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There are four essential metrics when it comes to financial reporting for investors and business owners: 1) net income, 2) revenue, 3) net worth, and 4) total assets. Cash flow is the real winning card when it comes to assessing creditworthiness and short-term financial performance. A business can find itself in hot water when it doesn’t have enough cash on hand to pay rent, payroll, and other bills-no matter how fast it’s growing or how profitable it is.
That’s why it’s crucial to prioritize the statement of cash flows and the insights it provides.
Monitor Your Cash
A company’s ability to manage cash can be found within the statement of cash flows. It illustrates the changes in balance sheet items over accounting periods. Special attention should be given to significant balance changes as well.
For instance, if accounts receivable increased from $1 million in 2018 to $2 million in 2019, the $1 million increase would be considered cash outflow.
This is due to more money being tied up in receivables in 2019. It is common for growing businesses to see an uptick in receivables due to their growth in proportion to revenue. The mounting receivable balance may be a sign of cash management inefficiencies. Any additional financial information, such as an aging schedule, may reveal notable write-offs.
Continuous reporting of negative cash flows from operations may also be a dangerous sign. There’s a cap on how much money a company can receive from selling off assets, taking on more debt, or issuing new stock. When operating cash outflows outpace operating inflows consistently, a red flag should go up. It can be a sign of weaknesses, such as poor inventory management, mounting costs, weak customer demand, and out-of-control growth.
How to Categorize Cash Flows
Three sections make up the statement of cash flows:
- Operations. This section converts accrual net income to cash provided or used by operations. Included here are all the income-related items of the cash flow statement, such as gains (or losses) on asset sales; depreciation and amortization; net income; and net changes in inventory, prepaid assets, accrued payables and expenses, and accounts receivable.
- Investing activities. A purchase or sale of property, equipment, or marketable securities would end up here. This section shows whether a company is reinvesting in future operations or divesting assets for emergency funds.
- Financing activities. This shows transactions with investors and lenders. Examples include Treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.
Below these three categories are the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.
Keeping a watchful eye
Effective cash management can be the difference between staying afloat and filing for bankruptcy — especially in an unpredictable economy. Contact us to help identify potential problems and find solutions to shore up inefficiencies and shortfalls.