Financial statements are business owners’ tools to make informed business decisions. A balance sheet tells you how valuable your business is. The income statement tells the efficiency of your business operations. Many business owners have survived just by using these two statements. However, many business owners overlook the cash flow statement. It can be your saviour at times of crisis when the business is slow, expenses are drying up, and cash reserves are limited. Studies show that the single largest cause of business failure is cash crunch, and yet the cash flow statement stays in the shadows of its other financial statements.

A business that can read cash flow statements with entrepreneurial insight can improve profitability and business value and prepare for the next stage of business finance.

What Does a Cash Flow Statement Tell You?

The balance sheet and income statement provide a broader picture of the business’s finances, while the cash flow statement goes into detail and tracks cash inflows and outflows. It is free from adjustments and reports the truth about hard cash.

The cash flow statement categorizes cash movement based on the source:

• Cash flow from operations (CFO) tells you how much cash your operations generated. It adds cash inflows from customers and debtors and deducts cash outflows to suppliers, employees, tax authorities, and others.
• Cash flow from investing (CFI) tells you how much cash was used to buy assets like furniture, equipment, stocks of other companies, and cash inflow from the sale of assets, interest income, and capital gain from investments.
• Cash flow from financing (CFF) tells you the cash movement in the company’s capital structure: cash inflows from taking new loans or raising equity capital, and cash outflows from interest on loans, dividends to shareholders, share buybacks, and loan repayments.

Business Decisions That Need Cash Flow Statements

You can read your cash flow statements and derive insights to unlock value from your business without increasing sales. Here are a few scenarios:

Help Startups Manage Initial Losses

For a startup, the financing cash will be high as you use your savings and take a loan to start a business. In the early years, business operations may generate negative cash flows as you spend more than you earn. For instance, Jake opens a bakery and spends on rent, website, raw materials, marketing, and delivery costs. Since his business is new, he may not get enough orders to meet his expenses, leading to negative cash flow.

Jake needs to track operating cash outflows and ensure he has sufficient financing cash inflows to cover his losses. This will let him know in advance how many days of cash he has left, so he can make alternative funding arrangements, such as borrowing from friends, using a credit card, taking out bank loans, or selling non-core assets, to secure cash.

Unlock Business Value for a Profitable Business

The cash flow statement shows which source is generating the most cash and where your cash is draining. If your CFO is consistently lower than net income, your cash is probably stuck in customer credits (accounts payable). You can dig into your accounts receivable, follow up with clients to collect payments, and unlock stuck cash. Another scenario could be a significant cash drain from financing activity because your operations are unable to keep up with debt and dividend payments. This could trigger the need for debt restructuring or dividend cuts to prevent the financing cash drain from depleting your cash reserve.

Manage Daily Operations Smoothly

A business needs adequate cash inflow to meet its immediate obligations, such as salaries, rent, and utilities. Some cash ratios can serve as indicators of your cash flow health.

• Operating Cash Flow Ratio = CFO/current liabilities

It tells you if your operations are generating sufficient cash to meet current liabilities due in the next 12 months. A ratio of below 1.0 could be a warning sign of cash shortages, and you can apply for a working capital loan. You can adjust this ratio by maintaining a cash reserve to cover such shortages.

• Current Ratio = Current Assets / Current Liabilities

The current asset includes the cash reserve and indicates whether your business has sufficient liquidity to meet its current liabilities.

If your business has long inventory cycles, you may use the quick ratio to assess its liquidity.

• Quick Ratio = Current Assets – Inventory / Current Liabilities

Improve Capital Structure and Optimize Capital Allocation

The cash flow statement can not only help manage operations but also improve a company’s capital structure, which comprises debt and equity. You can determine whether your operations can maintain your existing capital structure by examining operating and financing cash flows. For instance, Mary is earning $25,000 in cash from operations but is experiencing a cash outflow of $28,000 in loan interest. She could restructure the debt with lower interest rates and longer maturities, unlock any stuck cash in operations, and prioritize debt repayment, starting with high-interest debt.

Making Informed Investment Decisions

Operating and financing cash flows can tell you whether the business has surplus cash. If the business is consistently generating surplus cash, it can consider investing that money in business or in stocks, mutual funds, real estate, and other instruments to diversify its source of income. For instance, Bella reports $50,000 in operating cash inflows and $10,000 in financing cash outflows. She can use the $40,000 surplus cash to buy equipment and reduce the lease expense. The new equipment will help her generate more operating cash, which she can invest in stocks, thereby compounding returns.

Making Financing Decisions

It is easy to invest in business growth when you have surplus cash. Sometimes a growth opportunity comes knocking, and you need a significant amount to scale your operations. At times like these, you seek external financing. A lender will look at your operating cash flow to see if you can service your debt. As business grows, so will your operating cash flow, which you can use to reduce debt.

Contact Glenn Graydon Wright LLP in Oakville to Help You with Financial Statement Analysis

To make optimal use of the statement, you need accurate, up-to-date cash records and the ability to see the story behind the numbers. Many new entrepreneurs may not have the experience or skill to crunch the numbers. You could consider hiring a skilled business consultant to analyze and use the data to improve your business finances and unlock value. To learn more about how Glenn Graydon Wright LLP can provide you with the best accounting and business services, contact us at 905-845-6633 or connect with us online to schedule an initial consultation.