CHAPTER 2

STARTING WITH CASH FLOWS

Cash Flows—Just How Important Is It for a Business?

Not so long ago, back before central bankers and governments both near and far had to bail out the world’s economies, the concept of understanding cash flow was basically a foreign language, best left to the bean counters and Wall Street financial types to deal with. This was before the worst financial crisis to hit the United States (and for that matter, the world) since the Great Depression was experienced, starting in 2008 with the collapse of Bear Stearns and Lehman Brothers, which laid the foundation for the start of the Great Recession (that many still argue the world has not fully emerged from).

You may be asking why this reference is being provided, which is simple. Unlike central banks, businesses cannot magically create cash when needed and out of thin air but rather must understand what sources of cash are available and how cash is used or consumed.

Now let’s go back in time to pre-2008, when life for businesses, governments, and even the individual consumer was different. Capital or access to cash was readily available, credit underwriting standards were limited to poor (think residential real estate mortgage lending), financial markets appeared healthy, and economic growth was solid if not strong across most industries. The focus in the mid-2000s time period was not on understanding or even caring about cash flow but rather, most parties were concentrated on a financial report perceived to be more important, the income statement or profit and loss statement (the P&L). And why not? Times were good and the income statement was going to relay just how much profit a business was producing and how wealthy everyone had become. Oh how quickly times have changed!

There’s no doubt that the income statement (covered in-depth in Chapter 4) is important as it is designed to measure how much net profit or loss a business generates over a period of time. The problem that arises is when a party becomes too fixated or overly reliant on just the income statement and does not bother to understand the income statement’s two ugly stepsisters, the balance sheet and the statement of cash flows. As most savvy parties will attest, paying attention to and understanding cash flows represents the economic backbone of every company that hopes to survive, grow, and prosper.

And because businesses can’t print or create “cash” on demand such as the world’s central banks, it goes without saying that in this day and age of economic uncertainty, a business’s ability to generate internal cash flows can mean the difference between life and death.

• The income statement: It is important to understand the income statement but remember this represents just one element of a business’s financial condition and tells only a portion of its financial health story.
• The balance sheet: Appropriately, the quick and frequently used reference or acronym for the balance sheet is “BS.” So without going into a great deal here, it is of critical importance that you trust the balance sheet. That is, you need to make sure the assets listed on the balance sheet are not lying and its liabilities presented are telling the whole truth.
• The statement of cash flows: Understand the P&L and trust the BS but most importantly, rely on the cash flow statement. The cash flow statement is the lifeblood of every business and offers invaluable insight into the financial condition of a business as to how it produces and consumes cash, in good times and bad.

So now that we have your attention on understanding the importance of cash flow, we dive into this concept head first with Exhibit 2.1. For our example we use a business that has been operating many years. This established business makes profit regularly and, equally important, it keeps good financial conditions. It has a good credit history, and banks lend money to the business on competitive terms. Its present stockholders would be willing to invest additional capital in the business, if needed. None of this comes easy. It takes good management to make profit consistently, to secure capital, and to stay out of financial trouble. Many businesses fail these imperatives, especially when the going gets tough.

EXHIBIT 2.1—SUMMARY OF CASH FLOWS DURING YEAR

Dollar Amounts in Thousands

Exhibit 2.1 summarizes the company’s cash inflows and outflows for the year just ended, and shows two separate groups of cash flows. First are the cash flows of its profit-making activities—cash inflows from sales and cash outflows for expenses. Second are the other cash inflows and outflows of the business—raising capital, investing capital in assets, and distributing some of its profit to shareowners.

We assume that you’re familiar with the cash inflows and outflows listed in Exhibit 2.1. Therefore, we are brief in describing the cash flows at this early point in the book:

• The business received $51,680,000 during the year from selling products to its customers. It should be no surprise that this is its largest source of cash inflow. Cash inflow from sales revenue is needed for paying expenses. During the year the company paid $34,760,000 for the products it sells to customers. And, it had sizable cash outflows for operating expenses, interest on its debt (borrowed money), and income tax. The net result of its cash flows of profit-making activities is a $3,105,000 cash increase for the year—an extremely important number that managers, lenders, and investors watch closely.
• Moving on to the second group of cash flows during the year, the business increased the amount borrowed on notes payable $625,000, and its stockholders invested an additional $175,000 in the business. Together these two external sources of capital provided $800,000, which is in addition to the internal $3,105,000 cash from its profit-making activities during the year. On the other side of the ledger, the business spent $3,625,000 for building improvements, for new machines and equipment, and for intangible assets. Finally, the business distributed $750,000 cash to its stockholders from profit. This distribution from profit is included in the second group of cash flows. In other words, the $3,105,000 cash flow from profit is before the distribution to shareowners.
• The net result of all cash inflows and outflows is a $470,000 cash decrease during the year. Don’t jump to any conclusions; the net decrease in cash in and of itself is neither good nor bad. You need more information than just the summary of cash flows to come to any conclusions about the financial performance and situation of the business.

Cash Flows—What Does It Not Tell You?

In Exhibit 2.1 we see that cash, the all-important lubricant of business activity, decreased $470,000 during the year. In other words, the total of cash outflows exceeded the total of cash inflows by this amount for the year. The cash decrease and the reasons for the decrease are very important information. The cash flows summary tells an important part of the story of the business. But, cash flows do not tell the whole story. Parties need to know two other types of information about a business that are not reported in its cash flows summary.

These two important types of information (as summarized in Chapter 1 and discussed in more depth in Chapters 3 and 4) are: