3 Signals from your Cash Flow Statement You Can’t Ignore

Amongst a flurry of paperwork that a business owner reads, sorts, and misplaces in a given quarter, there are three fundamental financial documents you’ll receive from your accountant. We’ve written before about the Balance Sheet and Income Statement. But your Statement of Cash Flows (SCF), or Cash Flow Statement, is the most important of all.

Unlike the Balance Sheet, which acts more like a snapshot, the SCF shows the impact that the activity of your assets has on your business over a period of time.

Think of it this way: if your life was put into an Income Statement, it would take into account the money you earned when you earned it. In reality, most of us have to wait for payday. Meanwhile, the Cash Flow Statement considers only the cash you have on hand day to day, like what’s going in and out of your bank account or Venmo balance when Tina pays you for her portion of brunch.

And cash is important. The ability to pay immediate debts and cover regular expenses is the thin line between you and a downward financial spiral. It’s vitally important information for you to have. Money can’t buy you love, but it can keep your business liquid.

At its most basic, the SCF shows cash flow from three areas of your business:

-Operating: sales of core business products or services and related expenses;

-Investing: changes (and exchanges) in equipment, assets, or investments; and,

-Financing: cash flows from stock and debt management.

Being able to read and understand your Statement of Cash Flows is fundamental. (For a more in-depth explanation, click here.) But interpreting the signals your SCF may be giving you is a more subtle art. One that should be an ongoing conversation between you and your accountant. Below, we’ll explore three sneaky ways your SCF may be signaling important information to you, and why you can’t afford to ignore it.

The Cash Flow Statement shows whether you can cover immediate and ongoing expenses.

To be fair, this one may feel like a big “duh.” Paying suppliers, employees, rent, etc. in a timely manner depends on a consistent, liquid cash pool.

Besides pure numbers of cash inflow and outflow, another way to track this is with the “Operating Cash Flow Ratio”. That is, you take your Cash Flow from Operations off of your SCF, and divide it by your Current Liabilities from your Balance Sheet. This gives you an easily digestible single number that represents whether or not you’re able to cover current liabilities with current net cash inflows.

An ideal number is 1.0 or above, meaning you got the cash! Above 1.0 means you have cash left over to cover any emergencies, or start reinvesting.

Now, if this ratio is trending downwards, or is under 1.0...that’s when mental alarm bells should start ringing. You’re about to feel a squeeze, and you need to figure out what’s going wrong quickly, before debt piles up.

Tracking this number is fundamental, and tracking it over time is smart as well. If it’s trending upwards, you know you’re doing something right. Also, be aware that potential buyers and creditors will be keeping a close eye on this ratio.

The Cash Flow Statement can be used to predict future cash flow.

Remember what I said about tracking trends above? Taking multiple SCF’s over time and comparing them will give you a glimpse of any trajectories your current business model is sending you on. This is extremely important for future planning, and modeling for expansion and growth.

In practical terms, tracking trends on the SCF can, for example, help you model at what point you will have the cash flow to re-invest in better equipment, or open a new storefront. If cash flow is consistent, you can chart the fact that given a predictable influx and outflux, such possibilities will be feasible in six months, two years, etc.

Like all those productivity and self-help books told you: a plan without a deadline is just a wish. And tracking trends on the SCF will help you set realistic deadlines, and stick to your expansion plans.

The Cash Flow Statement can help monitor profitability as you grow.

This last one is probably the most sophisticated metric we’ll discuss today... but stick with me. If you take the Operating Cash Flow from your SCF and divide it by Net Sales on your Income Statement, you’ll get a ratio called “Cash Flow to Sales”.

This ratio tells you exactly how much cash is generated for each dollar of sales. Obviously, the higher the number, the better, as it measures profitability in your core business.

Comparing this ratio over time as your business grows will tell you if growth is affecting profitability. For example, if you notice it’s declining as sales increase, take note. Are you being forced to spend more on overhead as you expand? Take a close look at your business model. Expansion should ideally lead to more profitability per unit sold, and if it’s not, you need to figure out why.

Or perhaps you’re being a little lax with payment options. It’s possible that contracts with long-term clients are causing cash to get caught up in accounts receivable, draining cash reserves but not overall net profits. Tina from brunch saying she’ll hit up your Venmo account after splitting bottomless mimosas isn’t the same as her actually transferring that money to you immediately.

The SCF is a useful tool.

Just like a hammer, it’s less about what the Statement of Cash Flow is, and more about how you use it. A smart business owner will use the SCF to track liquidity, growth, and profitability over the long term, and quickly flag any warning signs they absolutely can’t ignore. Keep the above metrics in mind, stay in conversation with your accountant, and you’ll be well ahead of the curve.