The three most well-known financial statements used by stakeholders are the balance sheet, the income statement, and the cash flow statement. While all serve an important purpose in monitoring a company’s financial health, I’m an advocate for strong cash management practices in all organizations, particularly at an operational level. Hence, I have a bias for cash flow reporting.
Why Managing Cash Flow is Important
Aids short-term and long-term financial planning
To remain solvent, a company must have adequate inflows to meet its obligations, both operating costs such as cost of goods sold, wages, rent, maintenance, and other SG&A expenses and non-operating costs such as debt repayment, equipment purchases, interest, and dividend payments. The report provides management with information on cash-on-hand, future cash receipts and payments which helps financial managers understand what activities a company needs to prioritize.
Provides insight into all spending activities
In addition to operating expenses, the cash flow statement provides information about the types of payments not included on the income statement. For example, while principal repayments on debt financing or purchases of equipment are excluded from the income statement, they are included in the cash flow statement, thus providing a complete picture of the actual cash a business is spending.
Provides opportunities to improve cash flow
When businesses focus on cash management, managers can identify opportunities to improve operating cash flow such as:
- Requesting deposits on services, offering discounts on accounts receivable or factoring accounts receivable to accelerate cash inflows.
- Negotiating favourable payment terms with vendors to delay cash outflows.
- Applying Just-in-Time inventory management techniques to reduce payments and increase payment frequency to smooth out cash outflows and improve turnover.
Because the cash flow statement provides business stakeholders with information on whether they have a shortage or an excess of cash on hand, the report can help with crisis management (e.g. Covid-19). If management is alerted to a potential cash shortage, it can develop tactics to address such a challenge ahead of time. This can make an enormous difference to a company’s ability to survive challenging times.
Two Ways to Calculate Cash Flow Statements
The cash flow statement can be calculated in one of two ways: the direct method or the indirect method. Understanding how these approaches differ can help a company determine which to use for managing its cash and effectively oversee its finances.
The main difference between the two methods is how they calculate the “operating” cash flow.
The direct method
The direct method calculates the operating cash flow by listing all cash inflows and outflows during the reporting period by type (i.e. suppliers, customers, employees, landlord,). This method provides a more detailed view of the cash inflows and outflows.
Investing activities (i.e. purchase or sale of long-term assets, such as property, plant, and equipment, and investments in securities) and financing activities (i.e. issuance or repurchase of a company’s own stock, the issuance or repayment of debt, and the payment of dividends to shareholders) are included and netted from operating cash flow when calculating the net change in the company’s cash flow.
While this method is more rigorous and time consuming to prepare, it can help a business obtain a more accurate picture of its spending habits and patterns.
Essentially the direct method presents all cash receipts and disbursements by type going through the cash account, just as in the old days before online banking you would go through your cheque book.
The indirect method
The indirect method calculates the operating cash flow by adjusting net income for non-cash items such as depreciation, amortization, accrued interest and deferred taxes and non-cash working capital items such as accounts receivable, inventory, prepaid expenses, accounts payable, and accrued liabilities. This method is less detailed than the direct method, but it’s easier to prepare. It also includes investing and financing activities described above to arrive at the net change in cash flow.
Both methods provide valuable information about a company’s cash flow, but the direct method is more useful for small businesses with simple operations, while the indirect method is more useful for larger businesses with complex operations.
I recently worked with an early-stage company where we used both methods; the indirect method to report externally and created a “Cash Headroom Report (CHR)” for internal reporting based on the direct method. It analyzed daily and weekly cash flow for a three and six month window. The objective of this report was to alert management to possible “cash valleys” and plan strategies to manage them. We found this very useful for managing cash during the pandemic.
Things to consider when choosing which method
Company size can affect which cash flow statement method to use. For example, the direct method may be more appropriate for small businesses which have a low volume of transactions and simpler business arrangements makes listing the company’s transaction types easier A large company will have a high volume of transactions and more complex business arrangements, the indirect method should be considered to make creating a cash flow statement more manageable.
Consider determining what resources can be allocated to creating cash flow statements. It may be hiring additional staff or purchasing advanced software. Even though the direct method is more rigorous, it can help a business obtain a more accurate picture of its spending habits and patterns. If adequate resources are available to implement the direct method, the expense may be worth it by making the business more aware of its spending patterns.
When considering which method to use, focus only on how it applies to the operating activities section of the cash flow statement. As mentioned earlier, the investing and financing sections are presented in the same manner, regardless of the method chosen.
While the balance sheet and income statement are important reports for monitoring a company’s health, I believe an effective cash management reporting system is key to contributing to a company’s sustainability.
Ultimately every company must generate a positive cash flow which contributes to an enterprise’s value and provides a return to its owners.
As they say, “Cash is King”.