We are continuing our cash flow discussion this week with a look at some tools you can use and reports you can create and pull from accounting software for a better understanding of your current cash flow situation. If you’ve ever pulled a cash flow statement in QuickBooks and been utterly confused, you’re in the right place.

 

What we cover in this episode: 

  • 1:22 – Why are we concerned about cash flow?
  • 3:00 – Types of cash flow statements
  • 4:07 – What is a direct cash flow statement?
  • 5:03 – What is an indirect cash flow statement?
  • 5:56 – Explaining the indirect method and its purpose 
  • 11:22 – Is there any reason for business owners to regularly pull the indirect cash flow statement?
  • 14:38 – What do we do with this information?
  • 17:55 – Is it a manual process to create a direct cash flow statement? 
  • 19:11 – The importance of a safety net

Why are we concerned about cash flow?

Last week, in episode #21, we discussed how to Understand the Difference Between Cash Flow and Profit. There was a staggering statistic from SCORE that 82% of small businesses fail because of cash flow issues. We want to help business owners get a better grasp on where they stand. Understanding how cash flow ebbs and flows needs to be a huge priority. If the failure rate didn’t catch your attention, problems related to cash flow can also stunt your growth and cause stress. So our goal is to help you get a great handle on cash flow, become more proactive in managing your business and maintain control. 

We defined cash flow vs. profit and discussed potential implications of not managing cash flow, as well as best practices for cash flow continuity in our last episode. Head on over to episode #21 and listen to that one first before you dive into today’s topic.   

Types of cash flow statements

Have you ever looked at your QuickBooks cash flow statement and been a little lost? That’s probably because the one you’re looking at from QuickBooks is an indirect cash flow statement and isn’t as intuitive as a direct cash flow statement. We will explain both of these in greater detail below. If you’re not used to accounting or familiar with looking at financials, it’s confusing at first. So, that leads to the question – Why are there two different types of cash flow statements? One is more intuitive (direct), while the other is used commonly in the financial world. Both are important to understand, but we have to discuss each kind before we are able to answer that question entirely.

What is a direct cash flow statement?

Typically, a direct cash flow statement is not produced in software, but makes more sense logically. It lays out your money coming in and then your money going out (expenses, loans, payroll). The direct method is what you would think of if you were to sit down and create a cash flow statement yourself. But, there is a flaw in this when it comes to tying it to your financials. This method does not tie it into how cash flow relates to your profit, which is where the indirect method comes in. This method is very useful when it comes to cash flow projections.

What is an indirect cash flow statement?

The indirect cash flow statement is created to take either your profit or loss and reconcile it back to your cash flow. In the finance world, this is the cash flow statement you will be asked for, so it is important you understand how it works because it does matter when it comes to getting lending or selling your business for example. Its purpose is to show the relationship between how your profit relates to your cash flow. 

This method takes profit or loss at the top and it reconciles non cash flow items off like depreciation and bad debt first. These types of items are things that show up on your profit and loss statement, but you’re not paying any money from the bank. Again, this method is trying to take you from your financial statement to a cash basis, so these would be reconciled.

Next, the indirect method looks at accruals. For example, receivables and payables affect your profit and loss statement, but you haven’t exchanged cash yet. Yet again, those would be adjusted off to get back to a cash basis. Your next question might be, well why does the finance world use this method if the direct method seems more logical?

Explaining the indirect method and its purpose 

The main advantage of the indirect cash flow statement is it looks at how those things were used. From a banker or investor perspective, the indirect method provides a look at how your business’ cash flow plays into the P&L and shows the source. The indirect method gives a better picture of how the cash flows ebb and flow for the business and provides a better understanding of the utilization of the cash. There are three sections to the indirect cash flow statement – operational impact, investing impact and the financing impact. 

  • Operational impact – This focuses on anything related to running the business. The focus is getting to the net cash flow impact of the overall operations of the business, like getting revenue from clients and paying expenses. 
  • Investing impact – This relates to any investment activities that can impact cash flow, whether it’s from investors or any money you may put in yourself as the owner. This is a bit more direct in nature, but it’s not how you make your money as a business. This is not included in the operational cash flow but in the overall cash flow analysis. 
  • Financing impact – This takes a look at any loans you may have for the business. Again, not operational in nature, coming from the operations of business, but money coming from another source. 

Once you get all of the cash flow impacts together, you can see an overall picture of what is going on with your cash. How much of our cash came in from operations? How much came in from financing? 

Is there any reason for business owners to pull the indirect cash flow statement?

