Four Things a Cash Flow Statement Tells You

CFS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a cash flow statement and balance sheet.

A pro forma cash flow statement shows all cash that you expect will come into the company and all cash that you expect will go out of the company during a period of time based on your stated assumptions.

The cash flow statement answers four questions for you and your potential investors:

  1. Does the cash at the end of the period (the last line of each column of the cash flow statement) equal the top line (i.e., cash and cash equivalents) of the balance sheet? Make sure you are comparing a cash flow statement that ends on the same date as the date of the balance sheet.
  2. Does the company run out of money? Is the cash balance at the end of any period negative? Check on both the annual cash flow statement and on the monthly cash flow statement.
  3. Does the company’s core business eventually generate enough cash to sustain itself? You will learn this by examining the line net cash provided (used) by operating activities. For the first few years, this is likely to be negative (with the cash shortfall made up for by influxes of cash from loans and/or investments).But eventually, the company should be able to sustain itself. When net cash provided (used) by operating activities becomes positive, the company has achieved a sustainable growth engine (see Eric Ries’ The Lean Startup).
  4. Is an investment being used to pay off a loan? Most investors want their cash to be used to grow the company; they do not want it used to retire debt. Such a situation can be most easily seen by examining the monthly cash flow statement. Look at any month in which the line issuance of stock has a positive entry. Is there a corresponding negative entry on the line proceeds from (payments on) notes payable? If so, there could be a problem.However, in some cases this could be okay, e.g., when the lender holds a convertible note and the note is simply converting into equity. In such cases, no cash is actually changing hands; it is simply a bookkeeping entry and a conversion from debt to equity for the same party.

Let’s take a look at a cash flow statement to understand how these four questions get answered.

The figure below shows a cash flow statement for the first five years of a company.

Sample CFS

All cash flow statements are organized into three horizontal sections, each corresponding to a different set of events that cause cash to flow into or out of the company:

 Cash flows from operating activities

Cash flows from operating activities show cash that relates to your primary business. The first entry is profit or loss from the business (copied from the bottom of the income statement). The rest of the entries are adjustments because not all profits or losses are reflected in cash. So, for example:

  • Depreciation was on the income statement and contributed to expenses (and thus decreased profit), but unlike other expenses, it caused no corresponding reduction to cash. Therefore the first thing we do on the cash flow statement is add back the amount of depreciation.
  • Any decrease (or increase) in accounts receivable between the last period and the current period must be reported here as an increase (or decrease) in cash.Notice that if customers pay you during the current period for something that they purchased in a previous period, no entry is made on the income statement, but you did have a positive cash event. That cash event is recorded on this line.
  • Any increase (or decrease) in accounts payable must be added to (or subtracted from) cash for the same reason as explained above for accounts receivable.
  • If there is any change in the accrued liabilities between the last period and the current period, that change needs to be added to or subtracted from cash.
  • Any changes to inventory would not be reflected in your income statement but would affect cash. Specifically, if you increased your inventory since the previous period, that needs to be reflected as a net cash loss, and a decrease would be reflected as a net cash gain.

The sum of the above items is shown as net cash provided (used) by operating activities.

Cash flows from investing activities

Cash flows from investing activities show cash that relates to your major purchases (or sales) of fixed assets (e.g., real estate, equipment, acquisitions, vehicles, computers, and so on.)

Notice that although such major purchases cannot be subtracted from your earnings in the current year (that’s why they don’t appear on your income statement), they do impact cash!

The full amount of their purchase is recorded here because the company is incurring the entire cost of the asset from a cash perspective. Their sum is shown as the net cash provided (used) by investing activities.

Cash flows from financing activities

Cash flows from financing activities show cash that relates to financing your business, e.g., loans you accept (or make payments on) and investments received by the company.

It is shown on two separate lines, one for investments, and one for loans. Notice that loans and investments you accept have no effect on your income statement but have a significant effect on your cash, which is why they appear here. Their sum is shown as net cash provided (used) by financing activities.

Summary lines on your cash flow statement

At the bottom of each column a few summary lines appear:

  • The net increase (decrease) in cash line shows the sum of the net cash subtotals from the three aforementioned sections.
  • The cash at beginning of period starts at zero when the company is founded. Each subsequent year just copies the value from the end of the previous year.
  • The cash at end of period is calculated by adding the net increase (decrease) in cash to the cash at beginning of period.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash. You could also be unprofitable and have cash (e.g., with the help of highly optimistic investors).

Using your cash flow statement is the best way to find out exactly where your company is getting and spending its cash.

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Ken Teegardin (Creative Commons).