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Are you worried you’re running out of cash for your business? Do you find your business doesn’t have money to pay your bills or do you run short on cash for payroll? In this video, I’m gonna show you how to create a cash flow statement to better manage how your business is spending money.
Keeping track of finances is hard for many small business owners and many of our clients get overwhelmed for fear of messing up their accounting. What if you could have a simple document that was generated automatically to show the flow of cash into, and out of, the business and know if you could meet your business obligations? In this video, I’ll explain what a cash flow statement is, the components of a cash flow statement, and how to use it for your business.
What is a Cash Flow Statement
The statement of cash flows is the last of our 3 basic financial statements the business owner can use to track their business finances. The cash flow statement is used to perform a cash flow analysis and to determine the liquidity
of the small business.
The cash flow statement is created automatically through some accounting software like Quickbooks or Wave by running a report or arranging a copy from your accountant or bookkeeper. If you were to build this statement by hand it’s compiled with a balance sheet and income statement. We’ll touch on where these numbers come from and how it affects your business.
There are a couple of different ways the cash flow
statement is compiled: Direct and Indirect. The direct method is calculated when cash is paid, receipts from clients and payments are made in salaries. The direct method is easiest for a small business when using the cash basis of accounting. The indirect method adjusts for the non-cash items from other statements to identify an accurate cash flow.
Components of Cash Flow Statement
The cash flow statement is broken down into three separate sections that show the inflows and outflows of cash from operations, investing, and financing within the business. So let’s look at each section.
Cash Flow from Operations Activities
The cash flow from operations identifies the inflows and outflows of cash due to operations. This will include receipts for payments to your business for delivering a product or service. Outflows of cash can be payments for materials, to suppliers, or for wages from payroll.
This information would come directly from the income statement for receipts or payments for materials and suppliers. Payroll costs would be compiled from payroll numbers or from your 940 that show what you actually paid to your employees.
Cash Flow from Investing Activities
This section shows business purchases of assets like equipment, buildings, and marketable securities for cash payments. In our example, we see an outflow for payment for an equipment purchase of $40,000.
This amount comes from a one-time expense for home office equipment found on the income statement. Cash inflows accounted for in this section would include receipts from the sales of an asset like equipment, buildings, or securities.
Cash Flow from Financing Activities
The final section of the cash flow statements includes sources of cash from investors or banks and these cash inflows would be shown as capital raised from loans or equity. Outflows of cash would be payments of dividends, stock buybacks, or payments of outstanding loans.
In our example, the statement includes $60,000 in loan payments for a bank loan of $400,000. We get the information on the $400,000 bank loan from the balance sheet but the $60,000 will be the individual payments made during the period.
How to Use it for your Business
Besides analyzing the general liquidity of the business, there are a few ratios that compare the cash flow statement and the other two financial statements.
Current Liability Coverage Ratio
Our first ratio is the current liability coverage ratio
. If you remember our balance sheet video, a current liability is one that needs to be paid within 1 year. This means the ratio indicates a business’s liquidity and if it can generate enough cash to pay those obligations within 1 year. The ratio does account for dividends that are paid to investors for this calculation. The formula for the current liability coverage ratio is:
Current Liability Coverage Ratio =
(Net Cash from Operating Activities – Cash Dividends) / Average Current Liabilities
Current Liability Coverage Ratio = ($168,000 – 0) / $200,000
From our example
, net cash from operating activities is $168,000 but since we don’t have any dividends to pay this will be $0. We will still take this $168,000 / $200,000 which comes to 0.84. A ratio result of less than 1.0 like this example is one where a business is suffering a liquidity crisis.
Operating Cash Flow Ratio
The operating cash flow ratio
is a liquidity ratio used to determine if a business generates enough cash to meet basic business operations. Unlike the current liability ratio, this ratio does not include dividends in the calculation. This ratio is also used to determine its short-term liabilities considering dividends and can be used to analyze a business’s health by the business owner or an investor. To determine the operating cash flow ratio is:
Operating Cash Flow Ratio =
Net Cash Flow from Operations / Current Liabilities
Operating Cash Flow Ratio = $168,000 / $200,000 = 0.84
Using our example
, the net cash flow from operations is $168,000, and our current liabilities come from our balance sheet which totals $200,000 which results in 0.84. A ratio of less than 1.0 means the business is experiencing a cash crisis.
Cash flow coverage ratio
Our third ratio is the cash flow coverage ratio.
This particular formula is a solvency ratio which means it is geared more towards the long term. This cash flow ratio determines if a small business can cover long-term liabilities or debt with a maturity of longer than a year. The ratio formula we use to determine this is:
Cash Flow Coverage Ratio =
Net Cash From Operations / Total Liabilities
Cash Flow Coverage Ratio = $168,000 / $ 600,000 = 0.28
For our example
, we again use Net Cash From Operations which is $168,000 then this by total liabilities of $600,000 that we get from our balance sheet again. The result of this formula is 0.28, which if you have followed the other ratios needs to be 1.0. Because our result is 0.28, this means our example business is in danger of defaulting on its debt.
The cash flow statement is a powerful and effective document to analyze the business’s liquidity. If you run a small business then you know that “Cash is King” and long as you have the cash to run the business you are doing well.
You also need to understand that “Cash flow is Queen” and maintaining a positive cash flow into the business is arguably the most critical metric for any business owner. Tracking your cash flow can be done quarterly but if you need to be in a good cash position, you should generate this statement once a month yourself or from an accountant.
Do you know your cash position and how often to check your cash flow? Let me know down in the comments below.
Funded in part through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, conclusions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.