generally payable within the next 12 months, so it’s a short-term liability. In reality, a company’s cash position is its cash balance less repayment of short-term debts. This example shows the company’s net cash is cash balance less repayment of outstanding line of credit balance.

cash balance grid

What Is Cash Flow?

Once you understand the static cash terms, the next term to address is cash flow. Cash balances go up and down. Where did the money go or come from? Cash flow describes the increase and decrease of the company’s cash balance during a period of time.

Traditional cash flow

The traditional definition of cash flow is the amount a company’s cash balance increases or decreases during a specific period. An increase in the cash balances from the beginning of the year would be called positive cash flow. If the cash balances were to decrease, there would be a negative cash flow.

Operating cash flow

Operating cash flow describes how much a company’s cash balance went up or down during a period of time-based on its normal activities. It starts with the profit or loss for the period and then takes into account the following:

  • Whether the company collected on its sales (accounts receivable)
  • Whether the company paid its vendors for expenses incurred during the period (accounts payable)
  • Other activities that use or generate additional cash from normal operations.

This does not include cash flow related to borrowings or repayment of borrowings, investments in assets, and other non-normal operation activities.

Free cash flow

Free cash flow is the amount of cash the company generated during the period after paying all its obligations due and necessary capital expenditures. This number more than net income can indicate the true performance of a company for a period of time.

Understanding the Statement of Cash Flows

Truly understanding cash will help in assessing the health of your company, making decisions, and determining priorities. Every month, a company should have financial statements which generally include an Income Statement, Balance Sheet and Statement of Cash Flows.

People often omit or ignore the Statement of Cash Flows, but it provides critical information. Compared to the other two financial statements, the Statement of Cash Flows is the most difficult at first to understand. But when you do understand it, the fog surrounding cash balance will start to lift.

Your controller or CPA can help you understand your Statement of Cash Flows. They can also show you cash used or generated in investing or financing activities which will give you the true free cash flow of a company. With their help, you can even create a better cash balance plan for future periods.

Understanding the harsh reality of cash, what the different terms are saying, and how to read a Statement of Cash Flow will help you make better decisions and improve your business. Without sufficient cash, a company will die.

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