Where Does the Cash Go Answers

Tom Crouser August 21, 2012 Comments Off on Where Does the Cash Go Answers

Thanks to those who attended my webinar on this topic last Friday. In essence the answer is that the Statement of Cash Flows tells us precisely where the cash goes and ties the Income Statement into the cash accounts. Several specific questions came up during and after the session so here are my answers to those.

+ Question: What have you found to be the most common cause/source of decreased cash available for profitable companies? What do you recommend be done to minimize this?

Tom: For profitable companies, the most common issue is that an increase in sales requires cash to be used for an increase in receivables and/or inventory. You don’t necessarily want to minimize this; rather you want to avoid spending your cash on other things such as dividends (withdrawals or distributions) or purchasing equipment. That’s where a Statement of Cash Flows is beneficial … it shows you where you cash is going and helps minimize overspending.

For unprofitable companies, the most common issue is that cash goes out to pay for current operating expenses, of course. Sales of $1 million does little good if it cost $1.2 million in direct materials, wages and overhead. That’s where a good cash-flow budget can help you see the problem before it becomes a problem.

+ Question: My cash at end of period matches my balance sheet but my cash at beginning does not – Any idea why not?

Tom: Not really except that there’s an error in the calculation somewhere. Your professional accountant can help you track that down.

+ Question: You showed all receivables, including payroll tax and sales tax payable decreasing. Isn’t that unrealistic if sales and profits are strong? I know it is just an illustration, but it doesn’t seem to match the real world.

Tom: It appears we’re mixing metaphors here -> receivables are an asset and payroll tax and sales taxes payable are liabilities so the two are opposite. So it is quite common for accounts receivable to go down -> creating cash -> and then the cash be spent on paying off current liabilities (such as accounts payable and taxes payable). This happens mostly during a stable or decreasing sales period.

The flip side, during periods of rapidly increasing sales, you could expect an increase in receivables as well as liabilities which is the exact opposite of what I illustrated. The full illustration of the Statement of Cash Flows, which I used, was one such example taken from a real company.

And note, net income can increase on lower sales, especially if a company sheds marginally profitable work. So sales and “profits” are not necessarily in lock step with each other. So, yes, both match the real world. Course there are a whole bunch of potential variations on the same theme.

+ Question: So a “loss” of cash due to paying down a loan is not necessarily a bad thing unless it gets in the way of other current obligations.

Tom: Absolutely and a great question. First thing we should protect is our current ratio (current assets / current liabilities) and second is our days’ cash on hand (which should be 30+ and can be estimated by dividing annual sales by 365 and then multiplying by 30 – not precise definition but close enough for most of us).

I have worked with a number of folks who are (least were) debt averse. They would take all their cash and focus on paying down their non-current liabilities without considering their current liabilities. Then they’d get in trouble when adversity hits without any cash to compensate.

So IF one has a good current ratio (2:1 is standard) and enough cash on hand (30 days) THEN any cash in excess of the 30 days may be used to reduce non-current liabilities (noting that the current portion includes the next 12 months of note payable) and that would typically be a good thing.

+ Question: What time period should we use for our Statement of Cash Flows?

Tom: The Statement of Cash Flows is (or should be) one of the financial statements and included just as often as financials are received. I strongly advocate that to be monthly for a number of reasons but some prepare it quarterly.

To read more on this click on this article, Why Net Income Doesn’t Mean Cash

Hope this helps.

Tom

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