Alright, so now you may be wondering, do I need to pay attention to this report if it only matters to the finance world? The answer is YES! Why? Because you can’t just pull a report once and get a loan. You need to know and understand how your business looks to the outside world on a regular basis. If you are going for loans, you want to be able to do it at a time that is the best and most effective for your business. Also, as a business owner, it gives you more power to understand these reports. The more you look at them, the better you’ll get. 

While the direct cash flow statement is how we would project a cash flow budget, we recommend pulling the indirect cash flow statement with your monthly financials. You want to see your balance sheet, your Profit & Loss and your cash flow stmt. 

By looking at this report monthly, it adds utilization of cash to the picture that is missing from the balance sheet and P&L. Your balance sheet might show that you have receivables, but not the timing. Your P&L can show great profits, but if you’re not collecting it in a timely manner, cash flow suffers. The cash flow statement could shed light on the fact that you aren’t collecting your receivables fast enough, which would explain why you’re constantly tight on cash. It will show you how the cash flow ebbs and flows, where the cash is being used, how it is coming and going, and if it is tied up in inventory or receivables. 

What do we do with this information? 

Both the direct and indirect statements have their purpose. While the direct statement will show when and what’s coming in, it won’t show you that you have $200k in receivables you haven’t collected. You want to understand the indirect because of the role it plays in how your business appears to the outside world, but real-world every day cash flow management will happen with the direct method. 

Gather historical data or make estimates

Now we want to get into real life cash flow management. You have to gain an understanding of where you are now. What’s been going on? How is cash flow going? How have collections been? How has Accounts Payable been managed? Gather historical information on a monthly basis (12 months). If you don’t have historical data, you will have to start with some estimates and adjust as you gather more information.

Evaluate cash coming in

Layout what you expect to see coming in the door. What is coming down the pipeline? This not only includes sales, but any loan or investor influx. Look at all your inflows and the timing of each. Are they seasonal in nature? Do you have some months that are slower than others?

Evaluate cash going out

Look at your monthly bills, like overhead, rent, payroll, etc. Look at all your cash outflows and the timing of each of these.  Do you have a large insurance bill you have to pay every March? Ensure you are including those annual charges in addition to the monthly commitments you have. This is when you start to see your inflows aligning with the outflows to make sure you have enough cash to cover all of your expenses. 

Make projections

Project forward for the full year (by month) for what you expect. The next 90 days will be the most accurate because the further out, the less accurate so focus on the next quarter most heavily. This will allow you to set aside a reserve for that big insurance bill so you have funds available when it comes due, etc.   Projections will become more and more accurate as time progresses and helps significantly in business planning. 

Compare projections to actual on a monthly basis

Look at this every month. Start looking at the actuals next to what you projected and make updates as needed. By comparing to your actuals on a regular basis, you will see where they did and did not align and are able to make adjustments, improving your accuracy over time.

Is it a manual process to create a direct cash flow statement?

Typically you are creating your direct cash flow statement manually. There are tools you can use that will give you a good starting point though. If you pull a cash basis P&L from your accounting software, that will show you most ins and outs but will require you to look through it and ensure everything is there, like adding any necessary debt service or principal payments. Most softwares will not simply run a report that shows your cash flow this way, but this isn’t usually too difficult to pull together and begin projecting out for the year. You will probably spend a few hours putting the first one together. Managing this into the future becomes easier though.

The importance of a safety net

As you look at your cash flow projections, we always recommend setting up your safety net as well. It’s also a good idea to set up a reserve account that you put savings into monthly and establish a line of credit as well. The time to be doing that is when you don’t have issues. You are in a better position to apply and it’s there for when you do need it. 

Conclusion

Today’s episode was all focused on helping you gain control of your current cash flow situation. Cash flow issues are the main reason small business fail, so this is definitely not an area you want to ignore in your business. 

There are two different types of cash flow statements, which we explain and talk about why each one is important. The direct method is used more regularly in the day-to-day management of cash flow, while the indirect method is used by the outside world and lending. We define both types of statements and spend some time talking about why the indirect method is important to understand as an owner. 

There are three parts to the indirect methodology that we break down and explain. They are the operational impact, the investing impact and the financing impact. We then talk about when you should be looking at this report, as well as laying out the steps for getting a good handle on your current cash flow situation. By creating a direct cash flow statement manually, you will be able to pull together your inflows and outflows and project it out for the year, allowing you to see any potential issues before they arise. 

We also discuss the importance of a safety net. This could be in the form of a savings account or line of credit, but this is something to think about proactively. If you wait until you need it, many times it’s too late. Take the time to pull this information together because it could mean the difference between success and failure. If you have any questions, please email us at info@pjscpas.com.