Understanding your cash flows is critical in running a business, just as understanding your training log is critical for backpacking. As a hiker, I know the miles that I need to achieve each weekend and how often I need to hike in preparation for my next successful backpacking trip.
As a business owner, do you know how much cash you need to run your business or how much cash you need to prepare for your next successful year?
The cash flow statement is a very powerful tool in determining financial stability of your business and to determine future needs. It also compliments the income statement by reconciling your net income to your net cash.
3 key indicators your Statement of Cash Flows could be telling you.
The statement of cash flows, a required financial statement, is one of your best business tools. Classifying cash receipts and cash payments into three categories (operations, investments and finance). Separate disclosure of non-cash investing and financing activities is also necessary.
Operating net cash flows is an important measurement because it indicates how much cash your business generates from operations. Businesses commonly use the direct and indirect method for reporting the operating activities. Regardless of the method, the amount of cash flows from operating activities is the same. The operating activities include the cash receipts from the sales of goods and services and cash payments to suppliers and employees for inventory and expenses. Users of the statements, such as investors, lenders, and other external parties, look closely on these activities to assess the ability of the business to generate positive cash flows and its financial health. Users can use the operating cash flow statements from several periods to determine a trend in cash. A positive trend can indicate financial health, whereas a declining trend can indicate a weakness.
Using my hiking analogy, operating activities is comparable to how well you are performing in your mountaineering plan. Are you putting in enough distance and elevation effort to have successful backpacking? A business owner may question how well their operations are performing in a certain financial period?
Investing net cash flows is an important measurement because it indicates how much cash you are using to grow your business and planning for long-term. The investing activities commonly include purchasing of long-term assets, making and collecting loans, and purchasing and disposing of investments. Users look closely on this to see how much cash you are using to expand your business. As a hiker, am I investing in the tools that I need to produce results? Keeping the same hiking boots for years will not help me out and will probably result in having to take time off due to injury. What happens if you do not invest for the equipment needed to run your business? Can you afford for your production to be stopped or be postponed?
Financing net cash flows is an important measurement because it indicates your ability to repay debts and how much return you are providing your investors. The financing activities commonly include the liability and equity items such as cash amounts obtained from creditors and repayment of the amounts borrowed, cash amounts obtained from owners and a return on their investment. Users look closely on this to assess the ability of the business to meet obligations to repay loans and pay dividends. As a hiker, am I meeting my goals? Have I committed to a hiking a new trail? Did I postpone this hike? As a business owner, did you obtain financing by committing to certain terms? Did you pay down your debt or did you have to obtain additional financing?
How well do you know cash activities in your business?
Business owners should start, if not doing so already, using your cash flow statements for internal planning. You can estimate your cash flows based on current and historical cash flow trends that can identify and avoid potential funding shortfalls. Just like hikers use their mileage log to train for backpacking trips and achieve their personal record. If I fall short on my hike time, I will look back at my hiking trend to identify what I did wrong and how I can improve for the next hike. If a business owner falls short on their cash, they can look back at the year and identify what went wrong and how they can improve for the next year.