Chapter 20
The Importance of Cash Flow – For Better, For Worse, For Richer, For Poorer…
A business is a lot like a marriage. It takes work to make it succeed. One of the keys to business success is managing and maintaining adequate cash flows. In the field of financial management, there is an old saying that revenue is vanity, profits are sanity, but cash is king. In other words, a firm’s revenues and profits may look spectacular, but this does not guarantee there will be cash in the bank. Without cash, a business cannot pay its bills and it will ultimately not survive.
Let’s take a look at the distinctions between revenue and profits, and cash, using a numeric example for a new business:
| Income Statement | Cash Flows | |||
|---|---|---|---|---|
| Revenue* | $1,000,000 | Revenue (cash received) | $400,000 | |
| Cost of goods sold** | (500,000) | Cost of goods sold (paid in cash) | (300,000) | |
| Gross profit | 500,000 | Net cash | 100,000 | |
| Operating expenses*** | 200,000 | Operating expenses (paid in cash) | 90,000 | |
| Net income/net profit | $300,000 | Net cash | $10,000 | |
* Sales of $400,000 were paid in cash
** Purchases of $300,000 were paid in cash
*** Operating expenses of $90,000 were cash paid
Revenue is reported in the income statement as $1 million which is a sizeable amount, but only $400,000 was cash paid by customers. (The rest is reported as accounts receivable.) Gross profit is reported in the income statement as $500,000. This is also a respectable number, but only $100,000 translates into a positive cash flow, because some of the inventory purchases were paid in cash. (The rest of the inventory is reported as accounts payable.) The company must still pay some of its operating expenses, leaving only $10,000 cash in the bank.
When investors and creditors review the income statement, they will see $1 million in revenue with gross profits of one-half million or 50%, and a respectable net income of $300,000 or 30% of revenue. They could conclude that this looks pretty good for the first year of operations and incorrectly assume that the company now has $300,000 available to spend.
However, lurking deeper in the financial statements is the cash position of the company–the amount of cash left over from this operating cycle. Sadly, there is only $10,000 cash in the bank, so the company cannot even pay its remaining accounts payable in the short term. So, how can management keep track of its cash?
The statement of cash flows is the definitive financial statement to bridge the gaps between revenues and profits, and cash. Therefore, it is vital to understand the statement of cash flows.
