Every Cash Flow Statement I've seen from an accounting software sucks (looking at you, QBO)😿. It's a shame because the Statement of Cash Flows (SCF) is one of the most practical financial statements to really understand the health of a business. 🩺

If you read the breakdowns of the downfall of Enron, the SCF and related party disclosures were throwing red flags 🚩 years before it all came down.

So what is the SCF and how can you use it? Let's dig in 👇

I created the meme above to demonstrate how easy it is to get lost in business terminology and vanity metrics. When assessing the core value of a business, what matters most (especially for small and medium size business) is how much and from where cash is coming. 💰

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How the SCF is Built

There are three "basic financial statements" in Generally Accepted Accounting Principles (GAAP): the balance sheet, income statement, and statement of cash flows. ☘️

The balance sheet is a snapshot 📸 at a specific date of the assets, liabilities, and (book) equity position of a company. It's where you'll find cash balances, how much customers owe you, how much property and land you have, how much you owe vendors, the debt balance, and how much book value in equity is.

The income statement is a summary over a specific time frame (usually a year) 🗓️ that captures how much revenue (income) and expense was incurred by the company. It has basic sections of Income, Costs of Goods Sold, General and Administrative, Other Income / Gains (Losses). When you add back Interest, Taxes, Depreciation / Amortization, you get EBITDA - a popular metric for valuing businesses.

The cash flow statement is a combination of the two other statements. 👨‍👩‍👦 Using basic algebra, we know that if last year's balance sheet balanced, and this years balance sheet balances, then the change in cash is driven by other balance sheet items. The SCF helps you pinpoint the source or use of cash in the business. For example, it will tell you if the business' core operations is generating cash or if debt or equity are the primary sources.

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SCF Sections

There are three sections to a quality (and GAAP-compliant) SCF:

Cash Flow from Operating Activities

The most common presentation (there are two acceptable ways) of the SCF is the "indirect method." ↩️ This starts with net income from the income statement and backs out (adds back) any non-cash income or expense. For example, depreciation expense is a non-cash deduction - so it get's added back to calculate the cash generated by the company.

You then adjust for the changes in current assets and liabilities 💵 - or balance sheet accounts that include activity supporting business operations. For example, if accounts receivable increased year-over-year by $1,000 then that had a negative impact on cash generated by accrual net income. Vice versa for liabilities like accounts payable - if those increased year-over-year then it was a "source" of cash compared to accrual net income.

Net income +/- add backs +/- working capital-type balance sheet account changes = Cash Flow From (Used in) Operations. You generally want this number high for an SMB as it shows that a business can support itself based on operations alone. 🩻

Cash Flow from Investing Activities

Generally, this is where changes in long-term assets are adjusted for. ⚙️ For example, if a business bought $5,000 in new equipment, that would represent in a $(5,000) use of cash that wouldn't show up in accrual net income. This is also where non-operations based investments in assets would be recorded. 📈

This is generally a Use of Cash section unless you are selling investments the business has made in the past.

Cash Flow from Financing Activities

This is where we see impacts of long-term liabilities and equity recorded. This is where you record the cash impact from borrowing more money from a bank 🏦 or raising more capital from investors 👨‍🦱 - as those would be income statement neutral items, but would impact your cash balance.

This is also where principal loan payments (only principal, as interest expense is in accrual net income) and investor distributions are recorded.

Unlike Operating Activities, a consistent amount of positive "sources" from Financing Activities may represent start-up operations or an unprofitable business. 😬

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How To Use It

Once you get a hold of a properly presented SCF, it can help you in several ways.

1. Run a common size analysis of Cash Sources: 💯 look at how much cash was produced by, or used in each section. Use it to narrow down where most of the cash is being used in the business - a key to lowering overall cost of capital.
2. Dig into Operating: where is most of the cash being used in the operating section? 🤷‍♂️ Could be that AR is growing, or AP is shrinking. Use this as a guide to read the balance sheet and look for ways to make operations self-sustaining.
3. Analyze the War Chest: 🏴‍☠️ the investing section represents hard assets and (hopefully) strategic assets to support the business long-term. Make sure the assets purchased accomplish that strategy. The business is not a place for "moon shot" investments or random K1s to go.

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A qualify SCF can also pave the way for proper planning and forecasting. 🌡️ By projecting forward the income statement and balance sheets, you can predict how much cash the business will need or will generate in the next quarter, half, or year +.

In my time as a financial statement auditor, I built hundreds of cash flow statements by hand in excel for small businesses. I would say that most of my client's lenders never read them, or knew how 🤏 - which is a shame because it's a big tell on the pulse of the company.

And as a last point - if you run a SCF from your accounting software, know that the issues are usually: (1) bad categorization, and (2) incorrect or non-existent add-backs to Operations. It's terrifying how many of these straight print-outs have been provided to lenders just as a check-the-box item. They really take some massaging 💆‍♂️ to get right, but it's worth it as a unique tool for deep insights into a business.

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