The Cash-Flow Statement

Another way to keep your cash flow under control is to monitor it correctly. But be sure to use the right cash-flow yardsticks. Because it can be difficult to derive cash-flow information from the usual financial statements, many managers gauge their cash flow either by adding depreciation back into net income or by using working capital from operations as a substitute. Both measures, however, are often at odds with actual cash-flow performance and can give off confusing, or even misleading, signals.

● Net income plus depreciation: Even though many financial pros do use this formula (cash flow = net income + depreciation) to define cash flow, it’s not entirely accurate. The formula represents more a measurement of profitability, or what some business researchers call gross cash flow, than net cash flow. For example, it’s a paradox of business that companies with little or no growth usually have fewer cash problems than high-profit, rapid-growth firms.

● Working capital from operations: Again, some use the working capital formula (current assets
– current liabilities = working capital) to measure cash flow. Even though working capital is expressed in dollars, it can’t be spent like cash. Working capital is a concept that doesn’t pay day-to-day bills; only cash does.

Flow-of-Funds Statement
A cash-basis presentation in your flow-of-funds statement avoids the potential problems of relying too heavily on working capital trends while, at the same time, quickly gives you a clear picture of your company’s overall liquidity. The flow-of-funds or cash-flow statement can be structured a number of ways—none of them complicated—to reflect changes in your cash position.

To be useful, your flow-of-funds statement should tell you whether your operations are generating enough cash to support expenditures. Specifically, you will want to know how much cash was generated from operations, how much cash was used, and whether your net cash positions improved or deteriorated during the year. In condensed form, your statement might look like this:

ABC Corporation: Flow of Funds (000s)

Net cash provided by operations $37,000
Uses of cash:
Dividends (20,000)
Interest (net of tax) (5,000)
Financing activities 7,000
Increase (decrease) in net cash $19,000
Net cash balance—
beginning of year $15,000
Net cash balance—end of year $34,000

In this case, the net cash generated by ABC Corporation’s overall operations was more than sufficient to take care of interest charges and a hefty dividend payment. Moreover, financing provided a further increment to cash resources. All in all, cash and cash equivalents more than doubled during the year—an admirable performance.

➤ Observation: The definition of net cash provided by operations is the key to the statement. Normally, this figure encompasses cash raised from sales, less out-of-pocket costs of goods sold and other out-of-pocket expenses. Cash sales means just that. Notes and accounts receivable do not qualify and must be deducted from sales. However, if notes or accounts receivable decline, extra cash is coming into the company and sales should be adjusted upward. Cash cost of goods sold consists of the actual dollars spent for manufacturing during the period. An increase in inventory means that extra cash was spent, so the cost of goods sold should be adjusted upward. A downturn in inventories lowers your cost of goods sold. Conversely, a decrease in accounts or notes payable indicates additional cash payments and raises the cost of goods sold, while an increase lowers the item.

Keep in mind that you must also adjust other expenses to reflect cash transactions. If accrued liabilities declined, cash was used to pay them off, so add that amount to cash expenses. An in¬crease in accrued liabilities should be deducted from cash expenses. If prepaid expenses rise, add the amount to cash expenses; if they decline, reduce cash expenses commensurately.

Making Your Cash Count
Be aware of the opportunities that can enhance the cash you have on hand to meet short-term expenses. For example: Participation in electronic funds transfer (EFT) programs generally leads to a reduction in payment costs, compared with the use of checks. Moreover, by arranging for discounts in return for fast payment, you can reduce receivable carrying costs.
Also consider keeping your money in money market accounts. By combining your present checking account with a money market deposit account, you can put your liquid assets to work and save yourself most activity fees in the bargain. Look for other ways or programs that banks have to improve cash management.

Managing a Financial Emergency
Even if you make all the right moves in managing your cash flow, including reliable forecasts, accurate analysis reports and up-to-date liquidity studies, you may still wind up in the midst of a financial emergency. The reason is simple: Many such emergencies are caused by events outside management’s control, such as an international financial crisis or a severe recession.

All financial emergencies have one common characteristic: If not dealt with quickly, the resulting dilemmas create more problems and become a drag on every facet of operation and planning. For this reason, a financial contingency plan should be part and parcel of every cash-management program. The objective of your financial contingency plan should be to quicken your response time to unforeseen financial strains. No two financial contingency plans will be the same simply because no two companies are alike. Nevertheless, every plan should contain basic elements:

● Develop an early warning system: Earlier, we observed that early warning is the key to effective cash management. Nowhere is this more true than in dealing with a cash crisis. The first step is to determine which key variables have the greatest impact on the financial viability of your firm. These variables will differ from firm to firm. For some, inventories will be the culprit. Still others might find loan interest to be the chief burden.

Also, keep close watch on the assumptions that have been built into your cash-flow forecasts. Oftentimes, the fact that one or more of the assumptions have proved invalid is the earliest warning sign of impending difficulty. For instance, if your forecast assumes that interest rates will drift lower and they go up instead, your company could be headed for trouble, particularly if you will need to do some financing.

Further, you should take a close look at your company’s history to find the cause and cure of past financial crises. History may not repeat itself; but even if it doesn’t, your knowledge of how past difficulties have been overcome should yield positive results when dealing with the next crisis.

● Set your priorities: Once you have identified an emerging financial crisis, you will need to know the following: (1) what can be done; (2) how long will it take; and (3) how much cash you can raise. The best way to obtain this information is to establish a list of priorities, organized around the four types of management decisions discussed in the beginning of this section. To that, you could add potential financing sources, so your priority list probably would wind up looking something like the sample on page 54.

Priority List
Type of Action Estimated Cash Response Time
Timing Changes
Speed Collections


Delay Supplier Payments
Delay Capital Expenditure
Other
Policy Changes
Reduce Inventory


Reduce Dividend
Cut Capital Expenditure
Reduce Expenses:
Administration


Production
Sales
Volume Changes
Cut Part‑Time


Cut Overtime
Cut Shift
Layoffs
Irreversible Policy Changes
Liquidate Assets


Financing:
Short‑Term


Long‑Term Equity
➤ Observation: Each type of action has its own strengths and drawbacks. For instance, tim¬ing changes are easy to implement but can go only so far and will merely delay the inevitable in a protracted crisis. Volume changes can change cash-flow patterns in a hurry but are effective only when the emergency is related to declining sales. Policy actions offer the most fertile field for cutting expenses, but they take time and can also delay a recovery. All things considered, the best approach usually involves a combination of decisions, each supplementing the other.

● Establish an emergency reserve: Once you understand what kind of actions can be taken in an emergency and how long they might take, you can set up a sort of insurance policy in the form of an emergency reserve. The size of the reserve is up to you. It should depend, however, on the length of time it will take to mobilize your other cash resources, and the estimated size of a cash drain during an emergency.

For example, if you estimate that it would take four business days for an initial emergency response to yield cash and your maximum cash drain could be as high as $5,000 per day in an emergency, you would need a reserve of $20,000 for full protection.

To be effective, the reserve must always be available at a moment’s notice. Therefore, most traditional investments, such as Treasury bills, are out, even though they may be perfectly safe. Usually, such reserves are held in money market funds or in an interest-bearing account. However, an unused line of credit would suffice if the funds were committed by the bank.

Summary: The cash management system set forth in this section can make a considerable contribution to your firm. Thoughtfully used, it will identify cash-flow imbalances before they become major problems and point the way toward their solutions. Consequently, when your cash flow is on an even keel, you can devote much more time to another important matter: building your company’s revenues in a scope and sequence that contribute directly and effectively to an overall profitable operation.