Not enough companies are listening to their balance sheets.
Balance sheets tell a story about your company’s financial health, but only 7% of small business owners generate monthly financial statements. Privately held mid-sized businesses fare better at consistent financial statements, but their leaders tend to focus on the Profit and Loss (P&L) numbers. While P&L illuminates profitability, it doesn’t address the most critical element of a business—cash flow.
The story of your cash flow lives in the balance sheet. It reports the company’s assets (what it owns), liabilities (what it owes), and net worth (the difference between what it owns and what it owes).
Generally, you can calculate the cash flow in the period between balance sheets as the change in the cash account(s) minus the change in the loan account(s).
For example, if your beginning balance sheet shows $500 in cash and the ending balance sheet shows that you still have $500, the change in the cash accounts is $0. If your beginning balance sheet shows $1000 in loans and the ending balance sheet shows $700, the difference is -$300. The change in the cash accounts ($0) minus the change in the loan accounts (-$300) is the net cash flow ($300), so you generated $300 in cash. However, you used it to pay down a loan which is why your cash balance didn’t change.
But your P&L says you generated $1000 in profit—so how did you only generate $300 in cash? Once again, the story is in the balance sheets. Here is how we write the story, chapter by chapter.
Chapter 1: Company Profit
Your company’s profitability is the first indicator of its financial health. Along with the P&L, profit may also be found in retained earnings on the balance sheet. This chapter is comprised of revenue (the combination of price and sales volume), cost of goods sold, and operating expenses.
Chapter 2: Working Capital
Working capital = accounts receivable + inventory – accounts payable
Working capital represents your available operating liquidity. In other words, it’s the money available to meet current, short-term obligations.
Chapter 3: “Other Capital”
Other capital = all other assets – other liabilities
“Other assets” are everything else outside of cash and working capital assets. “Other liabilities” are all the liabilities except accounts payable and loan accounts (which are part of the net cash flow).
Chapter 4: Net Cash Flow
In chapter 4, the story finally comes together. Using the data from chapters 1-3, you can calculate your company’s net cash flow and get a better picture of the financial health of your business.
The first three chapters let you know how well you managed your business to generate cash through profits and how you used that cash, and chapter four indicates your net cash flow.
As a leader in your company, you are responsible for ensuring profits and using your cash wisely. In the above example, management invested an additional $1.5 million into working capital.
In Part Two of this article, we will examine if the working capital (and therefore the cash) was well managed. So as you are writing the story of your business through your balance sheet, we hope it ends well with lots of cash flow. But if you don’t like your company’s financial story, we’re here to help. Contact iMpact Utah today.