Your cash flow statement is arguably your most important financial report, as it lays out the cash coming in and out of your business. It shows whether your current operations can sustain your business. Where cash flow management gets difficult is in interpreting your numbers and determining whether positive (or negative) cash flow is a one-off occurrence or a more serious problem waiting to happen.
Let’s look at how to read your cash flow statement to better run your business.
Cash flow statement layers: Operating > Investing > Financing
Cash flow statements are broken down into three main types of cash flow: operating, investing, and financing. Each serves its own purpose, but still influences the others.
Operating cash flow: Testing the quality of your ‘earnings’
Your operating cash flow is the money generated from trading activities minus your business expenses. Think of this level as your profit vs. cash: for your business to sustain itself, your operating cash flow should track higher than your net income. If it’s not, it means your business isn’t covering its operating costs because cash is tied up elsewhere, maybe in excess inventory or accounts receivable.
Here, you add back non-cash expense items, such as depreciation and amortisation. A quick way to assess your cash flow health is to use the quality-of-earnings ratio.
Quality of earnings ratio = operating cash flow / net income
A good quality-of-earnings result is indicated by a number above 1.0, which means trading funds your operations adequately.
Marty’s operating cash flow
Let’s look at an example of what operating cash flow looks like with Marty’s cafe:
Investing cash flow: Growth and maintenance
Investing cash flow comes from assets, whether spending on earning. At this layer, just having cash outflows doesn’t spell disaster, since this money maintains or grows the business (or both). You have to spend money to make money; the real question is whether your capital expenditure (CapEx) can be funded by your operating cash flow while still having cash to spare.
This is expressed as free cash flow, the cash left over after expenses and CapEx.
Free cash flow (FCF) = Operating cash flow – capital expenditures
Free cash flow (FCF) gives you flexibility and breathing room for debt refinancing and reinvestment.
Marty’s investing cash flow
Marty has found his operating cash flow, but how does it compare to investing in his business’s productivity?
Financing cash flow: Sustainably servicing your debts
When it comes to operating and investing activities, you’re trying to ensure your business sustains itself and can grow; at the financing layer, however, you’re looking to fund your business from external sources. Is it enough to finance growth, or are you just plugging holes in your shortfall?
Marty’s financing cash flow
Marty’s financing activity is the final layer that completes his cafe’s month-end cash flow statement:
Interpreting your cash flow
Your cash flow statement helps you assess the health of your cash flow and forecast future cash flows (positive or negative). Just as you would scrutinise and interpret your profit and loss reports monthly, you also need to do so with your cash flow statements. By using both in tandem, you can better identify barriers to positive cash flow.
With your cash flow statement, pay attention to these key metrics to see where you stand:
- Quality of earnings ratio: Cash flow from operations divided by net income. Anything above 1.0 indicates that trading generates more cash than profit in your P&L. This gives you your baseline.
- Free cash flow: Operating cash flow minus capital expenditures. Operating cash flow needs to absorb investing activities so your business can support its operations while also growing. If not, your business is drawing down cash reserves or requires more financing.
- Monthly comparisons: Compare month-on-month to track your cash flow. These are helpful for preparing your cash flow forecasts for going into slow and peak periods, while also identifying negative cash flow instances as one-offs or trends.
Operating with negative cash flow
If cash flow is negative in a month, don’t panic. There will be times when you’ll have more money moving out from the business than coming in. Instead, determine how long you can survive with your current cash reserve in the cash runway ratio. By dividing your cash reserves by your monthly burn rate (total cash leaving the business per month), you get a ratio of how many months you can operate at a loss.
Marty’s Cafe: two months, side by side
Toggle between a healthy month and a month where stock changes the picture.
Mastering your cash flow
Cash flow management is about maintaining all three activities — operating, investing, and financing — and getting them to work in ‘sync’ with each other. To get the best use of your cash flow reporting, scrutinise your numbers monthly and assess your current and future cash flow health using reliable metrics (quality earnings ratio, free cash flow formula, and cash runway) and forecasting. With a clearer understanding of how cash moves in and out of your operations at each layer, you will be better able to sustain and grow your business.
