Cash Flow Statement: Your “Show Me The Money” Statement

Look at your financials in 3-DLet’s start with a little quiz:

• Do you review your accounts every month and by no later than the 10th working day after the last month end?
• Does your review include all 3 financial statements – Profit and Loss (or Income) Statement, Cash Flow Statement and Balance Sheet and compare them against your Budget?
• Does your review include Aged Debtors, Aged Creditors and other key indicators for your business (for example, your sales pipeline)?
• Does your review include a high level Forecast (as distinct from Budget) for at least the next month, if not for the quarter?
• Do you review your progress against action plans for achieving your strategic goals?

If you answered NO to any of the above, perhaps it’s time to think about doing all of the above.

Why Do Monthly Business Reviews

The monthly review is about “working ON your business”. Are you tracking to budget? What’s the status with your key business indicators? Are you on track to with the execution and achievement of the strategic goals that you have set for the financial year?

Ideally the review should take the form of a scheduled regular monthly meeting with your key management team and your independent advisory board. If you don’t have an advisory board, you should at least have an independent “accountability partner” such as your accountant or business advisor facilitate the discussion.

This article is focused on the financial aspect of monthly reviews. However, I should stress that this is not the only perspective that should be covered in the monthly business review. The other key aspects of your business that should also be addressed are Customers, Internal Processes, Employee Learning & Growth. (Note: This is the Balanced Scorecard framework which is a highly effective management system for setting, tracking and achieving key business objectives and strategies.)

Monthly Financial Health Check

A financial review is about bean reading as distinct from bean counting. Your financials are the equivalent of a business health check report card. Any adverse or unusual numbers, ratios or emergence of adverse trends are symptoms of potential business health issues which should be promptly investigated to determine the underlying cause(s).

Timeliness is therefore critical. It could prove fatal for your business to only discover in June 2010 that a critical business issue has been festering since say, September 2009.

Damage control by way of rectification action(s) or roll-out of alternative strategies has a higher chance of being effective in the early stages of ‘infection’.

Review Financials in 3-D

An apparently healthy profit figure in itself is not a reliable indicator of business financial health. Remember:

“Profit is opinion. Cash is fact.”

It is essential to take a 3-D view of the business i.e. Profit & Loss (performance), Balance Sheet (position) and Cash Flow Statement (lifeblood!).

The Cash Flow Statement is the Show Me The Money part of your accounts. It shows you:

• where the cash is coming in from, and
• where the cash is going or being used for.

This key financial statement provides critical management information yet the preparation, let alone review, of the Cash Flow Statement is almost always overlooked by SMBs. The only time it is done by an SMB is when the business is required to prepare and lodge Corporations Act financial reports and even then, the business usually only does it as a lip service to compliance and the statement is never given the close attention it deserves.

Other Benefits of Reviewing the Cash Flow Statement

• It is a quick way of finding out if your Profit and Loss and/or Balance Sheet are correct. A balanced Balance Sheet (ie Assets = Liabilities + Equity) doesn’t necessarily mean that your accounts are correct.
• It will tell you whether there have been prior period adjustments to your Profit and Loss and/or Balance Sheet. Prior period adjustments (eg going back and changing say the Sales figures in the July 2009 accounts in January 2009) are an absolute no-no from a risk management perspective.

  To use a football analogy, this is tantamount to changing the 1st quarter’s scores in the 3rd quarter of the game. How do you know whether you are winning or losing if previous scores keep changing?

  It also opens greater potential for fraud. Do not permit prior period adjustments: your accounts should be locked down after close of each month’s accounts.

Understanding the Cash Flow Statement

Below is an example is drawn from a real turnaround situation that I am involved with. I think it underscores the importance of preparing and reviewing the Cash Flow Statement as part of your monthly financial reviews.

This Statement was prepared in the course of developing a financing proposal for the client. I used the monthly Profit and Loss Statements and Balance Sheets that had prepared by the company’s accountant. It highlighted a raft of issues with the accounts and as a result, the bank required (not unreasonably) a clean up of the accounts before it was prepared to consider the financing request. This essential step has resulted in (a) the client incurring additional costs at the worst time; and (b) delay in achieving a resolution.

The table below sets out extracts of Months 1 and Months 6 to 9 of the company’s Cash Flow Statement. The Explanatory Notes that follows walks you what each section of the Statement means in general; not the specifics of this company’s numbers.

