Part I
Fitting Cash Flow into the Big Picture of Running a Business
In this part . . .
We begin with the first rule of business â you canât run out of cash. Business managers and owners need to understand cash flow. The logical place to start is cash flow from making profit. When you read about revenue and expenses in an income statement (also known as a profit and loss report), you arenât reading cash-flow numbers. The cash flows of revenue and expenses are different, and youâd better know why.
Business managers and owners need to know how to read their three basic financial statements from the cash-flow point of view, and that includes having a sure grip on the statement of cash flows and how it connects with the balance sheet and income statement. Ignoring cash flow is not an option in managing a business â unless you have more cash than you know what to do with. Many businesses operate with a razor-thin cash balance, so understanding cash flow should be a top priority.
Chapter 1
Getting in Sync with the Rhythm of Cash
In This Chapter
Defining the number one business rule: Donât run out of cash
Reviewing how revenue and expenses are tracked
Differentiating profit and cash flow: Kissing cousins but not identical twins
Sorting out basic types of cash flows
In running a business, you have to follow many rules, but one rule stands above the others: Donât run out of cash. As obvious as you may think this rule is, the importance and difficulty of maintaining an adequate cash balance are generally taken for granted in business management books and articles. Many business managers ignore cash until a serious problem pops up. They assume that cash will take care of itself, as if cash could be put on automatic pilot. Nothing is farther from the truth. If you donât pay attention to cash, you may be in for a nasty surprise.
To control cash, you must control cash inflows and cash outflows. To do that, you need cash-flow information, and you need to know how well your current cash balance stacks up against the short-term demands on cash. Managers depend on regular accounting reports for financial information; in particular, their monthly income statement (also called the profit and loss, or P&L, report). However, the income statement doesnât provide the cash-flow information you need.
You must turn to another financial statement for cash-flow information, appropriately called the statement of cash flows. But here is where things get rather befuddling for the business manager. The cash-flow statement lists adjustments to profit to arrive at the cash flow from making profit. It assumes that the reader has a good basic understanding of profit accounting and, therefore, knows why adjustments are necessary to find cash flow. But in our experience, business managers do not fully understand how their accountants measure profit, which makes understanding cash flow and why itâs higher or lower than profit very difficult.
This chapter starts by pointing out the catastrophic consequences of running out of cash. Next, we offer a brief review of profit accounting and the assets and liabilities that are used in recording revenue and expenses. Changes in these assets and liabilities are the reasons why cash flow differs from profit. Then the chapter takes the first steps in explaining the cash-flow aspects of making profit and why cash flow is invariably higher or lower than the bottom-line profit or loss number in the income statement. We also explain the cash-flow side of business transactions and the basic classes of cash flows.
Not Letting the Well Run Dry
One morning you arrive at your business. As usual, youâre the first person to arrive. But none of your employees come to work. Not one. Who will open the doors for customers? Who will sell your products? Who will start tapping on the computers? This scenario may seem like a nightmare, but itâs not the worst thing that can happen to a business.
Hereâs the real fiasco you should worry about: One day your accountant rushes into your office and tells you that the businessâs bank account balance is zero. You have $50 in petty cash and a small amount of currency in the cash registers. But thatâs it. Your checking account is empty. You canât cut any checks to your vendors, who will cut off your credit if not paid on time. You have a sizable payroll to meet in two days. If not paid, your employees will quit. And your bank is sure to notice that your checking account balance is zip and may consider shutting down your credit line. Itâs not a pretty picture, is it?
A zero cash balance puts you on the edge of a cliff. One false step and you can fall off and be unable to recover. When your suppliers, employees, and sources of capital find out about your cash problems â and they will â your credibility drops to zero. The businesses and various people you deal with depend on your ability to continue as a going business that they can rely on in the future. Running out of cash would pull the rug out from under the reputation of your business that you worked so hard to build up over the years. You could lose your business to creditors or have to declare bankruptcy.
Running out of cash is an extreme, worst-case scenario, although itâs a threat many businesses face. The purpose of mentioning it here is to emphasize its disaster potential for a business. Running out of cash is not just a life-changing event for a business; it can be a life-ending event. Business managers should never let their guard down regarding cash and cash flows.
Surprisingly, many business managers, small-business owners/mangers in particular, do not take an aggressive, proactive approach toward controlling cash. Instead of learning cash-flow fundamentals and techniques of controlling cash flows, they retreat into a passive mode. But very few businesses have the luxury of sitting on hoards of cash such that they really donât have to worry about the cash balance period to period. Many businesses operate on a razor-thin cash balance.
Outlining Profit Accounting Basics
The best way to avoid cash-flow problems and to generate a stream of cash flow is to earn profit. Measuring profit (or loss) is the job of your accountant. Each period your accountant prepares an income statement that summarizes revenue and expenses and profit (or loss) for the period. To understand cash flow emanating from profit, you need to understand how your accountant records revenue and expenses. Otherwise youâll be confused about why your cash flow from profit during the period is different from your profit for the period. You donât have to delve into the technical aspects of revenue and expense accounting â just understand the basics. This section gives you the brief overview you need to go forward with managing cash flow.
Weâre optimistic that you know that profit is the excess of revenue over expenses (and loss is the excess of expenses over revenue). We mention it simply to stress that profit accounting really refers to revenue and expense accounting. Profit (or loss) is just the residual number left over after recording revenue and expenses for the period.
The brief discussion of revenue and expense accounting in this section is no more than dipping our toes in the water. Profit accounting involves much, much more than this very brief introduction covers. We go into more details later in this chapter in and future chapters. For a more extensive explanation of accounting methods and problems, see Accounting For Dummies, 4th Edition, by John A. Tracy (John Wiley & Sons, Inc.).
Reviewing revenue accounting
When a sale is made for âcash on the barrelhead,â to use an old expression, cash increases and the accountant increases the sales revenue account the same amount. At the retail level, most sales are for cash; currency and coins are received by the business, or a credit or debit card is accepted that almost immediately increases the cash account of the business. In contrast, many businesses sell on credit, especially to other businesses. No money is collected from the customer until a month or so after the sale. In those cases, the accountant records the sale immediately by increasing an asset account called accounts receivable and increases sales revenue the same amount. When the customer pays later, cash is increased and the accounts receivable asset is decreased. Notice the time lag between the two events â point one when the sale is recorded and point two when the cash is received.
Revenue accounting can be much more complicated than recording simple cash and credit sales. For example, some businesses collect cash from customers before delivering the product or service, such as newspapers that collect subscriptions in advance before delivering the papers, and insurance companies that collect premiums before the insurance period coverage begins. But in any case, recording revenue is coupled with a corresponding increase in an asset or, in some cases, a decrease in a liability.
Examining expense accounting
A business records many expenses by decreasing cash and increasing an expense account, such as paying the monthly utility bill for gas and electricity. This transaction is straightforward enough: Cash decreases and an expen...