Explanatory Notes

The structure of this Cash Flow Statement is not in accordance with that under Accounting Standards AASB 107 nor is it intended to be so. Rather, it is designed to be a practical business management tool.

This Statement gives you a snapshot of how much money came in or went out of the business and the 3 key areas where it came from or in which it was being used; being (a) trading operations; (b) fixed assets; and (c) financing (whether in the form of shareholder funding or debt financing).

1. The starting point is the net Profit/(Loss) from the Profit & Loss Statement. The objective is to adjust the accounting profit/loss for non-cash items such as depreciation and amortisation so as to derive a proxy for cash profit.

   Other adjustments such as the add back of financing charges and deduction of profit on sale of fixed assets (or add back of loss on sale of fixed assets) are also made as there are not “operational” items.

   Financing costs are also backed out of the profit figure so as to eliminate the effect of the financing structure from the operational cash flow of the business.

2. The Adjusted Trading Profit that is derived is the proxy for the cash profit from trading operations.
3. The next step is to then identify the movements in working capital items. This is based on movements in the relevant balance sheet items. It tells you how much cash has been used for (or generated from) working capital to achieve the trading profit.

   A negative Net Cash Flow from Working Capital changes is not necessarily bad: if you are selling primarily on credit terms and you are increasing your inventory to meet increased demand, this will be negative as you have to tie up more money in debtors and stock.

   What you do need to do is plan how you intend to finance the working capital requirements.

   The sum of Adjusted Trading Profit and Net Cash Flow from Working Capital changes show you the net cash flow from your day-to-day operations: your trading profit and the amount of money that is up in working capital to generate that trading profit.

4. The Investment Activities section shows you how much money was spent on fixed assets. It also shows the cash received from any sale of fixed assets. A loss on sale of fixed assets in the Profit & Loss doesn’t mean no cash came in the door. That loss is based on the sale price minus the depreciated value of the asset. You could have sold a car for $10,000. The depreciated value may only have been $12,000 resulting in an accounting loss of $2,000. BUT you would still have received cash of $10,000. Whether or not you had to pay out a lease will be reflected in the section dealing with your financing activities.
   In this example, you will note capital expenditure on store equipment at a constant amount of $482.62 (except in Month 8). Common sense will tell you that there isn’t right: no one spends such a precise amount on capex a month; and the matter requires further investigation. In this instance, investigation uncovered that this amount was in fact a lease payment. It was being incorrectly treated as capex and further, that the lease liability had not been recorded on the Balance Sheet ie the financial liabilities of the business had been understated on the Balance Sheet.
5. The Financing Activities section shows all monies that came in or was paid out in loans, dividends, equity raisings. Equipment finance payments are of constant amounts: if you take on a new lease or chattel mortgage, then there will be an increase in the month that the new facility was taken on but this increased amount will be the new constant going forwad. Any lumpy amounts (as in this case) or aberrations in amounts should be investigated.

   In this example, the aberrations arose from incorrect recording of the equipment finance liabilities ie both Profit & Loss and Balance Sheet were wrong!

   The sum of the Cash Flow From Operations, Investment Activities and Financing Activities is the net cash flow of your business – based on the numbers in your Profit & Loss and your Balance Sheet. It is the amount that should have gone into or out of your bank account. This is the amount by which your bank balance should have changed over the month.

6. This calculates the actual change in your bank balance as recorded on the Balance Sheet between the beginning of the month and the end of the month. If this amount does not equate to the net cash flow calculated in Line 7, there is a problem with the accounts and you had better start digging deeper into the numbers in your Profit & Loss and Balance Sheet, particularly if the discrepancy is large.
   In this example, the $50,392 arose from a litany of errors in the previous year’s accounts which flowed through via the opening Balance Sheet in Month 1. The $5,572 discrepancy in Month 9 arose from changes being made to the Profit & Loss account in prior months.

Hopefully this above provides a clear illustration of the importance of including the Cash Flow Statement in your monthly financial review as well as the importance of timely monthly financial reviews.

Accurate monthly accounts are crticial for ensuring you stay on top of your business and to gain the confidence of your bankers and your shareholders/investors.

If you are unclear about any of the matters discussed here, speak to your accountant, business advisor or contact me.

Summary

Timely 3-D financial reviews are a vital part of working on your business. Ignore it is asking for “tears before bedtime”. Contact me if you require assistance in implementing this vital process.